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Taxing the shadow economy

Rajul Awasthi's picture
Graphic: Nicholas Nam/World Bank

A sub-Saharan African tax commissioner went to buy a bicycle for his son. The seller asked if he would like to get a receipt and pay a 15 percent higher price, or take the bike with no receipt at a lower price. The tax commissioner paused and thought. What would you do?

Tax administrators, and most other people in developing countries, grapple with this issue every day. A large shadow economy undermines tax collections; reducing the shadow economy is associated with higher tax collections. Even when controlling for per capita income, a 1 percent smaller shadow-economy-to-GDP ratio is associated with a 0.125 percent higher tax-to-GDP ratio[1].
 
Complex tax laws, weak tax enforcement, and lack of incentives to make payments through formal banking channels are among the factors affecting the size of the shadow economy. Greater tax complexity imposes heavier compliance burdens on taxpayers, disincentivizes tax compliance, and encourages taxpayers to move into the shadows. Receipt-free cash transactions for goods and services increase the risk of tax evasion.
 
Despite the availability of banking services and alternative payments, key sectors of the economy remain largely cash-based in almost all developing countries. Not surprisingly, there is a strong negative correlation between the use of electronic or formal payments and the size of the shadow economy. This means that the more people use e-payments, the smaller the shadow economy becomes.
 
Governance matters
 
Governance-related factors, such as the quality of regulation and control of corruption, are also associated with a smaller shadow economy. Poor, burdensome regulation acts much like a complex tax system, discouraging compliance with formal economic systems and pushing activities into the dark. Corruption leads to lower tax morale and poor trust in government, which in turn leads to larger shadow economies.
 
Taxpayer trust in government is a fundamental driver of tax morale. Increased trust in tax systems can accrue by improving public benefits from taxation—as taxes and the public goods and services they finance are perceived as fair, equitable, and accountable (the “direct pathway”).

Moreover, forthcoming World Bank research argues that where fairness, equity, reciprocity, and accountability feature prominently in tax reform, taxpayers are empowered to make more successful demands of governments for improved outcomes (the “empowerment pathway”).
 
Finally, pursuing these same goals can strengthen the state-building role of taxation—more competence and greater political ability of governments to deliver benefits to taxpayers. In other words, tax is a lot more than just tax.
 
Ready for technology
 
The technological readiness of an economy also has a significant bearing on the shadow economy and taxation. Technology can shine a light into the shadows. In the digital world, Information and Communication Technology (ICT) platforms and modern technology that enforces tax compliance increasingly drive tax administration.
 
Today’s ICT systems allow tax administrators to access data on taxpayers’ financial transactions with banks and other institutions on a regular and automated basis. These data can be analyzed via algorithms to generate taxpayer risk profiles and to aid in risk management. Electronic invoicing systems allow reconciliations that test sales and profits to ensure they do not go underreported or unreported.

In Tajikistan, for example, where the Tax Administration Reform Project is financing a number of reforms, including establishing e-invoicing systems, the total number of individual (small) taxpayers has doubled to 273,000 in 2018 from 137,000 in 2012; the VAT productivity has increased from 37 percent to 40 percent; and, adjustment per auditor has increased from 184 million somoni to 712 million somoni over 5 years.
 
Altogether, potential taxes get forced out of the shadow economy and into systems of tax compliance, allowing services to be delivered. The higher an economy’s technological readiness, the better and more effective such compliance measures can be.
 
Some advice
 
In this context, we would like to offer a couple of pieces of advice:

  1. Use ICT-based technological solutions to stop underreporting or non-reporting of sales, or inflating expenses, through false invoices.
  2. Make formal payments for business transactions through banking channels—including electronic payments and “plastic money”—more attractive than using cash. (This is sometimes called “incentivizing.”)
There are other effective ways to improve tax enforcement: mandating limits on cash use; taxing cash withdrawals and deposits; mandating issuance of tax invoices, including e-invoices; requiring that point-of-sale systems be installed; applying withholding taxes; accessing third-party data; and matching data with tax declarations.

Measures to incentivize the use of formal payments range from taxpayer education and moral persuasion to invoice lotteries and actual tax rebates (for insisting on receipts and using formal payment methods[2]).

In Tanzania a taxpayer education campaign coupled with tax infrastructure improvements resulted in a total of 376,666 taxpayers registered with a newly introduced mobile tax payment for property taxes. In Punjab, Pakistan, a receipt lottery system has had a positive impact on revenues and the World Bank project is supporting tax audit improvements to further the gains.
 
Moreover, a successful strategy to tax cash-economy businesses and transactions requires a holistic approach to compliance. Traditional monitoring and enforcement tools—such as enabling tax administrators to access taxpayer data and match information from various public and private sources—play a key role.
 
As for our tax commissioner and the cash-or-receipted bike purchase, what do you think he did? He thought about the dilemma, paid the higher price, got a receipt—and unleashed a mighty fury on the shadow economy, from which we are still learning.
 
[1] Rajul Awasthi and Michael Engelschalk, “Taxation and the Shadow Economy: How the Tax System Can Stimulate and Enforce the Formalization of Business Activities,” World Bank Policy Research Working Paper, 2018
[2] For a detailed description, see Awasthi and Engelschalk, 2018