The Curses Weighing on the Provincial VAT: Magnification Effect and Invoice Sightseeing

Abstract

Two difficulties arise when different jurisdictions have value added taxes at different rates. First, "magnification effect" which consists of an automatic enlargement of the rate differential over and above the one established by the respective legislations. Second, a fraud known as "invoice sightseeing" which takes place when sales in one jurisdiction are declared as sales to a fictitious customer in a lower rate jurisdiction. This paper shows that either both or one of these difficulties will unavoidably appear if the jurisdictions adopt different VAT rates. Under certain arrangements, like the zero rate treatment for interjurisdictional transactions, the magnification effect disappears, but the incentives to perform "invoice sightseeing" are still present. Other arrangements are suggested under which such incentives disappear, but the magnification effect does not. Thus, the policy choice is to select a VAT procedure such that its effects upon economic efficiency and revenue are least damaging.