Tax Signaling

Abstract

A job applicant’s investment in education can function as a signal of her high productivity under certain circumstances. Might an entrepreneur’s choice to opt-in to a tax regime act in much the same way, as a signal of her business’s high quality? This paper explores the counter-intuitive notion that paying more tax than is legally required can be a signature of successful businesses. It uses as its jumping-off point recent evidence from both the United Kingdom and Canada that small-firm entrepreneurs view registering voluntarily for their countries’ value-added taxes (“VATs”) as enhancing their businesses’ reputations and legitimacy.

To make sense of these seemingly-disadvantageous tax choices, the paper introduces the notion of “tax signaling.” Its thesis has two parts. First, despite an apparent conflict, the signaling account of voluntary VAT registration complements the standard profit-maximizing account of voluntary registration offered by economists. Second, it argues that signaling is normatively desirable. Signaling reflects and, in turn, reinforces a high-trust-low-enforcement taxpaying equilibrium among businesses that are least likely to pay VAT voluntarily. This equilibrium generates a number of positive spillovers, including better matching of firms with counterparties, reduced competitive distortions between VAT-registered versus unregistered firms, and increased tax revenue at low administrative cost.

The paper concludes with policy implications and suggests that the tax signaling concept may have broad applicability, including for advocates of tax as a core element of corporate social responsibility.

Keywords: taxation, value-added taxes, entrepreneurship, small business, information

JEL Classification: H25, H32