Page 4 - Working Paper (Narrowing Tax Gap: Cross Countries Experience)

DDTC Working Paper 0915
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Understanding the tax gap provides a useful classified as shadow/underground economy-
tool for understanding the relative size and activities, such as street vendors, unlicensed taxi
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nature of non-compliance. By understanding driver; a plumber that gets paid in cash but does
the tax gap helps tax authority to recognize how not declare his earnings to the tax administrator;
non-compliance occurs and what strategies and a drug dealer broker. These activities have also
they need to structure and design especially for been considered harmful to the economy because:
long-term performance. Some countries even
disaggregated their calculation based on the type • Inappropriate and misplaced government
of tax, taxpayers’ behavior and by customer group policies and discretion due to unreliable
in order to come up with detailed and focused statistical data;
strategies. England, for example, experienced • Cash transactional basis, which is mainly
higher gap that can be attributed to small and the feature of the shadow economy, escapes
medium-sized enterprises (SMEs) compared to taxation, thus keeping tax revenues much lower
other group such as individuals, large business and than they otherwise would be. If the tax base
criminals. The problems for developing countries or tax compliance is eroded, governments may
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to raise revenues are twofold. First, they typically respond by raising tax rates – encouraging a
have limited taxable capacity and a large share of further flight into the underground economy
economic activity in the informal sector. Second, that further worsens the budget constraints in
their tax regimes may be riddled with numerous the public sectors;
tax relief initiatives and/or tax expenditures, which • A growing shadow economy may provide strong
further deplete the tax base and tends to reduce the incentives to attract domestic and foreign
efficiency and effectiveness of tax collection efforts. employees away from the official economy. 13
This paper is organized as follow. Section 2
Table 1 - Types of Underground Economic Activities
presents a brief overview of the cause of tax gap.
Section 3, then, compares and analyses cross-
Type of Activities Monetary Transactions
country figures on tax capacity and effort. Section
4 provides analysis of Indonesian case. And Illegal (prohibited Trade in stolen goods;
section 5 includes the main conclusion and policy production and distribution transactions of drugs;
recommendations in designing an effective tax of proscribed substances) prostitution; gambling;
smuggling; fraud.
reform program.
Legal (legal market activities Unreported income from
but kept hidden for tax- self-employment. Wages,
2. The Cause of Tax Gap evasion reason) salaries, and assets from
unreported work related to
2.1. Shadow Economy legal services and goods
Source: The Frazer Institute, 1997
mAjor driviNG forCEs bEhiNd
ThE sizE ANd GrowTh of ThE Thus, underground economy comprises
shAdow ECoNomy ArE AN all economic activities that would generally be
iNCrEAsiNG burdEN of TAx taxable. The percentage of shadow economy was
ANd soCiAl sECuriTy pAymENTs, differs around the world. Shadow economy during
CombiNEd wiTh risiNG the period of 1988 to 2000 was between 35 to 44
rEsTriCTioNs iN ThE offiCiAl percent for developing countries, 21 to 30 percent
lAbor mArkET. for transition countries like former Soviet Union
states, and 14 to 16 percent for OECD countries.
Advanced countries such as the United States and
What is a shadow economy activity? It is Switzerland have around 9 to 10 percent of GDP. In
also called as an underground or informal all European OECD countries combined, about 35
economy. According to the terminology used by million people are in informal sectors. This number
the International Monetary Fund, underground is growing in almost all countries which in the case
economy covers not only illegal activities but also of European countries it increases almost twofold.
unreported income from the production of goods Using World Bank WDI data, shadow economy
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and services. There are some activities that are
income is unknown to the authority. There is a difference between the
10 HM Revenue and Customs, 2014”Tax Gap Estimates for 2012-13”, hidden economy and tax evasion: Hidden economy is where an entire
Measuring tax gaps 2014 edition, An Official Statistics release. source of income is not declared and tax evasion is where a declared
11 Op.Cit., Le, Tuan Minh, Blanca Moreno-Dodson, and Jeep source of income is deliberately understated. In measuring the tax gap,
Rojchaichaninthorn, 2008. HMRC used the employer compliance random enquiry program (EC REP)
12 According to HMRC (2014), underground/hidden economy is all and data on compliance yield and non-payment.
undeclared activity that involves what they call ‘ghosts’ – whose entire 13 IMF, 2002,”Tax Policy in Developing Countries” IMF policy paper.