Revista nº 209. How does Tax In-Justice affect Informal Economy?

How does Tax In-Justice affect Informal Economy?

A reflection on the “Shadow Tax Morale”

“La disperazione più grave che possa impadronirsi

di una società è il dubbio che vivere rettamente sia inutile”.

“The doubt of whether living righteously may be useless,

is the gravest desperation seizing a society”.

Corrado Alvaro (1959)

Abstract

The shadow economy and, by extension, the informal sector, has become part not only of the global economy but also of customs and habits of a large portion of the world population. The added value that the informal economy may give to markets in crisis and to developing countries, however, fails to overcome the hardships that involve the irregular work on a legal level. The difference between the pro and cons of the informal economy cannot surpass the barrier that principles such as this of equality create in order to respect the democratic logic embedded in all modern states.

Given the acceptance of the informal economy by many communities, formal institutions, or laws, can do little to counter informal institutions, morals and social ethics, which, on the other hand, are transformed by informality in an exit option fully justified in the light of an unfair tax system.

To combat the informal economy is therefore necessary to fight the shadow tax morale and for combating the shadow tax morale is necessary to give to the people a political power to believe in, a fair one, which cares about their needs.

The participation in policy decisions on budgetary and taxation matters is only one of the initiatives that governmental authorities could take into consideration in order to ensure that informal workers return to the legal system. In this order of ideas, inclusivity is one of the tools that can positively change the tax morale and discourage the underground economy.

HOW DOES TAX IN-JUSTICE AFFECT INFORMAL ECONOMY? A REFLECTION ON THE “SHADOW TAX

MORALE”

The shadow (or underground) economy and consequently the informal sector are despite their obscure nature, an integral part of the global market economy. During the last two decades it has been observed and demonstrated that informal activities create employment and generate incomes which are immediately placed on the legal economy through the consumption of goods (Asea 1996; Kadokura 2007).

If, from a merely economic approach, in several occasions informal economy represents an added-value, the same is not true for what concerns taxation. The informal sector 1- namely the ensemble of the legal economic activities which, being hidden to Public Authorities become part of the shadow economy-, both from a legal and a political point of view, constitutes a serious danger for any democratic country dealing with the protection of human rights.

As a matter of fact, even where informal economy is accepted and considered a common means of subsistence, it still entails a breach of two groups of rules generally safeguarded by Constitution: labour norms and tax regulations.

The purpose of this paper is researching the causes which drive millions of people from all over the world to work in the informal sector, to waive their rights conferred by law and to live in the shadow.

It will be argued if the non-compliance, in these situations, is awarded to a different (negative) tax morale, also analysing the informal workers perception towards governing authorities.

Which is the burden and the responsibility of an unfair tax policy over the increase of informal economy and its influence on the creation of a tax morale keeping “démos” away from “cràtos”2?

The analysis on the effects that fiscal policies have on the informal economy may not start without some terminological and conceptual clarifications about four basic notions which are often confused during the approach to the issue under scrutiny. In fact, tax gap, fiscal evasion, shadow economy and informal sector, due to some features that they have in common – especially those implying direct consequences on taxation -, are sometimes associated and, despite some studies regarding these mentioned subjects may result useful for the analysis of the others, these are different concepts which should not be misunderstood.

The tax gap, namely the difference between the amount of tax imposed and the amount of taxes reported and paid, should be studied as separate concept even when generated by shadow economy, since it derives from the tax incompliance caused by both evasion and avoidance. Hence, the tax gap

1 The term “informal economy” (or “informal sector”) was created by Keith Hart, a British anthropologist who, during a study of the urban economy of Ghana in 1972, noticed that the majority of the population of Accra was working in a sector which was parallel to that regulated by the state. That same year, the International Labour Organization, used the same term during his “Employment Mission to Kenya”, to define the area of employees who exercised their activities outside the prescribed limits of the law.

2 I.e. democracy, in ancent greek δῆμος (démos) is people and κράτος (cràtos) is power.

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represents a result, an amount of taxes avoided or evaded, while shadow economy is a phenomenon which, due to its uncertain nature (sometimes it can be generated by a legal act or a fact and sometimes by criminal activities which eventually hamper the correct estimation of the tax gap), does not always implement the amount of unpaid taxes.

Tax avoidance and evasion, on the other hand are two criminal offences which may contribute to the implementation of the tax gap and they are originated by the non-payment of taxes arising from incomes earned both legally and illegally, through shadow economic activities or not.

The aforementioned activities -and, in general, shadow economy- can be divided into two groups: informal economy and criminal economy. The boundaries between these two groups are always established by national laws, since every country has the power to define through its own rules whether an economic activity is informal or criminal3. In general terms, economic activities can be differentiated on grounds of their criminal nature; the shadow economic activities can be defined informal when they are legal but not reported or recorded to/by Public Authorities, while illegal activities form the group of criminal economy.

In spite of the important commitment carried out in this field of studies by economists, nowadays a definitive and all-embracing definition of shadow economy is still missing4. A scheme, based on the division of economic activities in relation with the range of the violated rules, has been used over the years, as a matrix for the formulation of new models aimed at determining the concept of shadow economy and related activities which contribute to its formation. Both Lippert and Walker (1997), and Mirus and Roger (1997) elaborated this project using as guidelines only the illegal economy and the informal economy. The result was a pattern characterized by a list of shadow economic activities divided into two groups: illegal and informal activities, while the informal sector was split in order to observe the factual circumstances that gave rise to tax avoidance or evasion. For a better understanding, some examples can be found in the table shown below, elaborated by Schneider and Enste (2000) following the Lippert and Walker”s model.

3 The subdivision of the shadow economy into two groups, the illegal economy on the one hand and the informal economy on the other hand, is currently the most easy way to study the phenomenon from objective data which are the rules. It should be noted however that an absolute and irrefutable objectivity in this respect does not exist, since the norm is always limited to a particular territory. According to what has just been said, in fact, what might constitute a shadow economic activity in a country, may result a legal activity in another place due to different rules. Consider, for example, the prostitution, production and sale of light drugs or, why not, the interests on loans, which are illegal in some Islamic countries.

4The most precise and predominantly used definition seeks to relate the underground economy to officially measured national income: it comprises all presently not recorded productive (i.e., value-adding) activities which should be in the gross national product (GNP) (Frey & Schneider 2000). Another important definition identifies shadow economy with the “market based production of goods and services, whether legal or illegal, that escapes detection in the official estimates of GDP” (Smith 1994). A great commitment on this theme is also that of Tanzi (Tanzi 1999).

HOW DOES TAX IN-JUSTICE AFFECT INFORMAL ECONOMY? A REFLECTION ON THE “SHADOW TAX

MORALE”

As mentioned above and according to the evidence provided by the table, the informal sector is made by legal activities, for this reason, regardless of the motivations that lead people to hide their work to Public Authorities (which will be deeply discussed below), many scholars found and applauded the informal sector as the ideal channel for job creation (Asea 1996; Kadokura 2007). However, in the eyes of the law, such a utilitarian approach seems to be unlikely to derogate some core principles underlying the rule of law (Picciotto 2007; Bovi & Dell”Anno 2007; Amendola & Dell”Anno 2008).

At first glance, there is an overwhelming evidence that informal economy -and its exhortation- is in stark contradiction with the principle of equality. In fact, the disparity in treatment existing for those individuals working in the legal system and those operating in the informal one, cannot be underestimated; the informal sector is a hypothetical “limbo”, in which workers and consequently their families, unlike the formal ones, cannot achieve social security services. Under the same working conditions and with the same physical and intellectual effort, the informal worker, due to the opacity in which his profession is carried out, is cut off from all accesses to public healthcare, social benefit system, public education and legal bank system.

This said, in my opinion, the reference to another universal principle breached by informal economy arises spontaneously: the right to a decent existence worthy of human beings. Is it decent the life of those who live in a dimension which is parallel to the real and legal one, without being allowed to access to public services, often without being considered citizens and without being holder of positive rights universally recognised? The common sense suggests a negative answer. Then no, not in a free, democratic context.

In some areas of the world, especially in developing countries, informal economy absorbs the large majority of dependent and autonomous employment, whilst in other countries the poor prioritisation given by the political system to the issue in exam, causes a tacit acceptance of the irregular work. Both in the first and in the second case it may be detected an

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infringement of the aforesaid principles due to the “silent-approval” of state authorities committed in facilitating the consumption of goods and the money flow in order to levy proportional taxes on the value added and consumption – which are immediately chargeable and ensure the prompt collection of tax revenues – rather than the global welfare, in such a way that the redistributive role of taxation sharply wanes (Sheffrin 1993).

As a result, it seems evident that informal economy is in contrast with a principle which governs modern tax systems (Adams 1999) and which is often suggested by bills of rights and democratic constitutions: the ability-to-pay principle (Gallo 2007; Rosembuj 2013). Such a principle, more strictly connected to tax law than the other mentioned, however bizarre it might seem due to the fact that informal economy is far from those formalities which govern tax systems, is probably the only infringed rule which gathers both those in favour and those who disapprove the informal work.

Assuming that, even if the informal economic activity is exerted in the shadow, every informal worker pays taxes, if not on his/her income, on consumption, the ability-to-pay principle cannot fulfil its regulatory function into the tax system due to the existing lack of fiscal information of the worker personal income (Gallo 2007). This entails, depending on the different circumstances, a prejudice on grounds of equity for both the formal and the informal worker.

Supposing a situation in which, a formal and an informal worker are engaged in the same economic activity (same working hours, same workload and same wage: € 30.000 per year) is undeniable that the formal worker will suffer a prejudice due to the fact that he/she shall be obliged to pay taxes on the earned income, while the informal one, since he/she is not paying any income tax, will reap the benefit of a larger amount of money.

On the other hand, the situation changes when those two workers, one formal and the other informal, who, as in the previous example, are engaged in the same economic activity, earn € 6.000 per year and both have a dependent family with school-age children. The formal worker whose income does not reach the minimum amount for which the payment of an income tax is applied, will not pay taxes on the earned income and probably, in a welfare state, he /she will receive housing and family benefits, he/she will not pay for children”s school and his/her family will have free healthcare services during the period of time in which he/she cannot find a better job with a better wage. Conversely, the informal worker will have no access to the same benefits and probably he/she will look for another job, in order to sustain his/her family, which is likely to be informal too; in so doing, shadow economy will be fostered even more.

It can be observed, from the mentioned examples, that informal economy is harmful for who suffers it directly and indirectly and that the ability-to-pay principle should be considered much more than a general rule of tax law. Consequently, even in different situations, as is in the case of informal economy, such a principle can be considered an instrument able to rectify the

HOW DOES TAX IN-JUSTICE AFFECT INFORMAL ECONOMY? A REFLECTION ON THE “SHADOW TAX

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distortions created by the new market economy and, above all, those generated by moral frameworks and clichés, in order to finally contribute to the formation of a global justice (Verboon & Goslinga 2009; Verboon & van Dijke 2007).

The issue concerning tax morale will be deeply examined, but not before having explained some details about which are the main causes which lead to the creation and the improvement of the informal sector.

First of all, it is necessary to point out that both causes and consequences of the informal economy, as well as its proportions, differ from country to country. Various factors combine to increase this important group of shadow economic activities and none of them can be considered the most significant. The large majority of scholars committed to the issue in exam agree in defining that the unemployment, the burden of taxes and social security contributions, the excessive bureaucracy, the ultra-regulation of the labour market, the income inequality and the elevate degree of corruption are the most relevant determinants of the informal economy in conjunction with the decline of loyalty towards pubic institution and the degeneration of tax morale. This last two causes are strictly connected with the others and in spite of their undeniable aptitude to improve the informal economy, they may be also considered as direct consequences of distinct determinants (Bobek et al. 2013).

The aforementioned list of causes may not be considered totally exhaustive, since informal economy is usually manifested on both a collective and an individual scale. In this last instance, different and personal determinants can emerge, as a result a targeted analysis on singular motivations would be tough and counterproductive (Johnson et al. 1998).

Returning to the main causes of informal economy and focussing on their common features, it can be said that, in general and to varying extents, they depends on the existing relation between public authorities and community. In point of fact, it is not a coincidence that the two dominant doctrines on this matter link the informal economy increase with the modus operandi of governmental bodies.

The first approach, the standard one, of which Allingham and Sandmo (Allingham & Sandmo 1972) are the major exponents, recognise in the weakness of the sanction system the origin of informal economy. Under this model, when the extent of deterrence applied to those engaged in shadow economic activities is low, there is an implementation of the irregular employment.

The standard theory has been refused over the years, since it has been empirically proved that even if the low extent of deterrence may contribute to generate shadow economy, the “sanction factor” is not always related with the rise of the informal sector.

The prevalent approach among those scholar committed in the issue in exam is nowadays the institutional theory, a doctrine developed through the New

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Economic Sociology, considering the interdependence of economic and sociological models the key to understand the present economic system and contemplating the “reputational sanction” as the only way to prevent the shadow economy (Granovetter 1990; Granovetter 1985).

According to this theory, the institutions, i.e. “those rules that constrain human behaviours by affecting the expected playoffs for economic actors” (Feige 1998) produce an increase of the informal economy when formulated by legislative bodies and by habits and customs. In fact, there are two kinds of institutions: the formal and the informal ones. The first, which are based on the duty to respect the law, contributes to the formation of a tax moral together with informal institutions (De Soto 1989), which derive from models of conduct generally accepted by the whole community (Amendola & Dell”Anno 2008).

Often, informal rules, through imitative mechanisms and social sanctions are able to success more than the formal ones (Posner 2000), for this reason the discrepancy between the two types of institutions creates the perfect ground for the implementation of the shadow economy (Dreher et al. 2008; Dreher et al. 2014).

It is therefore clear that, although both kinds of institutions contribute to the creation of the tax morale, the influence of informal rules in human behaviours is always stronger than this of formal rules. Accordingly, it can be argued that tax morale, due to its substantial connection with the society”s perception of the tax system, will be a powerful deterrent for informal economy as long as the existing gap between formal and informal institutions and, consequently, between authorities and community, will be reduced (Schneider & Torgler 2007).

The irregular economic activity, as previously highlighted, undermines the equality principle and fosters the conflict of interests among citizens, for this reason, once accepted as an informal institution it can turn into a way of protesting against formal institutions which generate an “exit option” for those people who do not agree with the political choice of governing bodies (Amendola & Dell”Anno 2008).

The inequality factor, when conceived as a determinant for the implementation of the informal economy, can lead to the deterioration of the trust in the State authority and, as a result, may be considered as a further element of the “shadow tax morale” (Buehn & Schneider 2012).

Recent studies show that even income inequality may have a negative influence on the tax morale (Odoardi & Pagliari 2011), implementing informal economy more than some fiscal variables such as the tax burden and that there is a strong correlation between the rise of the underground economy and the coexistence of a welfare system unable to reduce income inequalities (Feld & Frey 2002).

At this stage, it can be assumed that some of the determinants listed above (tax burden, social security contributions, excessive bureaucracy and ultra-regulation of the labour market) cannot favour behaviours against formal

HOW DOES TAX IN-JUSTICE AFFECT INFORMAL ECONOMY? A REFLECTION ON THE “SHADOW TAX

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institutions and do not constitute a booster for the shadow economy in absence of a social discontent (Wenzel 2005). What has just been stated can be confirmed by the research of Torgler, probably the leading exponent of the institutional theory, who through its demoscopic studies (Latinobarómetro and World Values Survey) shows that when the tax morale is in contradiction with formal institutions, the underground economy grows, while a high degree of trust in governmental bodies and a low level of social inequality increase the quality of democracy, favour individuals” happiness and discourage illegality and informal activities (Bobek et al. 2013).

The analysed thesis may be also applied to the tax justice issue and, in particular, to the collective perception of the tax burden (Chong & Gradstein 2007). Thanks to the research of Bovi e Dell”Anno (Bovi & Dell”Anno 2007) it can be observed that a high level of acceptance of formal institutions by informal institutions creates a tax morale characterised by a significant degree of tax compliance which cannot be affected by an elevated tax burden.

The coincidence between formal and informal institution aimed at promoting a tax morale able to reject informal economy, therefore, depends on the trust that the community has on the governing authority (Feld & Frey 2007), a trust which can be earned through economic policies welcomed by the population and also through the participation of citizens in fiscal and budgetary decisions (Alm et al. 1999). Researches as those of Frey in fact, inform on the positive effect that direct democracy has on tax compliance. It is argued that subjective tax knowledge and participation in tax policy decision is positively correlated with trust (Picciotto 2007) and consequently, under my point of view, with a positive tax morale able to discourage informal economy (Frey & Torgler 2006).

The issue regarding the participation on fiscal policy decisions recalls the last observation of this paper, concerning “inclusivity” as a deterrence method able to combat informal economy.

For the purposes of the following analysis, the term “inclusivity” is used in order to designate a complex of rules and, as a result, tax policies, able not only to discourage the entrance into the informal sector through an appropriate welfare system, but also -and above all- measures capable of stimulating the spontaneous resurfacing of informal workers. Accordingly, the aforesaid participation in tax policy decisions could be considered as a measure endowed with a high degree of inclusivity (Kelly 2014).

It should be stressed that inclusivity may act as a bridge connecting formal and informal institutions, in order to reduce the existing gap between authority and society and allowing citizens to consider themselves as active parts of the political and territorial community to which they belong.

More extensive studies would be needed in order to find concrete examples of inclusivity in some current tax policies, however from the observations done until now on tax morale it is possible to extrapolate a partial conclusion

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concerning the existing relation among tax justice, tax burden, inclusion and democracy within the context of informal economy.

Tax burden and fiscal policies which do not take into consideration the ability-to pay principle may create a general discontent that leads the citizenship to conceive the tax system as unfair. The response of the community to this injustice would be the mistrust towards the politic authority, seen as an enemy of the population rather than its representative, with a consequent proliferation of anti-system acts and therefore, an implementation of the underground economy. Hence, the crisis of democracy would occur, and the power of the people would turn into the power of an authority which is alienate from the governed community.

In such a context, welfare policies and tax burden decrease would be a temporary solution (Clotfelter 1983) apt to transform the discontent in opportunism without introducing any positive influence into the tax morale (Verboon & van Dijke 2007). As a matter of fact, the informal worker, due to the mentioned policies, could be led to opt for legality entering into the formal system, without feeling him/herself included into the system. This means that this worker could leave the door opened to the shadow economy and return to the informal economy whenever he/she considers this sector more favourable and advantageous. As a result, the inclusivity factor makes all the difference: if the reform of tax policies would include also measures able to effectively integrate informal workers into the legal economy (Kirchler et al. 2008), a change of the tax morale would occur. As a result, informality would be condemned by the community and informal institutions would match with the formal ones.

A research on the fiscal measures able to promote inclusivity may be therefore an interesting evidence aimed at evaluating the influence that these inclusive policies have on the decrease of the informal work.

For now, I will conclude pointing out that the informal work, existing in both developed and undeveloped countries, is a serious outrage against the democracy and should be combatted as any other social disease -independently of its capacity to generate wealth -, in order to prevent the “shadow tax morale” from turning into collective justice and the law from becoming tax in-justice.

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