Taxes “are the contributions we pay for the privileges of belonging to an organized society.”
As the quote from US President Franklin D Roosevelt suggests in 1936, governments around the world must collect tax revenue in order to provide public goods and services to their citizens. There are several forms of taxes. The most common taxes are personal income tax, corporation tax and value added tax (VAT).
South Africa’s current VAT system is based on the New Zealand VAT system. It was introduced in South Africa in 1991 at a rate of 10%, replacing the general sales tax system which was levied at 12%.
As the VAT has a broader base than the general sales tax, the effect on tax revenue collected was considered neutral in terms of tax revenue collection.
South Africa’s VAT system turns out to be slightly regressive, in which a larger percentage of income is levied on the poor compared to the rich. But it is a good source of public revenue compared to other types of taxes, as individuals in the informal sector also contribute to the income stream.
Overall, the South African tax system is seen to be progressive in nature, as the rich pay taxes at a higher rate than the poor. Therefore, VAT should not be viewed in isolation.
In an effort to increase tax revenue collection, the VAT rate in South Africa was increased from 14% to 15% on April 1, 2018, after remaining unchanged for 15 years (since 1993).
The increase in the VAT rate resulted in an increase in VAT payments of 4.2% in 2018/19 and 5.8% in 2019/2020.
All entities that make sales in South Africa greater than R 1 million in a 12 month period must register as a VAT seller. These sellers must levy an output tax on all sales made and are considered agents of the tax administration.
Entities can also claim input tax on all purchases made on which VAT has been levied, if it is used for business purposes. The net amount remaining after subtracting the input tax from the output tax must be paid to the South African Tax Service.
Raising the tax rate is a seemingly easy way to increase tax revenue. However, there are dangers. We explored one of these in our research: the effect of changes in the VAT rate on the tax compliance behavior of small businesses in South Africa.
Why small businesses?
The South African tax administration has indicated that small businesses are a high risk sector as tax registration is particularly low in this sector. They also indicated that an increased focus of the audit will be on small, medium and micro enterprises.
Our field experience involved an online questionnaire that was completed by participants in small business leadership positions. Participants were assigned to one of four possible treatment groups: where participants experience a 1 percentage point increase or decrease in the VAT rate, or where participants experience a 5 percentage point increase or decrease of the VAT rate.
Our objective was to determine whether an increase in the VAT rate could lead to greater tax evasion. The research also examined whether tax compliance behavior would increase with a decrease in the VAT rate, as the benefit of tax evasion might appear less attractive. Some countries, such as Kenya, Greece, Belgium, Germany, Austria, Czech Republic, Bulgaria, Cyprus, Portugal and Moldova have reduced their VAT rates following COVID-19 to offer some relief.
The stakes are high because companies could opt for non-compliance if the rate is increased. This defeats the goal of raising taxes, as less revenue is collected.
We found that tax compliance levels among small businesses did decrease when the VAT rate was increased, especially if the increase was 5 percentage points.
Tax compliance is the term used to describe whether taxpayers meet their legal tax obligations. This includes recording as needed, submitting all relevant tax returns on time, reflecting the correct amount of tax payable, and paying that tax on time.
Better tax compliance obviously leads to higher tax revenues for a government.
The study found that small businesses are inclined to reduce VAT liability if the VAT rate increases. This may be because the entity considers it financially more advantageous to evade tax when there is an increase in the VAT rate, even considering the penalties imposed in the event of fraud. (expected utility theory). They do this by overestimating purchases rather than underreporting sales. This leads to an increase in non-conformities and a decrease in the collection of tax revenue.
The greater the increase in the VAT rate, the higher the level of non-compliance.
No significant relationship has been identified between a reduction in the VAT rate and tax compliance.
The results could be of value to policymakers in countries considering a change in the VAT rate to increase tax revenue.
Our research suggests that a small increase (one percentage point) in the VAT rate could limit the extent of non-compliance compared to a large increase (five percentage points).
A graduated and carefully calibrated approach, where rate increases are considered, may therefore be preferable to one-off large-scale increases.