The Effect of the VAT Rate on Tax Evasion: Evidence from the Restaurant Industry in Greece

Abstract

This paper examines the effect of value-added tax (VAT) rates on tax evasion in an environment of limited tax-shifting opportunities. I focus on the recent rate reduction in the Greek restaurant industry (August 2013) and implement a difference-in-difference methodology using large fast-food restaurants as the control sample, due to the fact that they exhibit high constraints on underreporting. I find that the rate reduction for non-alcoholic sales, from 23% to 13%, significantly increases compliance; the reported sales to inputs ratio, which is used as a measure of disclosure of hidden sales, increases by 11.8% on average. I also document the reverse effect for the VAT rate increase in September 2011. The effect is more pronounced in small firms and firms with less alcoholic sales. These results are consistent with the partial adjustment of VAT revenues to the new tax rate, in order to maintain a reasonable VAT ratio (revenues to credits) that avoids signaling evading behavior to tax authorities (VAT ratio targeting). Finally, I show that, the overall fiscal cost from the rate reduction becomes minimal, accounting for the partial downward adjustment of VAT revenues and the higher direct taxes from the increase in reported sales.