Audit selection and firm compliance with a broad-based sales tax.

INTRODUCTION

The retail sales tax is a major revenue instrument of most state and local governments in the United States, accounting for roughly one-third of state and local own-source revenues in recent years. Numerous aspects of the sales tax have been studied, including its administration, its incidence, and, especially in recent years, its vulnerability to erosion with the growth of internet commerce. (1) However, with the exception of Murray (1995), firm compliance with the sales tax has been largely ignored. We extend this 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 officially labeled the Gross Receipts Tax (GRT), and it is the state's largest single source of revenue. In 2002, tax collections from the GRT were nearly $2 billion, or over one-third of the state's general fund revenues. (2) The GRT is typically 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. (3) This broad-based coverage implies that the GRT tax base is rich in business-to-business transactions, compared to the typical sales tax that emphasizes business-to--consumer transactions. (4)

The lessons from the New Mexico experience with the GRT seem especially timely for several reasons. There is recent evidence that the traditional state sales tax based on retail sales generates distortions by reducing the relative prices of non-taxed services (Merriman and Skidmore, 2000), and this type of distortion is avoided by the use of a broad-based sales tax like the GRT. With many states currently facing significant budget deficits, there is renewed interest in additional revenue sources, and the New Mexico tax has potential as an alternative form of a state sales tax. (5) As a prominent U.S. example of a broad-based sales tax, the New Mexico experience also may provide an object lesson for the federal government, especially in light of ongoing discussion of a national sales tax and the form of such a national tax.

As with any tax, however, there are potential compliance issues with retail sales taxes (Due and Mikesell, 1995; Murray, 1995). With its broader base, the New Mexico 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 (and fewer complications) 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 state sales tax, the tax rate under the GRT 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.

There is a large literature on individual compliance with the income tax (Andreoni, Erard, and Feinstein, 1998; Alm, 1999) but little work on compliance with other taxes, including firm compliance with the sales tax. (6) A notable exception is the work of Murray (1995), who investigates the determinants of audit selection and audit productivity for the Tennessee sales tax. He concludes that sales tax accounts in Tennessee are audited non-randomly and that greater opportunities for underreporting lead to increased tax evasion. Despite these valuable insights, there are no other studies that have examined audit selection and subsequent firm compliance with the sales tax. It seems especially useful to determine whether similar--or different--results on the determinants of audit selection and firm compliance hold for other states, for other sectors of firms covered by the tax, and for a broad-based sales tax like the GRT.

This is our purpose here. 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 sales tax returns. Our second-stage firm reporting results show that a firm's compliance decision is related to its opportunities for cheating; that is, firms that exhibit greater variation in deductions, that operate in the service sector, that miss filing deadlines, and that have an out-of-state 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 (perhaps through reporting requirements). We also find some evidence that firms seem able to discern the audit selection procedures of the State, even though these procedures are informal and unpublicized; that is, compliance is positively correlated with the predicted probability of audit, generated from fitted values from the selection equation. The tax authorities should, therefore, recognize that, even absent an explicit audit selection strategy, firms may be able to perceive, even anticipate, the audit selection rules.

In the next section we discuss the main features of the GRT and its administration. We then outline our methodology. We present our estimation results in the following section and our conclusions in the final section.

NEW MEXICO'S GROSS RECEIPTS TAX

The New Mexico statute enacting the GRT specifies that the tax be imposed "... for the privilege of engaging in business in the state." (7) In principle, then, the GRT is an especially broad-based tax, imposed on the receipts from all activities (including services) unless specifically exempted or deducted by the legislation. Exemptions from the tax are relatively few, and include non-retail transactions like wages, bank interest, sales subject to separate taxes (e.g., gasoline or liquor sales), and receipts of 501(c)(3) non-profit organizations. Deductions are also limited, and are given largely for special tax breaks, such as a deduction for research and development services, for "chain of commerce" inputs in the production process, and for items produced in New Mexico and then exported. The chain of commerce deductions are similar to those under a value added tax, and prevent the GRT from becoming a turnover tax; however, the incomplete coverage of deductions allows some tax pyramiding to persist. Firms are also required to pay "compensating taxes" on transactions that involve a purchase from outside the state; these compensating taxes are voluntarily reported.

The New Mexico tax code specifies that the GRT be imposed on the seller. The tax rate levied is the state base rate plus the local jurisdiction (municipal or county) add-on factor. In practice, this means that firms located in more than one jurisdiction may pay taxes on the same types of transactions at different rates, depending upon the location of the transaction. Tax rates vary from 5 (the base state rate) to 6.5 percent, depending upon the jurisdiction within the state.

For the most part, individual firms may evade the GRT liabilities by remitting to the State only a portion of the full GRT liability, mainly by underreporting gross receipts or by overstating deductions. Of these two methods, officials believe that underreporting of gross receipts is the most commonly used method, given the relatively small scope for deductions in the broad base of the GRT. Nonfiling of returns is not believed by officials to be a viable avenue for evasion. Any firms found to be noncompliant are subject to fines.

The New Mexico Taxation and Revenue Department (NMTRD) administers the GRT and the audit program. State auditors examine the practices of all firms conducting business in New Mexico. Auditors may also perform "combined audits," in which a firm selected for possible noncompliance with, say, the GRT, may have aspects of its tax reporting examined, including its gross receipts and compensating taxes as well as tax withholdings and corporate income taxes. This policy of combined audits means that the audit selections may be initiated for taxes other than the GRT. According to officials, nearly all audits are prompted by a desire by the NMTRD to improve the GRT collections. (8)