Andrew Young School of Policy Studies
Research Paper Series
Research Paper Series
Working Paper 06-42 March 2005
AUTHOR:
James Alm
Calvin Blackwell
Michael McKee
ABSTRACT:
The retail sales tax is a major revenue instrument of most state and local governments in the United States, and numerous aspects of the sales tax have been studied. However, firm compliance has been largely ignored. We extend this limited literature by examining sales tax compliance using a unique data set for New Mexico. This data set allows us to estimate both the factors that determine the likelihood that a firm will be selected for an audit and, conditional upon audit selection, the firm characteristics that determine the level of firm compliance.
New Mexico’s “sales” tax is labeled the Gross Receipts Tax (GRT), and it is the state’s largest single source of revenue. The GRT is imposed at a uniform rate, and its coverage is extremely broad because it is imposed on nearly all in-state transactions, including services as well as goods. This broad-based coverage implies that the GRT tax base is rich in business-tobusiness
transactions, compared to the typical retail sales tax that emphasizes business-to consumer transactions. As with any tax, there are compliance issues with retail sales taxes. With its broad base, the GRT offers different opportunities for evasion than a pure retail sales tax. For example, all food is taxed under the GRT, so there are fewer opportunities for evasion for grocery stores. The heavier taxation of business-to-business transactions under the GRT generates matching paperwork that may also enhance compliance. With a broader base than the typical sales tax, the GRT tax rate can be lower than that under an equal-yield retail sales tax, and a lower rate may enhance compliance. In contrast, the GRT includes services, and sales taxes on services are often easier to evade than taxes on commodities because service transactions concern intangibles. Overall, there are many unanswered questions about firm compliance with any sales tax, especially one that takes the form of a GRT.
This paper examines the determinants of state audit selection and subsequent firm compliance with a broad-based sales tax like the GRT. With the cooperation of officials in the State of New Mexico, we assembled a data set that contains detailed firm-level information on the firms subject to the GRT, on the firms that were actually selected for audit, and on the results of those audits. We use a two-stage selection model to estimate both the determinants of the State’s audit selection rule (if any) and, for those firms selected for an audit, the firm’s subsequent reporting result.
Our estimation results from the first-stage audit selection process indicate that returns are systematically selected for audit by the state, based on items reported by the firms on their tax returns. Our second-stage firm reporting results show that firms that exhibit greater variation in deductions, that operate in the service sector, that miss filing deadlines, and that have an out-ofstate mailing address have a lower compliance rate. If the State wishes to increase firm compliance with the sales tax, then it should re-orient its audit strategy to target firms with these characteristics.
transactions, compared to the typical retail sales tax that emphasizes business-to consumer transactions. As with any tax, there are compliance issues with retail sales taxes. With its broad base, the GRT offers different opportunities for evasion than a pure retail sales tax. For example, all food is taxed under the GRT, so there are fewer opportunities for evasion for grocery stores. The heavier taxation of business-to-business transactions under the GRT generates matching paperwork that may also enhance compliance. With a broader base than the typical sales tax, the GRT tax rate can be lower than that under an equal-yield retail sales tax, and a lower rate may enhance compliance. In contrast, the GRT includes services, and sales taxes on services are often easier to evade than taxes on commodities because service transactions concern intangibles. Overall, there are many unanswered questions about firm compliance with any sales tax, especially one that takes the form of a GRT.
This paper examines the determinants of state audit selection and subsequent firm compliance with a broad-based sales tax like the GRT. With the cooperation of officials in the State of New Mexico, we assembled a data set that contains detailed firm-level information on the firms subject to the GRT, on the firms that were actually selected for audit, and on the results of those audits. We use a two-stage selection model to estimate both the determinants of the State’s audit selection rule (if any) and, for those firms selected for an audit, the firm’s subsequent reporting result.
Our estimation results from the first-stage audit selection process indicate that returns are systematically selected for audit by the state, based on items reported by the firms on their tax returns. Our second-stage firm reporting results show that firms that exhibit greater variation in deductions, that operate in the service sector, that miss filing deadlines, and that have an out-ofstate mailing address have a lower compliance rate. If the State wishes to increase firm compliance with the sales tax, then it should re-orient its audit strategy to target firms with these characteristics.
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