VAT’s self-enforcement mechanism is powerful and also its greatest weakness. In Rwanda, China and Ethiopia, e-invoicing systems show promising early results in improving enforcement and compliance.
Evidence from some low-income countries suggests that electronic invoicing systems, which report sales data to the revenue authority in real time, may improve value-added tax (VAT) enforcement and compliance.
But it’s too early to say whether the magnitude of the revenue gain outweighs the cost of implementing such a system, for both taxpayers and the tax administration.
The problem with VAT
VAT recently turned 100 and, for a centenarian, it is showing few signs of slowing down – it has been adopted in more than 160 countries, where, on average, it contributes 30 per cent of total tax revenue.
VAT’s popularity is partly explained by its self-enforcement mechanism. Firms can deduct VAT paid on their inputs from their final VAT liability, so they have an incentive to ask their suppliers for an accurate receipt.
And since the tax authority receives records from both buyers and sellers, their ability to cross-check data deters false reporting.
Yet, VAT’s strength is also its greatest weakness. The self-enforcement mechanism breaks down in two situations:
- When firms sell to final consumers (who have no built-in incentive to ask for an accurate receipt).
- When taxpayers don’t believe that the threat of detection is credible and misreport their input costs or sales.
How e-invoicing might curb tax evasion
An e-invoicing system records business transactions, automatically applies the correct taxes, issues accurate and traceable invoices, and reports sales data to the revenue authority – all in real time.
Since the tax authority can more easily match buyer and seller invoices – ideally through automated cross-checks – taxpayers should not be able to claim input VAT credits without a matching report from a seller.
In theory, the system should curb evasive behaviour in two ways:
- By generating a more accurate digital ‘paper’ trail, it allows the tax authority to improve monitoring and increases the (perceived) probability of detecting evasion.
- If the system provides clearer records of transactions and facilitates pre-filled tax returns, this might increase voluntary compliance by making tax filing easier.
In practice, e-invoicing systems show promise
E-invoicing systems are growing in popularity in lower-income countries, and the evidence points to some promising early results.
- Rwanda has mandated that all VAT-registered businesses use electronic billing machines (EBMs) — a physical point-of-sale device that remits data to the tax authority. VAT revenue has since increased by about 5 per cent.
- China saw an even larger increase of 14 per cent, due to automatic invoice-matching which reduced over-claiming of VAT deductions.
- Ethiopia has seen similar effects on accuracy, where electronic sales registry machines (ESRMs, another point-of-sale device) increased VAT revenues, spilling over into higher reported corporate income tax.
Risks of e-invoicing
The risks of e-invoicing have led some researchers to argue that the digitalisation of tax systems places small firms at risk of “premature formalisation”, where their tax compliance costs increase faster than any gains in productivity.
A study in Ethiopia found that while ESRM adoption increased reported sales, taxpayers simultaneously adjusted their reported costs by more than the increase in sales. This dampened the overall revenue effect. It also suggests that taxpayers might respond to enforcement by shifting their tax-evasive behaviour to less-verifiable margins.
In Rwanda, during focus group discussions with taxpayers, researchers found that many smaller taxpayers faced practical difficulties in adopting EBMs, including expensive charges, intermittent connectivity, and uncertainty over correcting mistakes.
Evidence from Rwanda also shows that some firms say that they have adopted e-invoicing, but don’t issue electronic invoices unless customers explicitly demand them.
In Peru, evidence shows that e-invoicing can have undesirable spillover effects on a firm’s supply network. While non-adopting firms reported higher sales and more VAT when their trading partners adopted e-invoicing, they were also less likely to continue trading with a partner who had adopted e-invoicing. This suggests potential market segmentation, which can lead to inefficient economic decisions and – for the firm – lower productivity.
It is also unclear whether tax authorities, particularly in Africa, are taking full advantage of the vast data that e-invoicing systems generate. Structural constraints at revenue authorities, especially in software and data wrangling skills, mean that simply generating more data cannot alone cure VAT’s ailments. Revenue authorities will also need to adapt internal processes, incentivise tax officials correctly, and invest in IT skills.
Research from Rwanda showed that, despite the roll-out of EBMs, there were widespread discrepancies across VAT reports from buyers and sellers, largely due to transactions not being reported by one trading partner. There is hope though: more recent interviews with tax officials from Rwanda indicated that automated data checks have since been set up. They are now cross-checking self-reported sales on income tax declarations with the value of total sales from EBM records.
Will e-invoicing be another white elephant? While the promise exists, we are far from understanding how to maximise the return on investments in new technologies for tax administration.
Suggested reading on e-invoicing systems
- Ali M, Shifa AB, Shimeles A & Woldeyes F (2021), Building fiscal capacity in developing countries: Evidence on the role of information technology, National Tax Journal.
- Bellon M, Dabla-Norris E, Khalid S & Lima F (2022), Digitalization to improve tax compliance: Evidence from VAT e-invoicing in Peru, Journal of Public Economics.
- Bellon M, Dabla-Norris E, Khalid S, Paliza JC, Chang J & Villena P (2022), Digitalization and tax compliance spillovers: Evidence from a VAT e-invoicing reform in Peru, IMF Working Papers.
- Fan H, Liu Y, Qian N & Wen J (2020), Computerizing VAT invoices in China, NBER Working Paper.
- Mascagni G, Mengistu AT & Woldeyes FB (2021), Can ICTs increase tax compliance? Evidence on taxpayer responses to technological innovation in Ethiopia, Journal of Economic Behavior & Organization.
- Okunogbe O & Santoro F (2023), Increasing tax collection in African countries: The role of information technology, Journal of African Economies
- Zeitlin A & Eissa N (2015), Evaluation of electronic billing machines: effectiveness of tax administration, IGC Project Memo.