Income Tax Credits for Consumer Services: A Tool for Tackling VAT Evasion?

Abstract

This paper analyzes the effects of an income tax credit on evasion of the value-added tax (VAT). Based on the individual tax returns of the universe of VAT payers in Germany our analysis shows that harnessing incentives of consumers as third-parties in the last VAT stage through tax credits fosters firms' compliance with VAT. Our results point at strong stimulating effects of the introduction of the tax credit on reported sales as well as on the ratio of output to input taxes. However, only about half of the increase in reported sales can be ascribed to a decline in tax evasion. Based on our results, the response at the VAT evasion margin alone is not fully sufficient to recover the revenue losses associated with the tax credit. But when taking into account the formalization effects in social security contributions, the increase in net-revenues is likely.