No state can exist in the long term without effective taxation. To be able to execute its various roles, the state needs to acquire the capacity to enforce compliance with tax obligations. Taxation is particularly challenging in developing countries, since it is difficult for the governments to gain information about what taxable transactions occur in more informal economies. This does not only lead to large losses in government revenue, it can also create negative distortions in the economy. The pressing need to tackle tax evasion has led to growing interest in ‘third-party reporting’ – the verification of taxpayer reports against other sources.
This policy brief explores the potential of such an approach to improve tax collection – as well as its limitations. Evidence from Chile shows how the value-added tax (VAT) can facilitate tax enforcement by generating paper trails on transactions between firms. But third-party information is not a miracle cure against evasion. Its effectiveness can be severely reduced if the government's enforcement capacity is low or if taxpayers can make offsetting adjustments on other margins for which third-party information is not available, as a study from Ecuador shows.