Page 4 - Working Paper (Narrowing Tax Gap: Cross Countries Experience)
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DDTC Working Paper 0915

                      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
                   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
                   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
                   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.
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