Tax Evasion in an Open Economy: Value-added vs. Income Taxation

Ignoring tax evasion possibilities, a value-added and a cash-flow income tax have similar behavioral and distributional consequences. Yet the available means of tax evasion under each can be very different. Under a VAT, avoidance occurs through cross-border shopping, whereas under an income tax it can occur through shifting taxable income abroad. Given evasion, we show that a country would make use of both taxes in order to minimize the efficiency costs of evasion activity, relying relatively more on whichever tax is harder to evade. We then make use of aggregate Danish tax and accounting data from 1992 to measure the amount of evasion that occurred under the two taxes. While the estimates of evasion activity are small, the figures imply that Denmark could reduce the real costs of evasion activity by relying more on value-added taxes.