Nova workboard

a blog from young economists at Nova SBE

Tax evasion and shadow economy: Chronical problems or “economic illnesses” with possible remedies?

It is widely known that tax evasion is pervasive in most economies, imposing great revenue budget losses for the governments. But how serious are the side effects of the shadow economy? According to Murphy, in Europe, tax evasion represents more than €1 in every €5. Particularly, in Portugal the scenario is severe: in 2011 the size of the shadow economy amounted to 23% of GDP, an astonishingly large value when compared with the 10,6% of GDP that the government spends on health care. This implies that the taxes lost as a result of the parallel economy would be enough to cover 82% of the healthcare spending. Clearly, this is too big to ignore and highlights the need for effective action. The Portuguese government is addressing this problem closely, having designed a strategic plan for the period 2015-2017 to fight fraud and tax evasion and having already launched policies that create incentives for tax compliance. Namely, the well-known rule that allows tax payers to deduct 15% (the initial proposal was of 5%), and up to €250, of VAT in restaurants, hairdressers, hotels and car repairing, aims at decreasing tax evasion in some sectors that are more prone to avoid their fiscal obligations.

An interesting point is, therefore, to know if these kind of incentives have the capacity to increase the tax base and, if so, what are the downsides of such policies. The typical way to analyse tax payers’ decision of whether to evade taxes or not takes into consideration the probability of getting caught and punished, the size of the fine for evasion as well as the agents’ degree of risk aversion. While this “deterrence model”, originally put forward by Allingham and Sandmo (1972) ignores behavioural factors affecting individuals’ decisions, later research has addressed them. In this line, there is evidence that if citizens have confidence that the government will defend their interests then taxpayers will tend to be more cooperative, in the sense that they will pay taxes even when their optimal choice would be to free ride on other taxpayers’ contributions. For Portugal, this may actually have a negative impact on the tax base, since Portugal ranks poorly in the corruption perception index:  in 2014, it was only the 31st country more transparent, in a total of 175 countries.

Concerning policies that reward taxpayers, it is usually accepted that they increase tax compliance. Indeed, when incentives are given to “good” taxpayers, the relative price of paying taxes decreases. So, according to this argument, government’s decision to allow deductions of 15% of VAT will tend to decrease the tax gap. Nevertheless, such policy raises some equity concerns. Indeed, it can be argued that this incentive scheme is regressive since it benefits mainly high income people: to obtain the maximum deduction of €250, taxpayers would have to spend €9000 annually in the referred services, which is a value difficult to reach even for middle income families.

It seems, therefore, that this reward policy is actually able to increase the tax base but, certainly, the greatest gains to the fiscal system would arise from a decrease in corruption and a more transparent political process.

Carolina Santos

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Author: studentnovasbe

Master student in Nova Sbe

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