Tax evasion is a global scourge. The “black” economy has, by some estimates, reached 10 percent of GDP in advanced countries and can top 70 percent in developing countries. And it is getting worse.
Tax evasion is usually confronted in two ways: audits and harsh sanctions. But, as the rising tide of tax evasion suggests, these mechanisms amount only to a cat game of and mouse problem – and the mice, it seems, are winning.
As tax evasion becomes more pervasive, whole networks to help hide incomes have appeared, making it far less likely that those who break the law are punished. Moreover, because more people are evading taxes, tax administrations are under increasing pressure to become more lenient or to accept bribes.
One strategy for weakening ties among potential evaders is to introduce various conflicts of interests. For example, value-added tax is designed to encourage firms to procure invoices for their inputs in order to reduce their own tax outlays. But the results often fall short of the potential benefits, because VAT has helped inspire tax evaders to create even stronger networks that can hide an entire chain of transactions.
The Chinese have devised a novel solution. To encourage customers to request official receipts as proof of payment, some local tax authorities issue a type of receipt that doubles as a lottery ticket. The receipts can be used as scratch cards to win small amounts of cash, but they also serve as lottery tickets for winning larger amounts. To prevent forgery, businesses must purchase special, patented machines for printing these receipts. Records of the printed receipts are automatically transmitted to the tax authorities and are used to calculate taxes. Similar systems are in use in Taiwan and Latin America.
Another way to reward consumers for combating tax evasion is to offer subsidies. Some developing countries have introduced a far-reaching VAT refund system for consumers who collect official receipts. Northern Cyprus, like Turkey, offers a 2.5 percentage point refund on VAT, compared to the standard VAT rate of 13 percent.
But such systems are burdened by large administration and compliance costs. The process of collecting and verifying claims is time-consuming, and the net benefit for taxpayers is low. Moreover, the method is vulnerable to illicit practices, such as collecting receipts issued to foreigners and students, who cannot claim their own refunds.
Monetary subsidies to consumption are also often granted in developed countries for a variety of purposes, not least of which is fighting tax evasion. One such subsidy is permitting deduction of a fixed percentage of certain expenses from income tax. In Italy, expenditures for home improvements have been partly deductible for the past ten years, mainly to improve tax compliance by firms in the housing sector. New regulations have recently been introduced with the specific aim of cracking down on moonlighting. Under the 2007 financial law, those who claim the home improvement deduction must supply an invoice from the building contractor, which must specify the cost for labor.
In terms of reducing tax evasion, the results have been mixed. The bulk of claims for the subsidy come from northern Italy, which is usually considered less prone to tax evasion to begin with. While some cases of illegitimate claims are under investigation, there is no black market for receipts; fraud seems to arise mainly through falsified invoices. While econometric studies are not available, raw data show an increase in reported income and in the number of firms and official workers. However, taxable income in the sector is still growing at a slower rate than gross income as measured by national accounts.
When tax evasion is extremely common, taxpayers are likely to experience high transaction and psychological costs in resorting to tax auditors to enforce the issuing of receipts. But if consumers bear the brunt of costs for reporting violations to the authorities, subsidies may induce them to seek out vendors willing to offer legal transactions.
Yet these efforts are also costly. Whenever a firm chooses to evade, it becomes increasingly difficult to find a vendor willing to engage in legal transactions. When alternatives become difficult to find, the compensation requested for accepting an illegal transaction falls. As typically happens in these cases, once a critical mass of tax evasion is reached, it can jump to much larger values. This process might also explain why, although many reward systems have proven successful at the beginning, their benefits quickly fade.
Of course, there is a risk that subsidies and lotteries may diminish the moral motivation of citizens to obey tax laws, because compliance becomes conditional on some form of compensation. But if lotteries, subsidies, and other devices fail to control tax evasion, the Chinese have another method: the death penalty.
By Carla Marchese, Daily Times, January 13, 2008