Shadow economy dissertation
Statement of the Problem 9 1. Purpose of the study 10 1. Research Questions 10 1. Significance of this research 10 1. Governments and tax collecting bodies 11 b. The Theory of Tax evasion 21 2. Empirical Literature review 22 2. The relationship between a shadow economy and taxes is not clear. Tax evasion demotivates tax collecting people and authorities 27 2. A bourgeoning shadow economy makes it difficult to make policy based on accurate statistics 28 2. Data Analysis 40 3. Chapter Summary 40 References 41 List of Tables Table 1: Romania Shadow Economy Indicators; 1999-2012 25 Table 2: Variables of the Model and their expected signs 39 List of Figures Figure 1: Top 10 shadow economies of the developed world in 2017 4 Figure 2: 10 Largest Shadow Economies in the underdeveloped world 5 Figure 3: World Continent's shadow economies versus Tax evasion 7 Figure 4: Greece % shadow economy and % tax revenue collected to GDP; 1999-2012 24 Figure 5: Romania's % shadow economy and % tax collected to GDP; 1999-2012 26 Figure 6: Conceptual Framework 31 Figure 7: EU member Countries in Europe 35 Figure 8: The map of EU 28 Countries in Europe 35 CHAPTER 1: INTRODUCTION 1.
Introduction and Background After the end of the Second World War in 1945, leaders in both the developed and the developing world embarked on a global growth and development agenda. It is the agenda that has resulted in the interconnection of global economies; what economists call globalization. This has been attributed to the growth of the global economy from a mere Global Gross Domestic Product (GDP) figure of $1. Hart was surprised by the proliferation of self-employment and casual labor in the third world, labor that was usually not registered and often was not regulated by the law of the country or international laws. This he referred to as “the informal economy. ” Over time, Harts informal economy has gone to be classified into different markets based on the “unregistered” and “unregulated” activities that typify the market; Ardizzi et al.
gives another name to Hart’s shadow economy calling it an “underground economy” where he says that the dealings taking place there are not known and usually there is no data kept about such, Bernheim & Scheur (2014) see another variant of an informal economy where supplies are made by the unregistered supplier but for legal goods and Eilat & Zinnes (2013) see another variant of an informal economy; “the black market” where illegal goods (narcotics and weaponry) are traded. Indeed so many names surface literature of the shadow economy and at least 45 adjectives have been used (Giovanna, 2014; 2). Ad-hoc organizational structured businesses that have no access to organized markets, no access to credit markets, no access to technology and no access to formal education. Many business persons are mobile in the shadow economy with no any fixed location that would make them easily identifiable by tax authorities or the police.
The above aspects of a shadow economy rather make it difficult to notice, tax or punish because of not complying with the tax policy. In the past, after Keith Hart wrote his paper, it had been though that “the informal economy” was a problem of the less developed world (James, 2014; 115). However recent empirical studies reveal that a shadow economy can exist in the developed or the developing world. Overall, from Schneider, Buehn & Montenegro (2017; 443), this paper concludes that, Bolivia is the largest shadow economy all over the world (66. of the country’s GDP) where Netherlands is the smallest (8. of the country’s GDP) based on the statistics as at the end of last year, 2017. Since the activities taking place in a grey market are not recorded, it is difficult to estimate correctly the billions of dollars or the GDP output that circulates in the black market (Leandro, & Friedrich, 2017; 62.
Naomi, 2018). trillion dollars are lost by the global governments (Julia, 2011). This, according to Julia (2011) is 5. revenue that never reaches the coffers of government. The tax is lost through tax avoidance and tax evasions where studies point the size of the shadow economy as directly proportional to the tax revenue lost (Buehn & Montenegro, 2017: 443; Naomi, 2018; Julia, 2011; Leandro, & Friedrich, 2017; 65). According to the Organization of Economic Cooperation and Development (OECD 2017), Europe tops as the haven of tax evasion that coincides with its largest shadow economy in the world. This puts governments into financial problems something that makes it seek other sources of government revenue none of which can generate as much income as taxes (Litvinenko et al. Other studies have gone to term the shadow economy as equally of significance and should be left to operate Laissez-faire as it wholly compliments the official economy (Eilat & Zinnes, 2013: 1235; Zamana, & Goschin: 2015; 85 and Litvinenko et al.
Especially, With the global economy losing hefty tax revenue (to the tune of $ 3. trillion), it concerns economists and other governmental policy makers something that inspired this paper. This comes at a time when many governments over the world are facing huge fiscal financing budget deficits. According to Schneider, Buehn & Montenegro (2017; 443) also, Bolivia is the world’s largest shadow economy estimating 66. of the country’s GDP. Romania’s once top shadow economy in the European area (28. has also been studied in which contrary to other studies, her shadow economy is said to have placed it on a trajectory for growth (Eilat & Zinnes, 2013: 1235; Zamana, & Goschin: 2015; 85 and Litvinenko et al. Statement of the Problem The relationship between a shadow economy and tax has received a new enthusiasm in modern times.
Does the prevalence of underground market transactions increase chances of tax evasion? 2. Does a shadow economy nurture “young” entrepreneurs who in the future set businesses that can be taxed to increase a government’s revenue? 3. Does the shadow economy impact on the morale of tax collecting personnel? 1. Significance of this research The study fills the knowledge gap in existing literature on what actually is the effect of a shadow economy on taxes collected. The results could be used by: 1. The loss of the dollar value will mostly earn a protest especially amongst the “have-nots” in the society who will opt for two possible options: They can resolve to engage in underground economic activities and evade taxes or protest in what Karl Max called the proletariat revolution something that destabilizes the ruling regime (Bernheim & Scheuer, 2014).
High tax regimes also increase production costs making potential taxable firms close down (Braithwaite, 2017). Whichever of the three above happens, the government stands to lose tax income. It thus emerges that while taxes are the chief source of government revenue, high taxes have the potential of nurturing an underground economy or pushes firms out of business something that reduces the tax revenue of a government. This study thus chose to investigate how tax revenue is impacted by a shadow economy with the intent of identifying the causal factors for the grey market which would help address: social equity in taxation, sustainability of a tax policy and the prevention of tax evasion or tax hoarding resulting from the excess tax burden. Limitations of this study This study was constrained by a number of factors: 1.
The study chose to sample out countries in the EU where findings were generalized to all other regions of the world. There are errors in generalization as what the situation in Europe it could vary from what the situation is in another region. Some information was also sought from secondary resources. The accuracy of this study thus depended on the accuracy of the researchers who published the secondary resources from which information was sought. Chapter two presents a review of the literature as relates to the objectives of the study, chapter three presents the research methodology, chapter four presents the data analysis, interpretation, and discussion of the findings while Chapter five is the summary of the findings, conclusion, and recommendations of the study.
Chapter 2: LITERATURE REVIEW 2. Introduction A review of the literature as relates to the impact of a shadow economy on taxation will focus on what theory and empirical research reveal. This chapter will thus entail a discussion of the theoretical framework, the revelations emerging from empirical literature review, an overview of the literature, the conceptual framework and the chapter summary so as to highlight the expected results of the current research. Theoretical Framework Various theories have been discussed by economists that relate shadow economies and taxes; this section reflects on the concept of Laissez faire and the principles of taxation, the theory of optimum tax, the theory of crime and punishment and the theory of tax evasion as relates to black markets and taxes.
When this happened, the government stood to lose tax revenue as it would not accurately account for all economic activities in a “shadow economy. ” This would push it into hard economic times and it would never be able to dispense even its three core functions as had been advised by “the father of Economics,” Adam Smith. Stiligtz &Jay (2015) argue that a black market is a creation of the government and if it happens, the government will lose tax revenue. However, it would be noted that by arguing of a minimal government intervention in the market, Adam Smith was not stating that markets should be left free of the government as there are the three functions that he advised can only be well performed by a government; national defense, administration of justice systems and the provision of public goods (1776; Book V, 559).
Smith thus advocated for minimal intervention in the economy only on such crucial sectors of the economy. The theory was developed by William J. Baumol and David F. Bradford in 1970, who after observing the American market found out that, every tax has the ability to bring about price distortions. William and David were inspired by the then existing literature on taxation that had adopted a normative approach to taxation (Bernheim and Scheuer, 2014). The then policy theory advised that the maximum taxes are taxes that maximize the satisfaction of the society by the maximum number of people who were impacted (Utilitarianism). The most ideal optimal taxation is the one that considers the eight principles outlined by Gregory (2014) whose outcome is based on an analysis of the literature about optimal taxation.
The theory of crime and punishment The theory of crime and punishment was developed by Gary Stanely Becker in 1968. The theory became so successful in America that Gary and his theory rose to prominence winning the 1992 Nobel Prize in Economic Sciences, Gary also won the United States Presidential Medal of Freedom in 2007, and A survey of economics professors in 2011 named Becker their favorite living economist over the then past 60 years back, followed by Ken Arrow and Robert Solow (Wolfers, 2014). According to Wolfers (2014), towards the end of the 20th century, a developed America was in a crisis. The country had invested a lot to stop crimes with drug trafficking being a very common problem in modern America. Gary as a rational agent reasoned that, he would stop and park on the street where the fine that would be imposed on him was less the benefits that he would get from such a crime.
He later delved into the issue of crime and punishment later publishing a book in 1968, “Gary. S. B. Discrimination, economic. G. In 1972 when they wrote the theory of “Income Tax evasion”. According to Agner and Sandmo (1972), the taxpayer is usually faced with a situation in which they decide whether to pay taxes or not after the tax filing period has matured. In this case, they can decide to disclose their full income and pay taxes as required or understate them and pay little taxes for which the discovery of a false disclosure in the latter is punishable by law. Agner-Sandmo theory was based on six assumptions: 1. Agner and Sandmo (1972) considered the taxpayer as an individual who was risk-averse and under the risks of paying taxes, the taxpayer wanted to maximize income.
They chose the von Neumann–Morgenstern utility function: Max E (U) = (1-P)*U (W- Ф X) +PU (W- ФX-π (W-X)). When the taxpayer was not checked, the taxpayer’s utility became: U (W – Ф X) = U(Y). When the taxpayer fails to disclose their income, discovered and fined, their utility becomes: U (W – Ф X – π (W – X)) = U(Y). To maximize [Max E (U) = (1-P)*U (W- Ф X) +PU (W- ФX-π (W-X))], the first order conditions would become: =- Ф (1-P)*U’(Y)-(Ф-π) PU’ (Z) =0. Whichever the reason for the establishment, when a basket of goods leaves the official market to be supplied in the black market, the taxable goods base by the government declines. When it so does, again the government is in deficits and it cannot undertake to comfortably undertake long-term capital investments that would have increased its tax base (Mazhar & Méon, 2017; 90).
Therefore, while the taxable goods or income declines, the government’s ability to raise the taxable base is also negatively impacted. As the underground economy grows, it will be noted that the taxable base of commodities or income will be getting smaller and smaller (Mazhar & Méon, 2017; 90; Buehn, Dell’Anno, & Schneider, 2018; 1610). According to Leandro & Friedrich (2017, 65), Greek was the largest black market economy in the period 1999-2012. of Shadow Economy in EU 28 % of Shadow Economy in Romanian GDP Shadow Economy (£ ‘000,000) 1999 0. Source: Zamana, & Goschin, (2015; 85). From the table 1, it will be noted that the size of the Romanian economy was increasing between 1999 and 2008. Likewise, the growth of the shadow economy of Romania was growing for the same period placing more income at the hands of every Romanian as shown by the increasing shadow economy per capita.
An increased per capita in an economy means that consumers have an increasing purchasing power (Tobin, 2017). Gordana and his friends then did a Data Envelopment Analysis (DEA) with the DEA model comprising of three inputs (expenditure on tax administration, tax payment/evasion and time taken to comply) and output parameters (total tax collected and net tax revenue collected). In the model, they sought to analyze and set a model about which the output would be maximized with the minimal inputs (for Serbia). That is; maximizing total tax and net tax collected while minimizing the expenditure on tax administration, tax evasion and the time taken to comply with tax policies. A DEA of the above countries found that only five out of the thirteen countries had an efficient tax collection system.
To maximize on the total tax and net revenue collected, Serbia n taxes were supposed to be paid in 32 days contrary to its the 66 days as this was the time taken to pay taxes in the five EU members that were doing well. When the government does not know the amount of income or consumption it will tax, it is likely to under-collect or over-collect taxes (Veera, 2016. Whichever happens is disastrous for the government; When the government underestimates the dollar value of the taxable economy, it charges lesser tax where it is left in huge budget deficits. When the government overstates the economy, it will tax more when the reality was different. This may kill the entrepreneurial spirit in which people stop doing business due to the high tax regime.
Also, people may begin to evade or avoid taxes in a high tax regime and supply or demand goods and services from the shadow economy. A high tax regime will push people to evade them in which self-employment becomes the norm to do business. Such is not deemed useful due to low costs but the fact that one can evade taxes. Others become unemployed by choice as a heavy tax burden erodes all the benefits of their work. High taxes are thus a causal factor for shadow economies that in turn causes reduced taxes in the long run. An Overview of Literature From empirical literature, it is emerging that the relationship between the shadow economy and taxes is not yet made clear.
Introduction This chapter outlines the overall methodology that was used to carry out the study. The section includes the: research design, population, sampling procedure, and sample size, data collection, data analysis and the presentation of the findings of the study. Research Design A research design refers to the set of methods and procedures that are used to collect and analyze measurable variables as specified in a research problem (Dumi & Blakaj, 2017). This study adopted a descriptive study approach; this is a study approach in which the characteristics of a phenomenon are intensively analyzed and reported. The study categorically concerned itself with the aspects of a shadow economy and how they closely interrelated with those of the tax revenue in an economy. Figure 7 below shows the EU region that was sampled by this research.
Source: University of Texas Libraries Europe is the continent with the largest shadow economy ($ 3883 billion) of the six continents of the world and the European Union provides data ranging from the largest shadow economies to the smallest making it an ideal sample for the study. The 28 countries selected for study are selected using the judgmental sampling technique where the threshold to be met by a country is that “must be an EU member. ” In the researcher’s prejudgment, an economy with the largest victims of the shadow economy and the smallest at the same time would provide comprehensive information about how exactly a shadow economy impacts taxes. Data Collection This study primarily relied on data from global economic databases and publications; such included data from OECD, the IMF and the World Bank publications constrained about 2000 and 2018.
A model was then constructed and estimated to arrive at the actual values relating the independent and the dependent variables of the model. Both the dependent and the independent variables were measured in U. S. D that would easily allow for global comparison. A regression analysis was then done to explain how the independent variables of the model were accurately determined from the independent variables. X3= Smuggling. X4= understated income values. And ε= is the error term. Definition of Variables and priori expectations In the model above unregistered business activities, unregistered labor, smuggling and understated income(s) have been presented as explanatory variables of the model. For the tax revenue raised from the issue of licenses for business activities, a lot of it would be lost if the number of unregistered businesses increased in an economy.
People may also cheat on the true value of their total taxable income when paying taxes; here they will usually understate their incomes in which case they will pay lesser taxes than they were actually supposed to pay in reality. If it happens, again the government loses taxes. The variables studied together with their respective expected signs were summarized in table 2 below: Table 2: Variables of the Model and their expected signs Variables Expected Sign Measurement Total Tax revenue Lost Dependent Variable Tax/GDP ratio Unregistered business activities Negative (-ve). As found out by Georgios, 2017; 389. Unregistered Businesses/ Total number of businesses in an economy. Specifically, the chapter reported the: research design, Population, Sampling procedure and Sampling Size, data collection, analytical framework, the model specification, and its expected priori and how the analysis of data was conducted.
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