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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

Comments

Submitted by Wei Zhuang on

Thank you for the detailed introduction. We just discussed the tax administration this afternoon with Professor Shukla. We will learn more on how to improve tax collection. I think your article is very helpful to me. Thank you!

Submitted by David Harold Chester on

This article does not consider the best way to change the tax regime so that unlike almost every other tax it it is able to provide incentive to production whilst taking from part of the community the immoral gains that some take from others without either side realizing it! Please review my other comment (essay) on this website.

Submitted by David Harold Chester on

Socially Just Taxation and Its Effects (17 listed)

Our present complicated system for taxation is unfair and has many faults. The biggest problem is to arrange it on a socially just basis. Many companies employ their workers in various ways and pay them diversely. Since these companies are registered in different countries for a number of categories, the determination the criterion for a just tax system becomes impossible, particularly if based on a fair measure of human work-activity. So why try when there is a better means available, which is really a true and socially just method?

Adam Smith (“Wealth of Nations”, 1776) says that land is one of the 3 factors of production (the other 2 being labor and durable capital goods). The usefulness of land is in the price that tenants pay as rent, for access rights to the particular site in question. Land is often considered as being a form of capital, since it is traded similarly to other durable capital goods items. However it is not actually man-made, so rightly it does not fall within this category. The land was originally a gift of nature (if not of God) for which all people should be free to share in its use. But its site-value greatly depends on location and is related to the community density in that region, as well as the natural resources such as rivers, minerals, animals or plants of specific use or beauty, when or after it is possible to reach them. Consequently, most of the land value is created by man within his society and therefore its advantage should logically and ethically be returned to the community for its general use, as explained by Martin Adams (in “LAND”, 2015).

However, due to our existing laws, land is owned and formally registered and its value is traded, even though it can't be moved to another place, like other kinds of capital goods. This right of ownership gives the landlord a big advantage over the rest of the community because he determines how it may be used, or if it is to be held out of use, until the city grows and the site becomes more valuable. Thus speculation in land values is encouraged by the law, in treating a site of land as personal or private property—as if it were an item of capital goods, although it is not (see Mason Gaffney and Fred Harrison: “The Corruption of Economics”, 2005).

Regarding taxation and local community spending, the municipal taxes we pay are partly used for improving the infrastructure. This means that the land becomes more useful and valuable without the landlord doing anything—he/she will always benefit from our present tax regime. This also applies when the status of unused land is upgraded and it becomes fit for community development. Then when this news is leaked, after landlords and banks corruptly pay for this information, speculation in land values is rife. There are many advantages if the land values were taxed instead of the many different kinds of production-based activities such as earnings, purchases, capital gains, home and foreign company investments, etc., (with all their regulations, complications and loop-holes). The only people due to lose from this are those who exploit the growing values of the land over the past years, when “mere” land ownership confers a financial benefit, without the owner doing a scrap of work. Consequently, for a truly socially just kind of taxation to apply there can only be one method--Land-Value Taxation.

Consider how land becomes valuable. New settlers in a region begin to specialize and this improves their efficiency in producing specific goods. The central land is the most valuable due to easy availability and least transport needed. This distribution in land values is created by the community, after an initial difficult start and not by the natural resources. As the village and city expand, speculators in land values will deliberately hold potentially useful sites out of use, until planning and development have permitted their site-values to grow. Meanwhile there is fierce competition for access to the most suitable sites for housing, agriculture and manufacturing industries. The limited availability of useful land means that the high rents paid being by tenants make their residences more costly and the provision of goods and services more expensive. It also creates unemployment when entrepreneurs find the rents too high for them to operate and employ workers. This speculation causes wages to be lowered by the monopolists, who control the big producing organizations and whose land was previously obtained when it was cheap. Consequently this basic structure of our current macroeconomics system, works to limit opportunity and to create poverty, see above reference.

The most basic cause of our continuing poverty is the lack of properly paid work and the reason for this is the lack of opportunity of access rights to the land on which the work must be done. The useful land is monopolized by a landlord who either holds it out of use (for speculation in its rising value), or charges the tenant heavily in rent for its right to access. In the case when the landlord is also the producer, he/she has a monopolistic control of the land and of the produce. The product becomes more costly--this monopolist can effectively charge more for it, than what an entrepreneur normally would, were he/she able to compete on an equal basis, because of the excessive rent demanded by the landlord.

A wise and sensible government would recognize that this problem derives from lack of opportunity to work and earn. It can be solved by the use of a tax system which encourages the proper use of land and which stops penalizing everything and everybody else. Such a tax system was proposed almost 140 years ago by Henry George, a (North) American economist, but somehow most macro-economists seem never to have heard of him, in common with a whole lot of other experts. (I would guess that they don't want to know, which is worse!) In “Progress and Poverty” 1879, Henry George proposed a single tax on land values without other kinds of tax on produce, services, capital gains, etc. This regime of land value tax (LVT) has 17 features which benefit almost everyone in the economy, except for landlords and banks, who/which do nothing productive and wrongly find that land dominance has its own reward.

17 Aspects of LVT Affecting Government, Land Owners, Communities and Ethics

Four Aspects for Government:

1. LVT, adds to the national income as do all other taxation systems, but it can and should replace them.
2. The cost of collecting the LVT is less than for all of the production-related taxes—then tax avoidance
becomes impossible because the sites being taxed are visible to all.
3. Consumers pay less for their purchases due to lower production costs (see below). This creates
greater satisfaction with the government’s management of national affairs.
4. The national economy stabilizes—it no longer experiences the 18 year business boom/bust cycle, due
to periodic speculation in land values (see below).

Six Aspects Affecting Land Owners:

5. LVT is progressive--owners of the most potentially productive sites pay the most tax.
6. The land owner pays his LVT regardless of how his site is used. When fully developed, a large
proportion of the ground-rent from tenants becomes the LVT, with the result that land has less sales-
value but a significant "rental"-value (even when it is not being used).
7. LVT stops the speculation in land prices and any withholding of land from proper use is not
worthwhile.
8. The introduction of LVT initially reduces the sales price of sites, (even though their rental value can
still grow over long-term use). As more sites become available, the competition for them becomes less
fierce so entrepreneurs are more active.
9. With LVT, land owners are unable to pass the tax on to their tenants as rent hikes, due to the reduced
competition for access to the additional sites that come into use.
10. With LVT, land prices will initially drop. Speculators in land values will want to foreclose on their
mortgages and withdraw their money for reinvestment. Therefore LVT should be introduced
gradually, to allow these speculators sufficient time to transfer their money to company-shares etc.,
and simultaneously to meet the increased demand for produce (see below).

Three Aspects Regarding Communities:

11. With LVT, there is an incentive to use land for production or residence, rather than it being unused.
12. With LVT, greater working opportunities exist due to cheaper land and a greater number of available
sites. Consumer goods become cheaper too, because entrepreneurs have less difficulty in starting-up
their businesses and because they pay less ground-rent--demand grows, unemployment decreases.
13. Investment money is withdrawn from land and placed in durable capital goods. This means more
advances in technology and cheaper goods too.

Four Aspects About Ethics:

14. The collection of taxes from productive effort and commerce is socially unjust. LVT replaces this
extortion by gathering the surplus rental income, which comes without any exertion from the land
owner or by the banks--LVT is a natural system of national income-gathering.
15. Bribery and corruption on information about land cease. Before, this was due to the leaking of
news of municipal plans for housing and industrial development, causing shock-waves in local land
prices (and municipal workers' and lawyers’ bank balances).
16. The improved and proper use of the more central land reduces the environmental damage due to a)
unused sites being dumping-grounds, and b) the smaller amount of fossil-fuel use, when traveling
between home and workplace.
17. Because the LVT eliminates the advantage that landlords currently hold over our society, LVT
provides a greater equality of opportunity to earn a living. Entrepreneurs can operate in a natural
way-- to provide more jobs. Then earnings will correspond to the value that the labor puts into the
product or service. Consequently, after LVT has been properly introduced it will eliminate poverty
and improve business ethics.

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