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International Review of Applied Economics

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VAT Evasion and VAT Avoidance: Is there a European Laffer curve for VAT?
Kent Matthewsa a Cardiff Business School, Cardiff, UK Online publication date: 21 July 2010

To cite this Article Matthews, Kent(2003) 'VAT Evasion and VAT Avoidance: Is there a European Laffer curve for VAT?',

International Review of Applied Economics, 17: 1, 105 114 To link to this Article: DOI: 10.1080/713673162 URL: http://dx.doi.org/10.1080/713673162

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International Review of Applied Economics, Vol. 17, No. 1, 2003

VAT Evasion and VAT Avoidance: is there a European Laffer curve for VAT?

KENT MATTHEWS

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ABSTRACT This paper estimates the VAT revenue maximising rate of VAT for the European Union for given conditions of non-compliance and other black economy transactions. It estimates a Laffer curve for the standard rate of VAT using a pooled sample of data of revenue statistics for 14 countries in the EU. The results confirm that the efficiency of the VAT system declines as the VAT rate increases. The decline in efficiency is due to a mixture of a reduction in the VAT base, and VAT evasion and avoidance. As a result of the single market, the EU Commission has proposed a common or closely converged rate ofVAT within Europe. The actual common rate ofVAT has yet to be decided. This paper contributes to this policy debate.

1. Introduction The past 30 years has seen the industrialised economies gradually shifting their emphasis from direct taxation to indirect tax as a revenue-raising tool. In 1965, indirect taxes raised an average revenue of 3.5% of GDP within the OECD. By 1993, revenue raised by indirect taxes amounted to 7.0%. Value-added-tax (VAT) is the most popular form of indirect tax. In the 1960s only nine countries levied a VAT. Today, 90 countries levy VAT. Within the OECD only Australia and the USA have no value-added-tax. Direct taxation in the form of income tax has always created tensions between the social objective of distribution, the economic objective of efficiency, and the fiscal objective of revenue maximisation. The latter objective in particular was addressed by Arthur Laffer in 1974 in the familiar Laffer curve. Concern about efficiency loss from adverse incentives (including tax evasion and avoidance) and the consequent negative effects on tax revenue was one of the many reasons that prompted the re-focus from direct to indirect taxation in developed economies. However, even indirect taxes create distortions and produce incentives to evade and avoid. Indeed, the potential negative effect of indirect taxes on revenue was recognised by Adam Smith who, in 1776, wrote in the Wealth of Nations; High taxes, sometimes by diminishing the consumption of the taxed commodities, and sometimes by encouraging smuggling, frequently afford
Kent Matthews, Cardiff Business School, Aberconway Building, Colum Drive, Cardiff, CF1 3EU, UK. E-mail: MatthewsK@Cardiff.ac.uk ISSN 0269-2171 print/ISSN 1465-3486 online/03/010105-10 2003 Taylor & Francis Ltd DOI: 10.1080/0269217032000048330

106 K. Matthews a smaller revenue to government than what might be drawn from more moderate taxes. This paper addresses the question, given the existing state of the black economy and the incentive to evade and avoid Value Added Tax, what is the revenue maximising rate of VAT in the European Union? The paper is organised in the following way. The next section outlines a model of VAT revenue determination. The third section presents some econometric estimates of a VAT Laffer curve for given conditions of evasion-avoidance and the state of the black economy. The final section concludes on the revenue maximising rate of VAT. 2. VAT Revenue Determination
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Any sales tax will distort consumption decisions and can distort production decisions if the good is used as an input into production. The latter problem is avoided by having a crediting system of Value Added Tax. Thus, an important economic argument for VAT is that it is the least distortionary in the production process and falls largely on the consumer.1 Unlike a general retail sales tax, which is levied on the consumer, a VAT is paid and reclaimed along each stage of production. While ultimately falling on the consumer (who has no right of reclaim) collection of the tax falls on the producer at each stage of the value-added process. Since, at each stage, the producer reclaims VAT paid on inputs, there is less (but not zero) incentive to evade. However, because there are fixed costs of compliance that fall on the producers, it is generally argued that VAT rates should not be levied at rates below 10% (see Hagemann et al., 1988). It has therefore been claimed that the self-policing nature of the invoicing method of VAT reduces the potential for evasion. However, as Hemmings & Kay (1981) note; The built-in policing that the invoice method is claimed to provide is illusory. Even on transactions between registered traders, a buyer has an incentive to ensure that an invoice is issued but none to ensure that tax is indeed paid. Such checks could only be made by first tracing all invoices issued by a trader when corresponding claims for repayment of input tax were made by any of the other 1.25 million registered taxpayers, and then matching the totals of these to that traders declared output, a task that is clearly impossible. This section sets out a framework for the determination of VAT revenues by the decomposition of its components and the modelling of the determinants of the VAT base. VAT revenues will depend on the VAT rate, the VAT base, and the rate of VAT compliance. Let Rjt = Revenue from VAT for country j at time t, Yjt = GDP at market prices for country j at time t, Bjt = VAT baseVAT rated consumer spending at market prices for country j at time t, vjt = the representative VAT rate for country j at time t,

VAT Evasion and VAT Avoidance


jt

107

= the compliance rate (proportion of VAT declared) for country j at time t, then; Rjt = and R Y
jt

vjt
jt

1 + vjt

Bjt

(1)

vjt
jt

1 + vjt

jt

(2)

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where jt is the VAT base as a proportion of GDP for country j at time t. Expression (2) states that VAT revenue as a proportion of GDP will increase directly with the VAT rate, an increase in the VAT base as a proportion of GDP, and an increase in compliance. The VAT base as a proportion of GDP will change with a change in the VAT base, the VAT rate itself, and the propensity for cross-border personal trade. The VAT base is given by the legal definition of goods and services that are rated for VAT payments. The VAT base will differ from country to country and is proxied by the proportion of consumer spending that is zero-rated and VAT exempted (zjt ) as a proportion of GDP. The higher the proportion of consumer spending that is zerorated and VAT exempted, the lower the VAT base. In addition, it is often the case that a change in the rate of VAT coincides with a change in the VAT coverage and therefore the VAT base. However, an increase in the VAT rate ( vjt ) will increase VAT revenues for unchanged expenditure on VAT rated items. However, the consequent increase in the retail price will cause a reduction in consumption of VAT rated goods and a possible reduction in the VAT base rate. The overall effect on the VAT revenue and the base is ambiguous. Taken together we can express jt as;
jt 1

= < 0,

(zjt , vjt )
2

(3)

= ?

where zjt is the proportion of consumer spending that is VAT exempted or zero-rated as a proportion of GDP in country j at time t and ( vjt is the change in the standard rate of VAT for country j at time t. The compliance ratio will be a function of the culture of the black economy in a country. It may be argued that national cultural factors contribute to the degree of tax evasion in countries. A considerable body of evidence relates the size of the black economy to the demand for currency (see Bhattacharyya, 1990, and for a recent review see Rogoff, 1998, and Schneider & Enste, 2000). The culture of the black economy is proxied by the ratio of Currency to GDP in each country. It is argued that countries with a high ratio of currency to GDP reflect (among other things) a greater level of black economy activity and a lower compliance ratio than countries with a lower currencyGDP ratio. The main focus of the theory of tax evasion has been about direct tax evasion. Relatively less attention has been devoted to the subject of indirect tax evasion. The theory of direct tax evasion as set out by Allingham & Sandmo (1972) is ambiguous on the effect of tax rates on evasion. A higher tax rate will increase the incentive to evade, but evasion is a risky activity and greater risk could result in increased

108 K. Matthews compliance. Marrelli (1984) has extended the Allingham & Sandmo (1972) framework to the indirect tax evading, risk averse, and imperfectly competitive firm. The standard results regarding the ambiguity of the effect of the tax rate on the compliance ratio follows through the assumption of risk aversion.2 However, Cremer & Gahvari (1993) show that compliance decreases for an increase in the indirect tax rate in the case of a competitive risk neutral firm.3 The number of VAT rates also open up the possibility of evasion through misclassification. A good example in the UK would be the misclassification of adult clothing as childrens clothing, which are zero rated. The higher the number of rates the greater the possibility to misclassify goods and the lower the compliance ratio (see also Agha & Haughton, 1996). The above discussion suggests that the aggregate determinants of the compliance ratio will consist of the VAT rate, the ratio of currency to income, and the number of VAT rates in an individual country. The ambiguity of the effect of the VAT rate on compliance is captured by a quadratic term in the VAT rate. It is reasonable to assume that the incentive to evade is non-linear in the tax rate (Keen & Smith, 1996). Hence;
jt

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(vjt , v 2 , Njt , mjt ) jt

(4)

with the restrictions 1 > 0, 2 < 0, 3 < 0, 4 < 0, where Njt is the number of VAT rates in country j at time t and mjt is the ratio of currency to GDP in country j at time t. Combining Equations (3) and (4) with Equation (2), the full model of VAT base (as a proportion of GDP) and compliance determination can now be written as; R Y where; f1 > 0, f2 < 0, f3 = ?, f4 < 0, f5 < 0, f6 < 0
jt

vjt 1 + vjt

f (vjt , v 2 , vjt , Njt , mjt , zjt ) jt

(5)

3. The Data We have collected an unbalanced time-series of data on 14 countries of the EU. The sample period for each country was dictated by the availability of VAT revenue data obtained from the Government Finance Statistics Yearbook 1999 (Washington: IMF) and back issues. Individual country standard rates of VAT and the higher and lower rates were obtained from Eurostat. All macroeconomic data including currency in circulation with the non-bank public were obtained from International Financial Statistics Yearbook 1999 (Washington: IMF). The share of consumption that is VAT exempted and zero-rated was obtained from Eurostat for a single year and was the only pure cross-section data used in estimation. The panel data covered the following countries: Austria 197497, Belgium 197197, Denmark 197095, France 197097, Germany 197097, Greece 198797, Italy 197398, Ireland 197296, Luxembourg 197196, the Netherlands 197097, Portugal 198697, Spain 198696, Sweden 19801998, the UK 197398.

VAT Evasion and VAT Avoidance


12 10

109

VAT revenue / GDP

8 6 4 2 0 0 5 10 15 20 25 30 35 40

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VAT rate

Fig. 1. VAT revenue as a percentage of GDP compared with the standard VAT rate.

Ideally, a weighted average VAT rate (w) would be the appropriate measure of the representative VAT rate. However, consumption weights are not readily available.4 An alternative is the weighted average rate as calculated by each member state for the purpose of determining contributions to the EU budget.5 The problem with the latter measure is that it is calculated in discrete intervals and only covers the period of membership of the EU, which would severely curtail the size of the sample. We therefore use the standard rate of VAT as a proxy for the representative VAT rate. The use of the standard rate is based on two factors. First, most VAT-rated goods are taxed at the standard rate. Hence its use as a representative rate would not be a severe distortion.6 Second, we have obtained weighted average rates (w) for the countries in the sample from 199498 from the EC.7 The correlation between the standard rate of VAT and the weighted average rate is 0.9181. While this does not provide information about the temporal correlation over the full sample it provides an indicator of the cross-section variation of the standard VAT rate and the weighted average rate. Figure 1 provides a scatter plot of VAT revenue as a percentage of GDP against the standard rate of VAT for the full sample. The scatter plot reveals the humped shape of a Laffer curve. However we have to be cautious in this assessment since the ratio (v/(1 + v)) in Equation (3) will approximate a quadratic within a range. The chart also shows that there may be a number of outliers that need to be dealt with at the estimation stage.8 4. Estimation Taking logs of Equation (5) and assuming that the log function of f() is linear in its arguments, the restricted model to be estimated is described by; ln R Y
jt

= ln

vjt 1 + vjt

+ y0 + y1 vjt + y2 v 2 + y3 vjt + y4 Njt + jt


jt

y5 mjt + y6 zt +

(6)

110 K. Matthews where is an error term and the restriction is that the coefficient of the natural logarithm of [vjt/(1 + vjt )] takes on a unit value.9 An initial estimation indicated a strong rejection of normality in the residuals. The rejection of normality means that the distribution of the estimated parameters is non- standard and thus the conventional t test on the estimated parameters is not necessarily valid in finite samples but it does have asymptotic justification. Frequent outliers give rise to a fat-tailed distribution of the residuals. This in turn can give misleading estimates of the standard errors and indeed misleading estimates in small samples. The problem can be dealt with by the method of Robust estimation. The method of Robust estimation is a weighted least-squares framework where the weights are given by the size of the residuals. The smaller (larger) the residual the closer (further) the weight from unity. We follow the Hill & Holland (1977) method of Robust estimation, which is an iterative process beginning with a least absolute deviation estimator (LAD).10 We complement, conventional least-squares methods of estimation with the LAD estimator and robust estimator. The results are presented in Table 1. On the basis of the leverage identification procedure of Hill & Holland (1977), the year of introduction of VAT in Ireland (1972) was identified as a strong outlier and was subsequently rejected from the sample. The level of consumption that is zerorated or VAT-exempted as a proportion of GDP11 (zjt ) was not statistically significant and was excluded from the final results presented in Table 1. The first column shows the unrestricted equation with the coefficient on ln(vjt/(1 + vjt )) freely estimated. The results of the restricted equation are shown in column 2. The restriction of a unit coefficient on ln (vjt/(1 + vjt )) was accepted on the basis of a likelihood ratio test.12 The explanatory variables are defined as follows; = the standard rate of VAT in country j at time t, = log of currency in circulation outside the banking system in country j at time t relative to GDP = the number VAT rates per country j at time t, Njt vjt = the change in the standard rate of VAT from year to year for country j, DUM = 1 for the period of German unification for Germany, 0 otherwise. vjt mjt The data showed a sharp increase in the ratio of VAT revenue to GDP in Germany following unification; therefore, a dummy variable for German unification was included in the estimation. Since the demand for currency reflects black economy activity, and VAT evasion is part of this process, the potential for simultaneity in the use of the currencyincome ratio is allowed for by instrumental variables estimation13 (INS), shown in columns 4 and 5. The two final columns show the results from the least absolute deviation estimator and the robust estimator. The LAD and robust estimators are more efficient and therefore have greater precision than the OLS estimators. The most important point to make about the results is that the quadratic term in the VAT rate is significant and correctly signed in all of the restricted estimated equations, thus defining a revenue maximising rate. However, two criticisms of the data still remain. First, it can be argued that the lower revenue per GDP associated with a high VAT rate has nothing to do with evasion or avoidance but simply a lower VAT base. Second, the standard rate of VAT is a poor proxy for the representative rate of VAT.

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Table 1. Dependent variable = log of VAT revenue as a proportion of GDP; 14 countries (317 observations); pooled data, t values in parenthesis; mean of dependent variable = 1.8125 Variable Eq (1) (OLS) 1.797 (1.56) 1.624 (0.12) 6.255 (0.27) 2.223 (2.94)** 0.123 (7.93)** .009 (1.16) 0.297 (4.84)** 0.1753 5.694 9.4999 106.155 N/a Eq (2) (OLS) 1.000 7.020 (4.81)** 19.06 (4.73)** 2.09 (2.70)** 0.122 (7.77)** .008 (1.05) 0.289 (4.24)** 0.1753 5.325 9.5279 105.688 18.4% Eq (3) (OLS) 1.000 6.878 (4.74)** 18.70 (4.66)** 2.06 (2.66)** 0.123 (7.87)** 0.282 (4.16)** 0.1753 5.646 9.5616 105.128 18.4% Eq (4) (INS) 1.000 11.272 (6.42)** 29.40 (6.16)** 2.10 (2.43)* 0.258 (9.32)** 0.003 (0.39) 0.222 (2.90)** 0.1952 11.8154 19.2% Eq (5) (INS) 1.000 11.247 (6.41)** 29.33 (6.14)** 2.08 (2.42)* 0.259 (9.42)** 0.218 (2.87)** 0.1935 11.6128 19.3% Eq (6) (LAD) 1.000 6.803 (6.52)** 18.91 (6.10)** 1.76 (2.78)** 0.125 (10.01)** 0.022 (3.34)** 0.250 (4.48)** 0.1781 9.8319 18.0% Eq (7) (ROB)# 1.000 6.926 (5.01)** 18.97 (4.95)** 2.05 (2.82)** 0.129 (8.78)** .008 (1.15) 0.288 (4.55)** 0.1754 9.5431 18.2% VAT Evasion and VAT Avoidance

ln(vjt/(1 + vjt )) vjt vjt2 vjt mjt Njt DUM S. Error JBera RSS LogLikelihood Revenue max VAT rate

Intercepts not shown; ** significant at the 1% level, * 5% level, # 6th iteration.

111

112 K. Matthews
Table 2. Correlation matrix. z Z R/Y V W 1 0.2288 0.2362 0.1736 R/Y V W

1 0.6651** 0.6030**

1 0.8781**

** Significant at the 1% level (21 observations)

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Table 2 gives the correlation matrix between the proportion of consumer spending that is VAT-exempted and zero-rated (z), VAT as a proportion of GDP, the standard rate of VAT (v) and the weighted average rate (w) for the available data points. There is no significant correlation between the proportion of consumption that is zero-rated or VAT-exempted and VAT revenue or the VAT rates (standard or weighted). The only significant correlation is between the standard rate of VAT and the weighted average rate and between these two and the VAT revenue per GDP. This provides prima facie evidence that there is no relation between the VAT base and revenue for the countries for which data are available. It also confirms that the standard rate of VAT is a reasonable proxy for the weighted average rate. Turning to the effects of the remaining explanatory variables in Table 1, the negative sign on vjt suggests that the negative effect of the increase in VAT on consumption of VAT-rated goods is stronger than the revenue effect. It could also be an indicator of increased evasion or avoidance activity. During most of the period, VAT rates were raised more times than lowered. In the total sample, there were 52 rises in the standard rate of VAT and only 13 falls. It is possible that the rise in the VAT rate could have encouraged small firms to deregister or to increase its evasion activity. In contrast to Agha & Haughton (1996), and Matthews & Lloyd-Williams (2000), the number of VAT rates was not a significant explanatory variable. We also experimented with the proportion of consumption that is zero-rated or VAT exempted in 1995 as a pure cross-section variable but this also was also not statistically significant. Finally, the currency-income ratio has a negative effect on revenue, indicating possible black economy activity and non-compliance. 5. Conclusion The challenge for the EU in designing the definitive system of VAT is to accommodate two mutually inconsistent objectives. First, to provide the maximum degree of autonomy for member states in setting tax rates. Second, to ensure sufficient commonality so that VAT structures do not impede the single market. The current transitional system since the abolition of border controls has been the retention of zero-rated exports. Exporting firms claim the benefit of the zero rating and report the VAT identification number of their customer to the tax authorities. Measures to limit the scope for cross-border personal trade include the condition that firms engaged in distance selling (mail order) have to charge and remit VAT according to the destination principle (a further administrative burden adding to compliance costs of the firm). The Commission restricts the standard rate to a minimum of 15% and allows no more than two reduced rates.

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113

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The transitional arrangements have created additional costs to firms and may have created additional incentives to evade and avoid VAT by false invoicing and splitting up businesses to remain outside the tax threshold. Cross-border shopping would also make the transitional arrangements unsustainable.14 The definitive system of VAT, when it comes, would solve some of these problems. A common definition and scope for VAT could reduce the scope for evasion and increase revenue. Our results support the commonly held view that the efficiency of the VAT system declines with an increase in VAT rates. Lower spending by consumers, and VAT evasion and avoidance are positively related to the tax rate. We have found a well-defined Laffer curve for VAT in the EU. The revenue maximising rate of VAT for given conditions of non-compliance is in the range 18.019.3%. Upward adjustment for countries below this range, such as Germany and Spain, may be politically difficult and could create social tensions, whereas countries that have standard rates above this, such as Denmark and Sweden, could increase their revenue by lowering the standard rate. The Commissions Definitive VAT system has yet to propose a common VAT rate for the EU. The existing minimum rate is 15%; an upper bound of about 19% would be a common rate that maximises revenue in the EU. However, it can also be argued that, on the assumption that a governments utility function treats revenue as a good and the tax rate as bad, the socially optimal rate of VAT will always be lower than the revenue maximising rate. A reference point between the existing minimum rate and the revenue maximising rate could be a welfare maximising compromise. The current UK rate of 17.5% may be just such a compromise. Notes
I am grateful without implication to an anonymous referee for helpful comments. I gratefully acknowledge the able research assistance of Jean Lloyd-Williams, and Ingo Krueger. Special thanks also to Paolo Passerini of Eurostat for assistance with the data and to J. P. Mingasson Director General Budgets, EC for making available weighted average rates of VAT for selected member states. 1. In the case of VAT there is a resource cost to the producer as the tax has to be collected and administered by the firm. The seminal study on the compliance costs of direct and indirect taxes is Sandford et al. (1989) 2. An additional result by Matthews & Lloyd-Williams (2001) is that an increase in the ratio of input VAT (reclaimed VAT on inputs from the tax authorities) to output VAT (paid to the tax authorities) will increase non-compliance. This will become an important issue for inter-EU trade if VAT rates are not harmonised. 3. The aggregate implication of this has been tested by Agha & Haughton (1996) who find evidence that the higher the rate of VAT, the lower the rate of compliance. 4. The author has obtained weights for the UK and Belgium only. 5. HM Customs Annual Report 19941995 (London, HMSO), Cm 2980 p. 79 6. For example 57% of UK consumer and 45% of Belgian consumer spending was taxable at the standard rate. 7. Director General European Commission Budgets. Austria and Sweden 199598 only. 8. The two extreme observations on the chart showing a tax rate of 30 and 35% was for Ireland during 198283. 9. The semi-log quadratic specification has also been employed by Hsing (1996) to estimate a Laffer curve for the United States. 10. The iterative procedure for robust estimation is a variant of the M estimator described in Judge et al. (1985, pp. 829834) 11. Measured as the proportion of consumption that is VAT exempted or zero-rated in 1995? consumer spending divided by GDP for all years. 12. Chi square (1 df) = 0.93 < 3.84 (critical value)

114 K. Matthews
13. The additional instruments are the short-term rate of interest, ratio of consumer spending to GDP, inflation, and revenue from direct taxes as a proportion of GDP. 14. Keen & Smith (1996) also propose that registered VAT traders pay and remit a common VAT rate on all intermediate transaction across the EU but levy the destination VAT rate to consumers.

References
Agha, A. & Haughton, J. (1996) Designing VAT systems: some efficiency considerations, Review of Economics and Statistics, LXXVIII, 2, pp. 303308. Allingham, M. & Sandmo, A. (1972) Income tax evasion: a theoretical analysis, Journal of Public Economics, 1, pp. 323338. Bhattacharyya, D. K. (1990) An econometric method of estimating the hidden economy, United Kingdom 19601984: estimates and tests, Economic Journal, 100, pp. 703717. Cremer, H. & Gahvari, F. (1993) Tax evasion and optimal commodity taxation, Journal of Public Economics, 50, pp. 261275. Hagemann, R. P., Jones, B. R. & Montador, R. B. (1988) Tax reform in OECD countries: motives, constraints and practice, OECD Economic Studies, 10, Spring, pp. 85226. Hemmings, R. & Kay, J. A. (1981) The United Kingdom, in: H. J. Aaron (Ed.), The Value-added Tax: Lessons from Europe (Washington DC: The Brookings Institute). Hill, R. W. & Holland, P. W. (1977) Two robust alternatives to least squares regression, Journal of the American Statistical Association, 72, December. Hsing, Y. (1996) Estimating the Laffer curve and policy implications, Journal of Socio-Economics, 3(25), pp. 395401. Judge, G. G., Griffiths, W. E., Carter-Hill, R., Lutkepohl, H. & Lee, T. C. (1985) The Theory and Practice of Econometrics, 2nd edn (New York, Wiley). Keen, M. & Smith, S. (1996) The future of Value Added Tax in the European Union, Economic Policy, 23, October, pp. 375420. Marrelli, M. (1984) On indirect tax evasion, Journal of Public Economics, 25, pp. 181196. Matthews, K. & LloydWilliams, J. (2000) Have VAT rates reached their limit? An empirical note, Applied Economic Letters, 7, pp. 111115. Matthews, K & Lloyd-Williams, J. (2001) VAT evasion in selected sectors of the economy: a preliminary examination, International Journal of the Economics of Business, 8(1), pp. 3949. Rogoff, K. (1998) Blessing or curse? Foreign and underground demand for Euro Notes, Economic Policy, April, pp. 263301. Sandford, C., Godwin, M. & Hardwick, P. (1989) Administrative and Compliance Costs of Taxation (Bath, Fiscal Publications). Schneider, F. & Enste, D. H. (2000) Shadow economies: size, causes and consequences, Journal of Economic Literature, March, No 1, pp. 77114.

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