tax strategies to tackle the shadow economy

CHASING SHADOWS: TAX STRATEGIES TO TACKLE THE

SHADOW ECONOMY

Rajul Awasthi

ECA Region

Tax and Revenue Mobilization

June 2015

Questions this presentation tries to answer

• Why chase shadows?

• How can businesses vanish into the shadows? Why do they do it?

• What should be the tax administration’s strategy?

• How to deal with shadow economy-linked evasion?

• What incentives to provide for cashless transactions?

• How to reduce complexity?

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Is chasing shadows worth it?

(From a tax revenue point of view…)

2

As expected, high informality is seen to coexist with low tax uptake

Sources: IMF data including select Article IV consultation reports; Schneider, F., Andreas Bruen, Claudio Montenegro, “New Estimates for the Shadow Economies all over the World”, International Economic Journal, 2010 3

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0 10 20 30 40 50 60 70

Tax-G

DP

rati

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Shadow-GDP ratio

Tax-GDP on Shadow Economy, 143 countries, 2007

The relation is statistically significant

SUMMARY OUTPUT

Regression Statistics

Multiple R 0.455627

R Square 0.207596

Adjusted R

Square 0.201976

Standard

Error 6.865294

Observations 143

ANOVA

df SS MS F Significance F

Regression 1 1741.041 1741.041 36.93946 1.08E-08

Residual 141 6645.649 47.13226

Total 142 8386.69

Coefficients Standard

Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%

Intercept 27.95727 1.570819 17.7979 7.08E-38 24.85187 31.06268 24.85187 31.06268

X Variable 1 -0.27759 0.045673 -6.07778 1.08E-08 -0.36788 -0.1873 -0.36788 -0.1873

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Europe and Central Asia Region

The shadow economy and tax collection ratios are correlated

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60

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10 15 20 25 30 35 40 45 50

Shadow

Econom

y R

atio

Tax GDP Ratio

Tax GDP and Shadow-GDP Ratios, 40 countries, 2007

Sources: IMF data including select Article IV consultation reports; Schneider, F., Andreas Bruen, Claudio Montenegro, “New Estimates for the Shadow Economies all over the World”, International Economic Journal, 2010


Central Asia and the Caucasus countries have particularly high

levels of informality

Abdih, Yasser and Leandro Medina, Measuring the Informal Economy in the Caucasus and Central Asia,

IMF, 2008 6

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Kyrgyz Republic Georgia Azerbaijan Tajikistan Kazakhstan Armenia

Shadow Economy percent of GDP, 2008


The contributors to the size of the shadow economy vary across

economies

7 Abdih, Yasser and Leandro Medina, Measuring the Informal Economy in the Caucasus and Central Asia,

IMF, 2008

0 10 20 30 40 50 60 70 80 90 100

Kyrgyz Republic

Georgia

Azerbaijan

Tajikistan

Kazakhstan

Armenia

Relative Contribution of Cause Variables, 2008

Tax Burden Labor Rigidities Institutional Quality Regulatory Burden

Latin America and the Caribbean

The same overall trend is observed

8 Sources: IMF data including select Article IV consultation reports; Schneider, F., Andreas Bruen, Claudio Montenegro, “New Estimates for the Shadow Economies all over the World”, International Economic Journal, 2010

0

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5 10 15 20 25 30 35

Shadow

GD

P r

atios

Tax GDP ratios

Tax GDP and Shadow-GDP Ratios, 19 countries, 2007

Some firms are more informal than others

From: “Taxing the Informal Economy”, Joshi, Prichard, Heady, 2013 9

Many businesses are partially formal and partially informal; they selectively comply with

some government obligations, but not with others

How can businesses hide in the shadow economy?

Cash transactions make it easier to hide sales and profits

10

How can businesses hide in the shadow economy?

Businesses can maintain “duplicate books” of their transactions –

one for the taxman, and one for themselves

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In today’s high-tech world, they don’t have to be in this form, they can be automatically

generated on computers, using the right software

The data from Europe confirms that higher usage of cashless

payment systems is correlated with lower informality

Source: The Shadow Economy in Europe – Using payment systems to combat the shadow

economy, A T Kearney, 2009 12

Why do businesses vanish into the shadows?

Regulations can make running a small business a bit difficult

13

Why do businesses vanish into the shadows?

The data does show that complexity in tax regimes engenders

higher informality

Sources: Doing Business, The World Bank Group, 2009; Schneider, F., Andreas Bruen, Claudio Montenegro, “New Estimates for the Shadow Economies all over the World”, International Economic Journal, 2010 14

0

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Tim

e to c

om

ply

in h

ours

Shadow Economy as a percent of GDP

Positive correlation in complexity and informality

Tackling the shadow economy needs a multi-pronged strategy

One, sharpen tax administrations tools to detect and punish tax evaders

• Electronic cash register systems, E-invoicing and invoice matching

• Sectorial approach

• “Big data” based risk profiling and audits

• Legal framework providing for information collection and prosecution

• Use FIUs and AML laws and agencies

Two, create conditions that encourage businesses to stay out of the shadows

• Incentives to move towards a cashless economy

• Measures to reduce complexity of the tax regime

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In general, it is important for the tax authority to develop cooperative relationships with

private sector institutions to help develop an understanding that operating in the shadow

economy has a negative impact on the economy and on the quality and delivery of public

services

Sharpen tax administrations tools to detect and punish tax

evaders

Specific strategies to counter under-reporting of sales

• “Skimming” has always existed in one form or another

• Failing to ring cash sales into the cash register with the cash being kept by the owner of the business; or

• Tampering the Cash Register, for e.g. diverting sales to a second cash register that was kept “off the books”

• Automated skimming: Phantom-ware and Zappers

• Phantom-ware is a “hidden,” pre-installed programming option embedded within the operating system of a modern electronic

cash register (ECR)

• Zappers allow remote skimming of cash transactions

Enforcement strategies:

• Risk assessment: Risks can be identified by special audits targeted on specific sectors/industries. Extending these sample audits

could help identify which retail and service sectors were most at risk

• Auditors need to be taught how to obtain information from ECRs and POS systems to reveal suppressed transactions

• Many revenue authorities have trained specialized e-auditors in the use of Computer Assisted Audit Tools and Techniques

(CAATTs) to import large datasets and carry out a wide range of analysis and the use of specialized audit software such as IDEA,

ACL or SESAM

• Computer forensic investigations can be used on systems and tools that have been secured after seizure in a criminal

investigation for testing and analysis in a forensic laboratory

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evaders

Sectorial Approach

• Tax administration conducts own analysis of informal

sector tax risks, taking into consideration contribution

of specific business sectors to informal activities

• Tax-specific sector analysis identifies economic

sectors with a high incidence of shadow economy

activities and an above average revenue potential

• Identify the precise sub-segments of economic

activities requiring priority attention and the

development of specific strategies to improve

compliance.

• Advanced tax administrations have sectorial risk

maps of compliance behavior in specific business

segments.

• Common high risk sectors: the construction sector,

the transport sector (in particular taxi companies)

17


evaders

Systematic IT-based risk profiling

“Big data” based risk profiling: Expanding data mining and information

collection and matching are crucial to reduce the shadow economy

• Any reform to reduce the shadow economy needs to create a basis for collecting

data to identify money flows and business relationships

• A legal basis for routine data exchange must be ensured

• Public institutions: customs administration, business registry, land registry,

motor vehicle registry, central bank

• Private institutions: banks and credit card companies, insurance, leasing,

portfolio management, and factoring-services companies

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evaders

Strengthen legal framework

Legal framework that gives powers to tax authority to collect and use information

• Powers to ask for information from taxpayers and from third parties

• Powers to allow automatic flow of information from third parties, e.g., banks and

other FIs, customs, company and property registrars, etc.

• Automatic Exchange of Information internationally

Legal framework that provides for prosecution

• Clear and consistent legislation to punish tax evasion

• Special provisions, in line with the strategic intent to combat electronic sales

suppression, criminalizing the supply, possession or use of electronic sales

suppression software

• Special penalties for production or possession of ESS tools

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evaders

Use FIUs and AML laws and agencies

• The Egmont Group has evolved over the years and in 2013 was comprised of 139 member

Financial Intelligence Units

• FIUs are set up as a central national agency responsible for receiving, analyzing, and

transmitting disclosures on suspicious financial transactions

• Traditional law-enforcement methods need to be supported by implementing know-your-

customer principles and reporting suspicious transactions to an FIU

• FIUs in turn need to share information with tax administrations, AML agencies, and police

where appropriate

• The position with respect to the availability to the tax administration of FIU information for the

purpose of making tax assessments varies significantly: some countries give the tax

administration direct access or require the FIU to provide relevant information while other

countries impose an express prohibition on the FIU providing any information

• Legal gateways are in place in most countries to enable FIUs to provide information

concerning possible tax offences to the agency responsible for investigating tax crimes,

though in many cases the FIU is able to exercise discretion in deciding whether to provide

information

Presentation Title 20

Create conditions that encourage businesses to stay out of the

shadows

Incentives for cashless systems

Presentation Title 21

Incentives and innovative approaches to increase use of banking channels and discourage cash

transactions by individuals

The Colombian Tax Code provides a 2% VAT refund for individuals on purchases made by debit

and credit card

Several European countries induce undeclared work to formal economy by allowing tax

incentives for paying for household services through checks

The Mexican Central Bank encourages the use of credit transfers instead of checks or cash

through advertising campaigns

In Peru obligations that are fulfilled through cash payments exceeding US$1,000 must be made

via bank account deposits, wire transfers, payment orders, credit cards, non-negotiable checks,

or other means of payment

A lottery mechanism was introduced in Taiwan (since 1951) for encouraging consumers to take

B2C invoices; as of 2011 prizes ranged from NT 200 to NT 10 million and total prize amounted to

NT 7 billion ($20 million)

Incentive-based approach: encouraging voluntary use of the banking system for

payments


shadows

Incentives for cashless systems Monetary incentives and deterrent measures to turn shadow industry to formal economy in the EU

22

Belgium

Tax reductions are linked to the use of vouchers which are used to hire household services. Two types of vouchers, the

cheque AlE and the Titre-services are eligible for tax deduction, the former 30%, the latter 30 to 40%. The ceiling of tax

deduction for vouchers is 2,400 Euros (the sum of both vouchers)

Denmark In Denmark it is foreseen that the purchase of undeclared work is illegal but if buyers show a receipt or pay with electronic means,

they can avoid criminal liability.

Finland

A tax deduction system was introduced in 1997 for payments for eligible household services; if the tax deduction is larger than the

amount of central government income tax, local government taxes can also be reduced; tax deduction is 40% of the expenses that

were paid to a company, small entrepreneur or a non-profit organization (60% until 2011) and 15% of the wages paid for hiring an

employee. When employing an individual, employer social contribution is exempt

France

France allows 50% of expenses for cleaning, ironing, IT assistance or private lessons as deduction for income tax; the ceiling of tax

deduction is 12,000 Euro (or higher, based on some criteria) per year

Germany

Tax credit is allowed upto 20% of the costs for household-related services such as gardening, cleaning, laundry services or childcare

services. In addition, 20% of the wage costs for craft services such as repairs, refurbishing can be offset with income tax; buyers

should keep invoices for two years to avoid criminality

Italy

The purchase of undeclared work is illegal in Italy, but if buyers show a receipt or pay with electronic means, they can avoid criminal

liability.

Luxembourg

Tax reduction for the expense on housework services, care services for dependent persons or childcare is allowed but with maximum

tax rebate of 3,600 Euros per year and 300 Euros per month

Norway In Norway the purchase of undeclared work is illegal but if buyers show a receipt or pay with electronic means, they can avoid criminal

liability.

Sweden

The tax reduction system in Sweden has two component; RUT (cleaning, maintenance, servicing) and ROT (home renovation

services). Tax credit is allowed as to 50% of the labor costs (including VAT) of the household services. The sum of tax credit for RUT

and ROT must not exceed around 5,500 Euros by person per year.


shadows


Law-based approach: prohibiting payments in cash under certain conditions or

denying the deduction of cash payments as business expenses for tax

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Cash Payment Restrictions in the European Union

Belgium €3,000 January 1, 2014

Bulgaria BGN 10,000 (≈€5,112) July 1, 2011

Czech Republic CZK 350,000 (≈€12,763) January1, 2013

Denmark DKK 10,000 (≈€1,340) July 1, 2012

France €3,000 (residents and

nonresident traders

€15,000 (nonresident consumers) January 1, 2002

Greece €1,500 January 1, 2011

Hungary HUF 1.5 million (≈€5,000) (legal

persons)

January 1, 2013

Italy €999.99 December 6, 2012

Portugal €1,000 May 14, 2012

Slovakia €5,000 €15,000 (natural persons whoa re not

entrepreneurs)

January 1, 2013

Spain €2,500 (residents) €15,000 (nonresidents) November 19, 2012

Source: European Consumer Center France 2014, Veber and Brosche 2013.


shadows


Law-based approach: prohibiting payments in cash under certain conditions or

denying the deduction of cash payments as business expenses for tax

24

Other country examples

In India, there are provisions in the Income Tax Act which prohibit the use of cash exceeding Rs.

20,000 at a time for business transactions

In Kazakhstan, individual businessmen who carry on certain types of business are obliged to

accept payment cards and accordingly to install Points of sale (POS) terminals

Mexico has subsidized the purchase and installation of electronic payment terminals in retail

shops; the deduction of expenditures of a company in Mexico must be backed by a digital tax

receipt issued

South Korea allows credit card or check card usage as income deduction from wage earner’s

income: As of 2013, 15 percent of credit card usage exceeding 25 percent of total wage income

is eligible for income deduction; in 2005, electronically-traceable cash receipts were introduced

so consumers can pay cash and still business sellers are required to issue electronic receipts

This is where we want to be!

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shadows

Simplification of the tax regime - laws and administration

• Measure compliance costs regularly and set goals to reduce them

• Segment taxpayers and adapt administration to serve each specific segment

• Simplify tax forms and provide free, easily accessible tax computation software

• Provide multiple, convenient ways for taxpayers to file and pay taxes

• Maintain electronic taxpayer accounts reported automatically

• Use IT systems to provide responsive and user-friendly taxpayer services

• Use IT-based risk management techniques for audits; ensure compliant taxpayers

are not harassed

• Set time limitations on provision of taxpayer services

• Provide effective, objective channels of dispute resolution and accessible

mechanism to voice grievances (ombudsman)

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shadows

Simplification of the tax regime – tax policy

• Simple tax systems with clear tax legislation, and clear implementing regulations

(which interpret, but do not contradict the legislation)

• No excessive discretionary powers to tax inspectors to interpret tax laws

• Low and few rates and limited tax breaks or exemptions

• Subnational governments do not resort to excessive use of regulatory

instruments and fees to raise revenue

• Special, simplified tax regimes for SMEs, including withholding and presumptive

taxes, and simpler compliance procedures

• Tax policies and instructions drafted to be easily understood by taxpayers

• A stable tax policy regime over a period of time

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In shadow-less heaven, it will be as simple as this!

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Anyway, despite our best efforts, this will never change…..!

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Thank you!

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