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Chasing shadows: Tax strategies to tackle the shadow economy

Rajul Awasthi's picture
Digital work by Steve Johnson

Tax administrations in developing countries are increasingly concerned about the persistent problem of loss of tax revenues to the shadow economy, and they often deploy a range of strategies to plug tax leaks and augment revenues. The erosion of the tax base prevents governments from collecting the revenue it needs to provide essential services, such as healthcare, road construction, and education. Nonetheless, it’s a sticky problem: how do you convince business owners to pay taxes?
 
Some possible answers, bolstered by evidence, include: simplify tax payment and provide incentives to formalize businesses. The World Bank’s Governance Global Practice will hold a conference between June 27-29 in St Petersburg, Russia, to bring together participants from almost 25 countries of the Europe and Central Asia region to discuss these issues under the aegis of the Tax Administrators eXchange of Global Innovative Practices, a peer-learning network of tax administrators. The event will be hosted by experts from the Public Sector Performance division of the practice.

One-third of the world economy is informal, as Friedrich Schneider, Andreas Buehn and Claudio Montenegro point out in their article, “New Estimates for the Shadow Economies all over the World.”  Informality is most prevalent in Sub-Saharan Africa, with activities in the shadow economy amounting to 37.6 percent of the ‘official’ GDP, but is also significant in the Europe and Central Asia region (mostly transition countries) at 36.4 percent. In comparison, the shadow economy amounts to just 13.4 percent of GDP in high income OECD countries.
 
Schneider, Buehn, and Montenegro define the shadow economy as including all market-based legal production of goods and services that are deliberately concealed from public authorities to avoid payment of taxes or social security contributions or having to meet certain legal labor market standards. A simple regression of tax-GDP ratios on the shadow-GDP ratios shows a statistically significant negative relationship.
 

Sources:  Schneider, F., Andreas Buehn, Claudio Montenegro, “New Estimates for the Shadow Economies all over the World”, International Economic Journal, 2010; IMF tax-GDP data, 2007
We can observe that high levels of tax complexity have a positive correlation with informality. The amount of time it takes to comply with taxes is greater when the tax regime and law is complex. We use the Doing Business report’s sub-indicator, Time to Comply, and observe its relation with the shadow economy, and find that indeed there is a positive correlation.



Experience of developed countries (see chart below, illustrating the European example) has shown that incentives – positive and negative - to carry out business transactions and make payments through formal banking channels, have a bearing on the level of informality. These incentives can be provided through tax policies and measures adopted by the tax administration.



The quality of governance matters as well.  An analysis of data from the Worldwide Governance Indicators finds that there are two, Regulatory Quality and Control of Corruption, which have a measurable impact in diminishing the shadow economy and increasing the level of taxation. Further, of the competitiveness factors analyzed by the World Economic Forum’s Global Information Technology Report 2015, technological readiness is found to have a significant effect, reducing the shadow economy and increasing taxation.
 
This analysis suggests that reducing complexity of the tax system, and adopting tax measures – policy and administrative - to incentivize formal payments for business transactions through banking channels, including electronic payments, and use of “plastic money”, can prove useful in reducing informality.  In addition, using ICT solutions to improve tax enforcement against shadow economy transactions, particularly measures to plug tax evasion directly related to transactions with the shadow economy, would be most effective.

We will discuss these and other issues related to making the informal economy formal on June 27-29 in St. Petersburg.

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Chasing shadows: Tax strategies to tackle the shadow economy.

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Loss of tax revenue hinders delivery of essential services such as healthcare and education.

Comments

Submitted by Apurva on

Great article Rajul, and particularly relevant to the Kenya and Uganda situations. It'll be interesting to know the sequencing of formalization though -- for ex, in Kenya, the bulk of the informal economy is small mom and pop outfits. Does it make sense to try to get them under the formal tax net? Or wait until the "big fish" are in it first? Cheers, Apurva

Submitted by arturo on

Thanks Apurva. While the really micro businesses should really be left alone, small businesses should be brought into the tax net. It's not only important for present and future tax revenues, there are other state-building benefits (not discussed here).

Submitted by Jackie Coolidge on

Great analysis! Just a couple point - I see that Schneider et. al. still show Estonia as an outlayer in the size of its estimated "shadow economy", but that seems to be an artifact of their assumptions about the velocity of money as a proxy indicator in their model. In Estonia, starting from the late 1990s, the population leap-frogged over many OECD countries in their use of e-money of all sorts, which threw off Schneider's estimates.

I suspect if that were corrected, your comment about "... including electronic payments ..." would be strengthened even further.

Re the simplified small business tax regimes in Central Asia, I would suggest more attention to the abuse of the "patent" regimes by medium-size businesses breaking themselves into pieces and under-reporting revenues in order to fraudulently stay in those regimes (which are usually extremely "generous" not only in terms of compliance costs but also in terms of the actual tax payments.) I would hazard a guess that the amounts of revenue lost from those abuses are higher than the amounts lost due to pure "informality" (i.e., micro-businesses that have managed to evade the tax authorities completely). If so, it would suggest we need to find better ways to identify the businesses that are in reality bigger than they pretend to be.

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