We Can Solve the US State Sales Tax Gap by Looking Overseas

The sales tax gap—the difference between taxes owed and taxes collected—for any given US state is very difficult to ascertain. State taxing authorities only find out about a transaction when it’s reported by one of the parties to it. We can only estimate how much tax revenue is going uncollected or unremitted through extrapolation and audit of suspected noncompliant businesses.

But in another hemisphere, Fiji has introduced and proven an effective digital invoicing system that closes the information gap, ensuring all transactions subject to their sales tax equivalent, a value-added tax, are reported to the tax authority. This system could serve as a model for state tax authorities in the US.

Information Problem

Tax gap preconditions come from asymmetry in information between parties to a transaction and the taxing authority. US businesses are tasked with both collecting, and later remitting, the sales tax owed and maintaining accurate business records to substantiate the transaction.

In the absence of records held by the business, the state tax authority will have no knowledge of the sale whatsoever—and won’t know to look for the unremitted sales tax collected by the business. The state also won’t know there’s income tax owed by the business on the profit from that transaction.

This information gap creates a substantial financial incentive for businesses to find ways to make cash transactions disappear, spurring an entire cottage industry of sales suppression techniques. More than 30 states have outlawed possession of so-called zappers, tools used by fraudster-businesses to delete cash transactions from their data.

Fiji Closes Loophole

Fiji subjects all taxable transactions, be they business to business or business to consumer, to a mandatory digital invoicing system. This system basically requires businesses to issue digital receipts for taxable sales to the consumer in the transaction. These digital receipts, or invoices, are simultaneously issued to parties to the transaction and the tax authority in real time.

Applying a similar system to US states and the information gap problem, any taxable transaction would produce a receipt shared with the parties and the state tax authority. The business wouldn’t have any incentive to “zap” their copy of the data, because the tax authority is already aware that they have collected and will now need to remit the sales tax owed.

This creates a paper trail even for cash transactions and allows for real-time auditing by the tax authority. Data manipulation or sales suppression becomes impossible, as the business’s record of invoices needs to match with the invoices held by purchasers and the authorities.

The other side of that coin is that it saves the business the administrative trouble of turning their accounting records into fiscalized records with the tax authority.

Such a rollout could make use of existing initiatives, such as the Streamlined Sales Tax Governing Board model Sales and Use Tax Agreement, which already has 23 full member states and Washington, D.C.

A person typing at a backlit computer keyboard arranged in Danbury, U.K., on Dec. 29, 2020.

Photographer: Chris Ratcliffe/Bloomberg via Getty Images

Need for Uniformity

This solution does have some challenges. Rolling out a real-time reporting mechanism for every taxable transaction in a state is a significant investment in both money and labor. Some countries have met this challenge by disaggregating the enforcement mechanism to individual consumers.

In Taiwan, invoices must be issued for all taxable transactions, and the consumer can retain their invoice to enter a bimonthly lottery. Consumers are thus incentivized to demand an invoice from every transaction and then report a unique identifier to the tax authority to enter the lottery.

The United Arab Emirates has also introduced a 5% VAT this year and announced plans to move toward digital invoicing. Japan has similarly introduced the Qualified Invoicing System, which requires taxable businesses to issue invoices for all transactions.

However, Japan provides a cautionary tale when such a system isn’t carefully implemented. Japanese businesses that have sales of less than 10 million yen (about $67,000), are exempt from the Japanese consumption tax.

That exemption has been maintained under the new invoicing system, but businesses seeking to receive a tax credit for consumption taxes paid must have a qualified invoice to do so.

In other words, a small business that wishes to attract business customers will want to register for and pay the 10% consumption tax. If the business can’t issue qualified invoices, it won’t be able to compete with other businesses that can.

This functionally ends the small business exemption in Japan and places the administrative burden, in addition to the actual tax burden, on those small businesses to register and be able to issue qualified invoices to remain competitive.

More generally, it highlights the need for uniformity in any hypothetical state transition to digital invoicing. Moving sector by sector or targeting businesses based on sales only chases the fraudsters to the exempted businesses and arbitrarily places an administrative burden on only some merchants.

Outlook

States have largely weathered both the pandemic and recent inflationary pressures well, with most exceeding revenue forecasts in 2023. Fiscal watchdogs have been blowing the budget deficit whistle for a while, however, and there are indications that at least some states’ cash-flush days are numbered.

When the specter of deficit inevitably darkens the steps of state capitols, there will be a mad dash to find sources of revenue—and all too often, there are spending cuts. Instead, state tax authorities should look at what has worked internationally to close the sales tax gap.

This is a regular column from tax and technology attorney Andrew Leahey, principal at Hunter Creek Consulting and adjunct professor at Drexel Kline School of Law. Follow him on Mastodon at @andrew@esq.social.