Taxes "are the dues that we pay for the privileges of membership in an organised society".
As the quote from US president Franklin D Roosevelt in 1936 suggests, governments across the world need to collect tax revenue to be able to provide public goods and services to their citizens. There are a number of forms of taxes. The most common taxes are personal income tax, corporate income tax, and value-added tax (VAT).
South Africa's current VAT system is based on New Zealand's VAT system. It was and introduced in South Africa in 1991 at a rate of 10%, replacing the general sales tax system which was levied at 12%.
Since VAT is more broad-based than the general sales tax, the effect on tax revenue collected was deemed to be neutral in terms of tax revenue collection.
The South African VAT system is found to be mildly regressive, where a larger percentage of income is taken from the poor in comparison to the rich. But it is a good source of government revenue in comparison with other tax types, as individuals in the informal sector also contribute to the revenue stream.
Overall, the South African tax system is viewed as being progressive in nature, as the rich pay tax at a higher rate than the poor . Which is why VAT shouldn't be considered in isolation.
In an attempt to increase tax revenue collection, the VAT rate in South Africa was increased from 14% to 15% on 1 April 2018 after it had remained 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 in excess of R1 million in a 12-month period need to register as a VAT vendor. These vendors need to levy output tax on all sales made and are seen as agents of the revenue authority.
The entities can also claim input tax on all purchases made on which VAT was 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 Revenue Service.
Increasing the tax rate is a seemingly easy way to raise tax revenue. However, there are dangers. We explored one of these in our research - the effect of changes in the VAT rate on tax compliance behaviour by small businesses in South Africa.
Why small businesses?
The South African Revenue Service has indicated that small businesses are a high-risk sector as tax registration is particularly low in this sector. They have also indicated that an increased audit focus will be placed on small, medium and micro enterprises.
Our field experiment involved an online questionnaire that was completed by participants in managerial positions of small businesses. The participants were assigned to one of four possible treatment groups: where the participants experience either an increase or decrease of 1 percentage point in the VAT rate, or where the participants experience either an increase or decrease of 5 percentage points in the VAT rate.
Our aim was to determine whether an increase in the VAT rate might lead to larger tax evasion. The research also considered whether tax compliance behaviour would increase with a decrease in the VAT rate, since the benefit of evading taxes might seem less appealing. Some countries, such as Kenya, Greece, Belgium, Germany, Austria, Czech Republic, Bulgaria, Cyprus, Portugal and Moldova reduced their VAT rates in the wake of COVID-19 to provide some relief.
The issues are important because businesses might opt for non-compliance if the rate is raised. This defeats the objective of tax increases as less revenue is collected.
We found that tax compliance levels among small business did indeed drop when the VAT rate was increased, especially if the increase was a 5 percentage point increase.
Tax compliance is the term used to describe whether taxpayers meet their legal tax obligations. This includes registering as and when required, submitting all relevant tax returns on time, reflecting the right amount of tax liability and paying that liability on time.
Better tax compliance obviously leads to higher tax revenue being collected for a government.
The study found that small business entities are inclined to reduce the VAT liability when there is an increase in the VAT rate. This may possibly be because the entity perceives it to be financially more beneficial to evade taxes when there is an increase in the VAT rate, even if considering the penalties charged if caught cheating (expected utility theory). They do so by overstating purchases rather than under-declaring sales. This leads to an increase in non-compliance and a decrease in tax revenue collection.
The greater the magnitude of the VAT rate increase, the greater the level of non-compliance.
No significant relationships were identified between a decrease in the VAT rate and tax compliance.
The results could be valuable 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 in prospect may, therefore, be preferable to large scale, once-off increases.