How to shrink the underground economy: Tax less to collect more

Peter Shawn Taylor
July 13, 2015
Canada’s Conservative government likes to boast that it has reduced the overall tax burden to the lowest level in half a century. Many of the reductions have been in form of highly individualized tax credits and deductions. While these boutique tax cuts may win votes, critics say they are economically inefficient. But by some measures, writes Peter Shawn Taylor, it also appears they are helping shrink the underground economy. In a system based on trust, perhaps targeted tax breaks are boosting taxpayer honesty.

How to shrink the underground economy: Tax less to collect more

Peter Shawn Taylor
July 13, 2015
Canada’s Conservative government likes to boast that it has reduced the overall tax burden to the lowest level in half a century. Many of the reductions have been in form of highly individualized tax credits and deductions. While these boutique tax cuts may win votes, critics say they are economically inefficient. But by some measures, writes Peter Shawn Taylor, it also appears they are helping shrink the underground economy. In a system based on trust, perhaps targeted tax breaks are boosting taxpayer honesty.
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There was a time when working in the ‘underground economy’ meant coal mining and related subterranean endeavours. These days, of course, it refers to the grey market, not the sooty black one. And at first blush it seems to be thriving

In April Statistics Canada released its latest estimate on the size of our country’s underground economy: $42.4 billion. With this up noticeably from $40.9 billion a year earlier, many commentators worried things are getting out of hand. “Canada has its work cut out for itself when it comes to cracking down on the underground economy,” the Toronto Star fretted. “The missing $42.4 billion means a lot of forgone tax revenue,” observed Canadian Business magazine.

But things might not be quite as bad as they seem in Canada’s shadowy underground economy. In fact Canadians’ tax honesty may actually be improving. What might be behind this apparent rise of tax truthfulness? One intriguing possibility lies in the Harper government’s much-maligned propensity to fiddle with the federal tax structure. Perhaps that panoply of boutique tax credits is actually making Canadians more honest at tax time.

While StatsCan pegs Canada’s underground economy at a sizeable $42.4 billion for 2012, in proportional terms the grey market actually appears to be on a long slow decline. Expressed as a percentage of total economic activity in Canada, the underground economy is 2.3 percent of GDP. That’s the same rate as 2011. For the nine previous years, it was 2.4 percent. Back in 1994 it was 2.7 percent. According the Canada Revenue Agency, which commissioned the research, “overall, the study provides encouraging signs that the underground economy is growing at a slower pace than the Canadian economy.”

Before we can speculate on what might be behind this recent improvement in tax compliance, we need to take care of a bit of paper work. This is tax policy, after all.

Data mining in the dark

First, when StatsCan works up its numbers on the underground economy, it ignores illegal drugs, prostitution and any other activity that resides outside the law. These official figures are only meant to capture the share of legal trade in goods and services that evades taxes owing. Paying cash to a handyman to build a deck in your back yard is thus part of StatsCan’s underground economy. The same goes for restaurant owners who use ‘zappers’ on their cash registers to hide sales from the taxman. But ill-gotten gains from selling dope won’t show up in the data.

This leads to our second necessary sidebar. There are many ways to estimate the size of Canada’s underground economy; and they’re all open to criticism as guesswork. “By its very nature, it is difficult to obtain information on the underground economy,” StatsCan admits in its recent release, “so the estimates must necessarily rely on assumptions, indicative information and various indirect methods.” The federal agency uses a bottom-up, or micro-economic, approach by calculating the propensity to avoid taxes on a sector-by-sector basis. Some industries, like utilities, mortgages and municipal services, are unlikely to engage in tax avoidance because they rely heavily on electronic payments. Other sectors lend themselves much more readily to under-the-table cash, such as home renovation, retail and food. According to StatsCan, underground activity accounts for over $2,000 in expenditures per household annually, with food & beverage, rental housing and tobacco the three biggest components.

(Because StatsCan calculates its figures this way, it can provide estimates on tax avoidance by province. Thus Prince Edward Island is Canada’s leading tax cheat because its economy is so dependent on cash-friendly endeavours such as tourist accommodations and meals.)

It is also possible to estimate the size of the underground economy from a macro perspective. Top-down methods include taking observations on monetary indicators or electricity consumption and using those figures to estimate total economic activity within a country. This is then compared to what’s been reported to tax authorities, with the difference being the underground economy. Economists can also use complicated econometric simulations to calculate the grey market. All these macro techniques tend to give much higher estimates because they capture illegal as well as legal activity. A 2010 econometric study pegged Canada’s total underground economy at a hefty 15.7 percent of GDP, far bigger than StatsCan’s current estimate of 2.3 percent. This macro data, however, reveals the same slow but steady decline in the size of Canada’s shadow economy that shows up in StatsCan’s work.

This June, the Bank of Canada unveiled a novel new technique for estimating the amount of unreported income of Canadians by knitting together anonymous income and expenditure data collected by StatsCan and the Canada Revenue Agency; taxpayers who spent more than they earned were assumed to have under-reported their true income to avoid taxes. In this way Canada’s underground economy was estimated at 14-19 percent of GDP, although its relative size appears stable between 1998 and 2004.

Canadian taxpayers cheat less than Russians, more than Americans

Setting aside differences in measurement methods, Canadians’ willingness to pay taxes can also be viewed from an international perspective. So where do we stand compared to other countries? Unsurprisingly, most developing and/or non-democratic countries rank quite low on tax compliance. Using the macro-method from the aforementioned 2010 study, the underground economy of Zimbabwe is estimated at 62 percent of GDP; in Russia, it’s 43 percent; Egypt: 35 percent. The average among developed countries in the Organization for Economic Co-operation and Development is 15.8 percent of GDP, so Canada sits right in the middle of its peers. But while we may appear less honest than the Boy Scouts of the tax-paying world such as Switzerland (8.3 percent), the United States (8.6 percent) and Luxembourg (9.7 percent), our tax system puts greater emphasis on self-assessment and voluntary reporting than many other modern economies. Both France and Israel, for example, impose presumptive income taxes on small business owners in the belief that self-reported figures can’t be trusted.

If Canadian tax compliance is improving, it’s not because Ottawa has hired an army of auditors. In fact, the Canada Revenue Agency has endured significant staffing cuts as part of the federal deficit fight − from over 40,000 employees in 2009 to 38,729 today with another 1,500 full-time employees set to depart by 2017.

In teasing out why some countries show much greater tax compliance than others, academic research suggests the three biggest determinants are the overall tax burden, quality of government and red tape. The amount of tax imposed is clearly important, however it alone doesn’t explain the entire situation. The underground economy in Denmark, by some measures the world’s leader in overall taxes, is about the same, on a proportional basis, as Bahrain, a wealthy low-tax petro-state. Cultural attitudes thus play a huge role in variations across countries. That said, plenty of evidence confirms a strong link between rising taxes and a greater propensity to evade taxes within countries. All other things being equal, a move to hike taxes is likely to increase the size of the underground economy.

Prior to the introduction of the GST in Canada in 1991 it was widely speculated the new tax would lead to a significant increase in tax avoidance. Based on a sudden spike in the cash holdings of Canadians – which would be necessary if people wanted to dodge the GST by paying for more things under the table – that’s exactly what happened. It’s been estimated the GST boosted the underground economy by 1.4 percent of GDP.

While raising taxes leads to lower levels of compliance, cutting taxes appears to have the opposite effect. This makes intuitive sense: the lower the overall tax burden, the less sense it makes to go to the trouble and risk of avoiding taxes. “The global transition to simpler, flatter income tax systems appears to reduce the size of the shadow economy,” states 2009 research from the German-based Institute for the Study of Labor based on a large amount of international tax data. This result is strongest in countries with trustworthy governments and robust legal institutions. Lowering taxes in the midst of widespread corruption does little to improve tax compliance. But the more taxpayers trust their government, the more they’re prepared to reward lower tax rates with higher levels of tax obedience.

Why is the underground economy shrinking?

Knowing all this, what might explain the slow but steady improvement in Canadian tax behaviour over recent years?

It is entirely possible the fall in the size of the underground economy is attributable to global trends such as growth in electronic payment systems. Or it might reflect greater government tax collection efforts, despite the job losses at CRA. It could also be an illusion based on poor quality data or statistical error. But given what we know about the underground economy, here’s a conjecture that seems to fit the evidence: If there’s been a change in the willingness of Canadians to pay their taxes, it is possible this new attitude is connected to the many and dramatic changes to Canada’s tax system implemented by Ottawa since 2006.

Tax reform and reduction has been a consistent focus of the Conservative government under Prime Minister Stephen Harper. Since his promise to cut the GST by two percentage points during the 2006 federal election, his government has created a wide range of boutique tax credits and deductions including a Children’s Fitness Tax Credit, Children’s Arts Tax Credit, Volunteer Firefighters Tax Credit, Search and Rescue Volunteer Tax Credit, Public Transit Tax Credit, First-time Home Buyers Tax Credit, Tradesperson’s Tool Deduction and on and on. Each one provides a qualifying taxpayer with a small but distinct and highly-personalized reduction in the amount of taxes they owe.

The recent 2015 budget included a proposal for a new Adult Fitness Tax Credit plus several larger tax innovations: the controversial income splitting initiative for families with children under the age of 18 which provides up to $2,000 in tax savings for qualifying families; and a major increase in the Tax Free Savings Account limit, pushing it from $5,500 to $10,000 per year and opening up a whole range of new tax planning possibilities.

All this has been criticized by myself and many others for making the tax system overly-complicated, inefficient and prone to political manipulation. It has also created many irreconcilable absurdities − such as the fact married couples now cycle in and out of eligibility for income splitting depending on the age of their children and whether or not they’re receiving employment or pension income − which in turn create all sorts of unusual incentive effects. Plus, the sheer number and specificity of all these tax credits has made it all but impossible to calculate your own taxes without the benefit of a tax consultant. Every new tax credit makes the tax code bigger and more impenetrable, which makes tax calculation more time-consuming and expensive. There are many good reasons to prefer a cleaner, simpler and more streamlined tax regime than what the Harper government has created.

The upside of boutique tax cuts

That said, the current tax credit-heavy system has had one significant and perhaps overlooked beneficial impact − it has created an individualized and customizable tax reduction system that looks different to every individual taxpayer.

Given the huge range of tax credits on offer, it’s entirely possible that no two Canadian families with identical total income will ever pay the exact same tax bill. You might be a married 40-year-old dad with two kids under the age of 16, but the tax you’ll pay on $50,000 worth of income could be quite different from all those other 40-year-old dads with kids the same age depending on whether you take public transit to work, what activities your kids enjoy and whether you happen to be a volunteer firefighter et cetera. In a world of infinite individualization, the Canadian tax system has followed suit.

The obvious strategic political assumption behind all this has been that happy taxpayers become willing Conservative voters. Ballot box evidence to date suggests that tactic has been working. But it is equally possible that these changes have implications that go beyond politics. Perhaps the sense that the tax system has been built with you in mind inspires a commitment to be a little more honest come tax time. Where the tax system once seemed cold and grasping, now it appears to recognize every little nuance and variation in your life − and reward many of them with a tax break. It is not that much different from the various ‘points programs’ businesses use to build brand loyalty: we’re paying attention to you and are prepared to recognize your patronage with special bonuses and discounts. You repay us by being faithful.

The small drop in StatsCan’s underground economy figures might thus be considered early proof that Canadians have responded to the Harper tax credit revolution with changes to their own personal sense of tax morality. We already know lowering taxes in a culture where taxpayers have faith in government can lead to higher levels of tax compliance. And if so, then the more personal and tangible the tax cut, the greater the beneficial response should be. For all the complications, inefficiencies and maddening absurdities created by the Harper government’s many boutique tax cuts, they might also be responsible for the observed improvement in Canadians’ sense of tax honesty. And that would be a good thing.


Peter Shawn Taylor is editor-at-large of Maclean’s. He lives in Waterloo.

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