Determinants of the VAT Compliance Gap in the European Union: The Role of Shadow Economy and Fiscal Pressure

A gap exists between the theoretical potential for revenues generated by Value Added Taxes (VAT), as well as actual collected amounts, known collectively as the "Value-Added Tax (VAT) Gap." The VAT Gap is composed of two main types of gaps. First, the Policy Gap represents revenue lost due to purposeful legislative fiscal decisions. Second, the Compliance Gap represents revenue loss stemming from intentional or unintentional failures in taxpayer compliance with tax laws. Most notably, these failures include administrative errors, insolvent businesses, and illegal evasion of taxes which are primarily influenced by shadow economy behaviors. The focus of this research is on determining the factors contributing to the European Union (EU) Member State's VAT Compliance Gap over the years 2013 through 2023. In particular, this research will investigate how informal economic behavior and governing structures produce compliance related revenue shortages as well as examine cross country differences in compliance patterns. Panel Data Regression Models using systematic methods to select models will be used to analyze the data. Comparisons between Fixed Effects and Random Effects specifications will be made based upon variance decomposition patterns which indicate that most shadow economy variations occur at a cross-country level rather than an intra-country level over time. Therefore, this suggests the use of a Random Effects Specification. The results provide evidence of a statistically significant positive relationship between shadow economy and the VAT Gap. Additionally, it was found that increasing standard VAT rates lead to an increase in noncompliance with VAT regulations; therefore, there appears to be some limitation to generating additional revenue via increasing VAT rates. These findings illustrate a considerable degree of cross-country heterogeneity in compliance patterns among EU member states. Furthermore, these findings support previous studies regarding compliance issues with respect to VAT. Overall, the findings suggest that integrated policies designed to reduce shadow economies through increased enforcement capabilities, enhance institutional capacity, develop and implement digital tax administration platforms and create real time e-invoicing platforms can help improve compliance with VAT regulations and improve fiscal sustainability among all EU member states.