Report to the Treasurer and Minister of revenue - by a committee of experts on tax complianceBill Birch Treasurer
Report to the Treasurer and Minister of revenue
By a committee of experts on tax compliance
Chapter 7 -
Tax Evasion and the Hidden Economy
7.1 New Zealand, like many other jurisdictions, relies on a tax system based on voluntary compliance. Taxpayers are expected to understand and comply with their tax obligations.
7.2 Under such a tax system, it is inevitable that some taxpayers will fail to comply with their tax obligations. For example, some people will seek to evade tax by submitting false tax returns that conceal taxable activities from the Inland Revenue Department. Other taxpayers will evade tax unintentionally because they do not understand their obligations. In this case, the taxpayer does not deliberately set out to submit a false return. However, such taxpayers will still file a false return if they are not reminded of their tax obligations either in their tax return, or in supplementary information provided by the Inland Revenue Department.
7.3 Although it is not feasible to eliminate tax evasion completely, it is important to keep the level of evasion under control. Increases in the level of evasion can threaten the integrity of the tax system. In particular, tax evasion undermines the ability of the government to raise revenue in an equitable and efficient manner. Individuals and businesses that evade tax in effect shift their tax burden onto those taxpayers who comply with their tax obligations. This shift results in an inequitable distribution of the tax burden, and disadvantages those businesses that choose to comply with their tax obligations.
7.4 In practice it is extremely difficult to monitor the level of tax evasion in New Zealand. This difficulty arises because tax evasion involves economic activities that are part of what is usually referred to as the €˜hidden €™ economy.
7.5 This chapter begins with a discussion of what is meant by the hidden economy and explains how estimates of the size of the hidden economy in New Zealand have been used to obtain an indication of the overall level of tax evasion. This introduction is followed by a discussion of what is being done to reduce the level of tax evasion. The chapter concludes with a description of the committee €™s recommended approach to reducing tax evasion.
7.6 As noted above, tax evasion involves economic activities that are hidden from Inland Revenue. In the course of evading tax, taxpayers either intentionally or unintentionally fail to take into account certain taxable activities when completing their tax returns. These hidden economic activities comprise part of what is usually referred to as the hidden or black economy.
7.7 The hidden or black economy comprises economic activities that are not measured in official statistics, including both legal and illegal activities.
7.8 For example, national statistics exclude certain legal market transactions that have deliberately hidden from authorities, such as the income that taxpayers have failed to declare to the Inland Revenue Department. Certain legal non-market activities, such as the unpaid housework, are also excluded because they are difficult to measure.
7.9 National statistics also exclude certain unreported illegal market activities, such the trade in illegal drugs, as well as illegal non-market activities, such as drugs produced for personal consumption.
7.10 Tax evasion typically involves a range of hidden economic activities, including both legal and illegal transactions, as well as market and non-market transactions. For example, the total level of tax evaded in New Zealand includes the tax evaded on income from unreported legal activities such as income earned from cash jobs, as well as income from unreported illegal activities such as prostitution, illegal gambling, and trade in illicit drugs.
7.11 Not all of the economic activities that comprise the hidden economy involve taxable transactions. For example, unpaid housework does not give rise to assessable income.
7.12 As a result, the total value of taxable economic activity on which tax is evaded will be less than the total size of the hidden economy. This feature means that estimates of the size of the hidden economy need to be adjusted in order to obtain estimates of the level of tax evasion. This result can be achieved either by excluding the value of non-taxable activities from estimates of the size of the hidden economy, or by adopting a narrower definition of the hidden economy that excludes non-taxable transactions.
7.13 The Inland Revenue Department commissioned three papers on the hidden economy from Professor DE Giles of the University of Victoria in British Columbia. The papers comprise the first serious attempt to estimate the size of the hidden economy in New Zealand and its interaction with the tax system131. The study covered the years 1968 to 1994.
7.14 The commissioned work estimated the economy-wide level of unmeasured market activity. This measure excluded non-market activities such as housework that are not subject to tax.
7.15 Of ficials advised the committee that the estimated long-run average size of the hidden economy was 8.8 per cent of GDP, while in 1994 it was 11.3 per cent. For 1994 the level of tax evasion was estimated to be $3.2 billion. A casual examination of the time series reveals that the size of the hidden economy fluctuates over time with a rising trend, as shown in figure 1. The research established a positive correlation between the business cycle and the hidden economy, so it is not surprising that the hidden economy was large in 1994 when the business cycle was near its peak, as it was in 1987.
7.16 No estimates exist of the size of the hidden economy or the level of tax evasion in New Zealand after 1994. Providing a reliable estimate would entail re-estimating the model using data for the years after 1994. Any attempts to estimate the size of the hidden economy after 1994 without re-estimating the model would require an assumption as to the proportionate size of the hidden economy. This assumption would affect the reliability of the figures, given the fluctuations shown in figure 1.
7.17 Professor Giles also investigated the relationship between the level and mix of taxation (that is, direct and indirect taxation as a share of total taxation) and the size of the hidden economy. The studies found that:
A decrease in the tax/GDP ratio from its current level slightly reduces the hidden economy/GDP ratio.
An increase in the proportion of indirect tax to direct tax from its current proportion reduces the hidden economy.
The introduction of GST in 1986 had a noticeable impact in reducing the size of the hidden economy relative to GDP.
If the government were to reduce tax rates to zero, the hidden economy would still remain at 4 per cent - 4.5 per cent of GDP132.
The rate of economic growth, unemployment, inflation and government regulation were found to be significant contributors to the size of the hidden economy.
7.18 These results point to some interesting conclusions. First, on its own, reducing the tax/GDP ratio is not particularly effective as a means of minimising the hidden economy given the substantial tax revenue foregone for only slight gains in reducing the hidden economy. Several reasons exist for modifying the statutory tax rates and the tax bases to which they are applied. These reasons include lessening the economic distortions caused by taxes and redistributing income. It follows that reductions in the size of the hidden economy caused by lower tax levels are best seen as a beneficial side effect of such a policy, rather than a prime reason for their introduction.
7.19 Secondly, getting rid of taxation does not get rid of the hidden economy. This finding implies that a significant proportion of income is unreported for reasons other than taxation, such as criminal activity or avoiding other forms of government regulation.
7.20 Finally, many other influences on the size of the hidden economy proved significant in the research. Aside from the rate of economic growth, unemployment, inflation and government regulation were found to be significant contributors to the size of the hidden economy. The government addresses these issues as part of its wider economic policy.
7.21 Internationally, New Zealand €™s hidden economy is in line with most OECD countries in terms of both the 1994 estimate of 11.3 per cent of GDP and the long-run average of 8.8 per cent of GDP. The estimates range from approximately 27 per cent of GDP for Italy to 6 per cent of GDP for Switzerland for 1994. Generally, the hidden economy has been growing in most OECD countries.
Source: Giles, D 1998 €˜The Underground Economy: Minimizing the Size of Government €™ in Grubel H, ed, How to Spend the Fiscal Dividend: The Optimal Size of Government, Fraser Institute, Vancouver (forthcoming).
7.22 Officials cautioned the committee about comparisons between studies and across countries. There is wide variation in estimates of size of the hidden economy depending upon the country concerned, the availability of data and the method employed in estimating it. Park (1979) and Feige (1982), for example, estimated the size of the hidden economy in the United States at 4 per cent and 33 per cent of GDP respectively for 1978133. These results show, as noted by Professor Giles in his paper, that not only does the evidence €˜suggest variation over time and across countries for the relative size of the hidden economy, but it is also rather imprecise €™134.
7.23 Since 1984, successive governments have introduced a range of initiatives that have reduced the scope for tax evasion in New Zealand.
7.24 For example, reductions in the rates of income tax, in combination with the introduction of the GST regime, significantly reduced both the incentive and opportunities for many taxpayers to evade tax. In particular, these changes discouraged the willingness of businesses registered for GST purposes to pay cash to suppliers of their inputs, as this would result in the loss of their input tax credits.
7.25 The broadening of the tax base, and reduction in tax rates, also enabled a significant extension of withholding tax regimes. This extension included the introduction of the dividend imputation regime, and the subsequent introduction of a resident withholding tax on interest and dividend income. These measures significantly reduced the scope for individuals to evade tax on their interest and dividend income.
7.26 More recently, the Inland Revenue Department has been seeking to encourage compliance by simplifying the tax system. This process involves a range of activities including:
The implementation of phase one of the project, Directions: Customer Requirements. This project improved the accuracy of the resident withholding tax system in order to reduce the number of taxpayers required to file tax returns.
The beginning of phase two of the project, which is directed at reducing compliance costs for businesses, especially small businesses.
The rewriting of the Income Tax Act to improve the ability of taxpayers to determine, calculate and satisfy their income tax obligations.
The introduction of a system of binding rulings to help taxpayers determine how the tax system applies in particular circumstances.
The planned introduction of legislation to codify the practice of self-assessment.
7.27 In addition, the Inland Revenue Department has been pursuing a range of initiatives aimed at discouraging non-compliance. These initiatives include:
introducing more effective penalty provisions;
making more effective use of information provided through the binding rulings system to identify potential threats to the tax base;
implementing legislation to ensure that stolen money is taxable;
implementing a wide range of compliance improvement initiatives.
7.28 The department €™s compliance improvement strategy is designed to identify key risks and compliance improvement opportunities and to maximise net revenue over time. The factors considered in the assessment of risk include the revenue at risk, the number of taxpayers involved, the opportunity for non-compliance, and the likelihood of the risk continuing.
7.29 Under the compliance improvement strategy, the Inland Revenue Department has planned the following initiatives.
Improving society €™s compliance attitudes toward tax compliance by promoting to the community the consequences to the evader and to society generally of people cheating on their tax obligations. The nature of such community awareness programmes is discussed in more detail in the committee €™s recommendations at the end of this chapter, as well as in chapter 16.
Improving Inland Revenue presence by, for example, co-locating staff with other agencies and enabling staff to work from home in areas where there is no office presence by the department.
Improving detection capability and investigating the effectiveness of conducting random audits.
Utilising intelligence collected from the several customer segments of the department.
Conducting research into the compliance of immigrants who have English as their second language by testing the extent to which their businesses are included in the tax system.
Improving staff capability by training new staff and retaining those audit staff with existing experience and by being more competitive in the employment market for these skills.
7.30 The audit selection process complements the compliance improvement strategy by a continuous review of large corporations and by individually selecting taxpayers for audit. The selection criteria include abnormal financial ratios or trading results, prior audit results and selected industry audits based on risk.
7.31 The Special Audit section of the department audits illegal activities, such as drug dealing and white-collar crime. This work is difficult and often dangerous. The committee commends the work done by the Special Audit staff and recognises the valuable contribution they make. The committee notes that the resources of Special Audit doubled in 1996 and a review of those resources is being conducted at present with a view to an increase.
7.32 As shown in Table 6, the Inland Revenue Department collects considerable revenue from its audit activities. Officials advised the committee that much of the revenue identified by Special Audit in the 1997-98 period was deferred for assessment pending the introduction of legislation making stolen money assessable.
Table 6: Revenue from audit activities
All Other Audit areas
Total Audit as a % of Total Tax Revenue collected by Inland Revenue
NB: €˜All Other Audit Areas €™ is all audit functions except Special Audit. The Special Audit figure is for additional tax assessed, measured on a cash basis, while the figure for all other audit areas is for non-compliance detected, which is measured on an accruals basis, and omits taxpayer errors, voluntary disclosures and objections and cases stated.
7.33 Although the estimated size of the hidden economy in New Zealand is around the lower to middle level for OECD countries, this is not a reason to be complacent. There is little doubt that the level of tax evasion in New Zealand would have been much higher now had previous governments not decided to broaden the tax base, reduce tax rates, and extend withholding tax regimes to cover a wider range of income.
7.34 These measures were implemented as part of the programme of tax reform that New Zealand has pursued since the mid-1980s. It seems likely that an inadvertent by-product of this major programme, and of the restructuring of the Inland Revenue Department that followed, may have been that the department was left with insufficient resources to tackle residual areas of tax evasion, particularly where the essential problem is non-declaration of income. In this connection, there are two factors to bear in mind.
7.35 First, measures to reduce tax rates, to broaden the tax base and to introduce withholding taxes chiefly involve changes in the law, followed by appropriate systemic changes to the department €™s administration. Attacking non-declaration of cash receipts or, say, discovering undeclared income kept in bank accounts in foreign countries, require other techniques: skilful auditing, careful detective work, and so on.
7.36 Secondly, tax evasion in the form of simple non-declaration of income appears nowadays to be concentrated in some relatively specific areas of the economy. The committee reaches this conclusion by setting to one side areas of the economy and types of transaction that do not lend themselves to evasion. Wages and salaries are the prime example. The PAYE system means that it is likely to be rare for wage and salary earners to evade tax simply by means of suppressing receipts. The same consideration applies to taxpayers who derive interest or dividends. Withholding tax that is now applied at source makes the non-declaration of interest or dividends an unpromising evasion strategy.
7.37 Different considerations that lead to a similar conclusion apply to large businesses that must entrust the preparation of accounts and tax returns to employees, and to businesses whose main sales are to other businesses, and not to retail customers. Tax evasion needs secrecy, which cannot be guaranteed if a firm €™s tax affairs must be known to employees, or if customers or suppliers are themselves in business and, therefore, have a duty to keep records of transactions for tax purposes. On the other hand, undertakings where evasion is a practical proposition include owner-operated businesses, businesses whose customers buy on private or capital account, and businesses that take some or all of their receipts in cash. The problem is exacerbated in such businesses by the factor of competition. If a few businesses evade tax, they are able to reduce prices. Often, competitors will feel obliged to follow suit in order to meet the market. Tax evasion by one can thus breed tax evasion by others.
7.38 Several conclusions follow from these considerations. First, although, like a number of other countries, New Zealand has a hidden economy estimated at about 10 per cent of GDP, in specific sectors it is likely that the proportion of receipts that are suppressed, and of tax that is evaded, is very much higher. Secondly, there are few, if any, broad-brush legislative responses. Rather, the Commissioner must rely on administrative measures, such as better taxpayer intelligence and better audit techniques. Like any tax authority, the New Zealand Inland Revenue Department keeps these matters in mind. However, as mentioned, it may be that in recent years the department has not kept evasion as much in mind as desirable.
7.39 One reason is that the attack on tax aspects of the hidden economy must differ from other fiscal measures. Major reforms, such as adopting a company imputation system or enacting withholding taxes, take a long time to plan; once in place, however, they can often be left to carry out their tasks. For the hidden economy, major systemic reforms are seldom feasible. Each improvement of audit technique or accretion to information about taxpayers is relatively small in the total scheme of the tax system. It follows that to be effective, such improvements must be regular and inexorable; Inland Revenue management should not implement some reforms to combat evasion and then turn its attention elsewhere, intending to return to evasion in some years €™ time. Rather, anti-evasion strategy should follow the "Kaizen" theories pioneered by the American philosopher of management, Edwards Deming135. This strategy is the committee €™s major recommendation for tax evasion. Below, the committee considers a number of more specific measures.
7.40 Deming argued that good management requires businesses to strive constantly for improvements in systems and techniques. Deming deplored the spasmodic improvements that he saw in many American businesses, which would invest heavily in planning and implementing new systems or plant, but then leave those systems or plant to operate unrefined for some years before circumstances forced another review. Deming advocated keeping systems constantly under review and making small regular improvements as opportunities offered. In the committee €™s opinion, this approach should be used in attacking the hidden economy. Major systemic successes are elusive, though they are most welcome when they occur. The committee recommends that an appropriate goal should be a sustained accretion of improvements, that steadily whittle away at the amount of tax that is evaded and that enable the department to respond quickly to new business techniques or to new systems of concealment that offer opportunities for new methods of evasion.
7.41 In order to maintain a strategy of a sustained, always improving attack on tax evasion, there is a need to ensure that the Inland Revenue Department keeps up to date with recent literature on anti-evasion measures, gathers and exchanges information about administration from and with foreign tax departments, and gathers information from the field in New Zealand. The objective must be to move smoothly to the next stage of the process, namely, to deploy this information in an anti-evasion strategy that is continually reviewed, tested, and updated. Tax departments need a formalised and regular means of bringing international experience and scholarly writings to bear on their attack on tax evasion. The committee understands that the activities that it has in mind are divided between the department €™s Policy Advice and Operations divisions. However, the committee does not have a grip on the methods that the New Zealand Inland Revenue Department employs for planning and executing anti-evasion strategies, nor, in particular, whether there is a unit dedicated to the task or whether this work is shared by a number of units. The committee leaves it to the Commissioner to decide whether policy formation and strategic planning as to the hidden economy and tax evasion should take place within the Policy Advice division or the Operations division or within a unit that draws personnel from each division. But the committee has no doubt that there should be a rationalisation and coordination of departmental expertise and focus in this area.
7.42 In addition, the committee recommends that the targeting of audits should not be based solely on the amount of tax being evaded by a particular taxpayer. Rather, the Inland Revenue Department should also target types of tax evasion that involve many taxpayers evading tax on small amounts of income. This approach would provide a more effective deterrent to tax evasion by drawing the attention of a wider range of tax evaders to Inland Revenue €™s audit activities.
7.43 Exactly what level of resources should be devoted to audit activity is not a straightforward matter. At first sight, it appears that the solution is to keep increasing the amount spent on audit until the marginal increase in revenue raised equals the marginal cost to the Inland Revenue Department associated with conducting that audit.
7.44 On closer inspection, however, this approach may result in an over-investment in audit activity because the benefits of increased audit activity are not equal to the amount of revenue raised. That revenue is simply a transfer from one group in the community (those not previously paying tax) to another (the recipients of government spending financed by that revenue). By reducing the expected rewards that taxpayers gain from investing resources in evasion activities, auditing lessens the extent to which taxation distorts taxpayers €™ decisions. The real benefits of audit activity are the reductions in those distortions to economic decision making and the more equitable distribution of income that results from improved compliance.
7.45 As outlined below, the committee also recommends that the Inland Revenue Department should:
continually identify opportunities for tax evasion;
continually look for new opportunities for the efficient operation of withholding tax methodologies, whether of existing or new design;
develop a strong community awareness of the cost to the community of tax evasion in terms of facilities, benefits and opportunities foregone, and the increased cost of existing services and facilities;
review the law relating to non-cash transactions, and effectively communicate the law to those sectors of the community where non-cash transactions are prevalent.
Identifying opportunities for tax evasion
7.46 By focusing on situations that provide opportunities for tax evasion, the Inland Revenue Department can more effectively target its audit activities. The department needs formally to evaluate the range of opportunities that taxpayers have for non-compliance with the tax system, and the circumstances in which the reporting of income may be avoided.
7.47 The incentive to evade taxation arises, for example, when the payer incurs a cost on a private account, such that the service provider is taxable and has to account for GST on the consideration for supply, and the payer obtains no relief for income tax or GST on the outgoing payment.
7.48 Tax evasion, however, is not solely the province of those involved in cash transactions. The Inland Revenue Department has in place methodologies for drawing its attention to tax evasion in many sectors of the economy. It is also improving both the way and speed with which it makes use of that information. However, the department must continue to focus on the opportunities for accessing and analysing useful information, to make the information available to those who are responsible for remedial and investigative actions, and to encourage the expectation that such actions be done promptly.
Withholding tax systems
7.49 The Inland Revenue Department should continue to look for new areas to apply withholding tax systems, taking into account their effectiveness in reducing the scope for tax evasion. This approach implies not only applying existing withholding tax systems to other areas, but also developing new systems. Such withholding systems should not, however, impose additional costs on those people who are responsible for making deductions, or who must disclose their income to the Inland Revenue Department. The committee discusses withholding tax systems in more detail in chapter 11.136
Community awareness programmes
7.50 The committee supports the Inland Revenue €™s decision to investigate the development of an integrated programme to alter community perceptions of the acceptability of tax evasion, and to promote voluntary compliance. Such community awareness programmes are also discussed in chapter 16 of this report.137
7.51 To this end, the committee recommends that the department should work closely with community groups, tax practitioners and particularly with specialists in public awareness campaigns to develop industry profiles and more effective compliance at all levels. In developing a community awareness programme, the focus should be on:
the costs of the cash economy to the community;
the fact that there is no excuse for the non-declaration of income;
the introduction of an awareness programme of tax obligations and moral attitude in school education curricula;
the seriousness of the consequences of detection;
the details of the department €™s initiatives on the cash economy, including community presence;
the publication of instances of evasion that have been identified and, where appropriate, the actions taken.
7.52 Other community initiatives might include the development, implementation and promotion of a programme about keeping good records and getting professional advice, and the development of €˜industry toolkits €™ to enhance tax agents €™ attention to tax matters of relevance for industry clients. The Inland Revenue Department could also introduce non-financial sanctions, such as educational measures, when a default is the result of lack of understanding rather than an intentional default.
7.53 The department could also consider the programmes recommended by the Australian Task Force on the Cash Economy, such as the community communication programme and the government agency co-ordination.
Review of the law relating to non-cash transactions
7.54 The law in relation to bartered goods and services is somewhat unclear. The courts have at times relied on the convertibility principle, which says that goods supplied to another person constitute income only if they can be converted into money. 138
7.55 While benefits in kind to employees are taxed under the fringe benefit tax rules, uncertainty remains when people who are not in an employment relationship exchange goods and services. The committee recommends that the law should be clarified so that such transactions do give rise to taxable income even when they cannot be converted into cash. This clarification still leaves the issue of how to value these goods and services. The only practical measure appears to be the market value of the goods or services supplied. The committee recommends that the government should review the law surrounding barter transactions.
7.56 The committee also recommends that the department should effectively communicate a suitable explanation of the tax law relating to barter transactions to those sectors of the community where barter transactions are prevalent.
131The most recent available information on Professor Giles' research on the hidden economy can be found on his website http://web.uvic.ca/econ/economet_he.html.
132 See para 7.19
133Feige E, 1982 "A New Perspective on Macroeconomic Phenomena: The Theory and Measurement of the Unobserved Economy in the United States: Causes, Consequences and Implications", in Walker M, (ed) International Burden of Government, Vancouver, pages 112-136. Park T, 1979 "Reconcilia-tion Between Personal Income and Taxable Income 1947-77" mimeo, Bureau of Economic Analysis, Washington DC.
134 Giles D, 1996 "Measuring the Size of the Hidden Economy and the Tax Gap in New Zealand: an Econometric Analysis", Working Paper 5a, Inland Revenue Department (NZ).