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Tax more, lose more

T C A Srinivasa-Raghavan

Extortion by the state, legitimised by some sort of legal sanction, is otherwise known as taxation. Little wonder, then, that rational people prefer not to pay the taxes due on everything that they earn.

This creates a conflict between private rationality on one hand and, if I may coin a term, the morality of public goods that go unprovided if tax avoidance and evasion are high. There are no bets on which wins.

That is perhaps why the portion of income on which people do not pay taxes has been sanctimoniously labelled in India as constituting the "underground economy", "shadow economy", "parallel economy" or, in India, the politically incorrect "black economy".

These value-loaded terms are meant to suggest that if only the full amount due to the state accrued to it, the money would be put to better use. The imputation is that by not paying the state its due, tax avoiders and evaders are moral deviants.

A recent pamphlet by Friedrich Schneider and Dominic Enste* of the International Monetary Fund asks how large the world "shadow" economy might be.

The authors estimate that as a percentage of GDP, the "shadow economy" is between 14 to 16 per cent in the developed countries (which is BIG), between 20 to 30 per cent in transition economies (which, too, is quite big) and 35 to 44 per cent in the developing countries (which is actually quite small).

In the developed countries, the shadow economy has grown from around 10 per cent in 1970 to 20 per cent in 2000. The growth has been fastest in the 1990s, up from 13 per cent of GDP in 1991 to 17 per cent in 2000. The main reason for this is the ever-growing rigidity of the labour markets of Europe.

It follows that there has also been an increase in the shadow labour force.

The authors say that in the Organisation for Economic Cooperation and Development countries, as many as 35 million people are a part of this ghost workforce - there and yet not quite there. No one even dares to venture a guess about the size of this ghost workforce in the non-OECD economies.

All sorts of factors influence the growth of the parallel economy. But high rates of extortion - whether as taxes, social security or regulatory infirmities - are chiefly responsible. "Countries with relatively low tax rates and fewer laws…tend to have smaller shadow economies," say Schneider and Enste.

What effect does a large shadow economy have on economic growth? Opinion, say Schneider and Enste, is divided. There is no conclusive proof either way that it depresses or enhances growth.

On balance, it would seem from what they say that the shadow economy is a force for overall good, never mind that governments can't seem to get their grubby hands on the money generated by it.

This is because "two-thirds of the income earned in the shadow economy is immediately spent in the official economy," they say. "So it is difficult to evaluate whether the shadow economy ultimately affects the official economy in a positive or a negative way."

The analysis of the shadow economies of the world and the way in which governments deal with them have thrown up some interesting policy prescriptions. The Central Board for Direct Taxes should think about them.

The most interesting prescription is that although even major reductions in tax rates may not substantially shrink the shadow economy, they may be able to stabilise it.

Ashok Lahiri might want to examine this proposition. Eighteen years ago, the very first report produced by the institution that he now heads, namely, the National Institute of Public Finance and Policy, was about the "black" economy.

Further, marginal tax rates have a greater bearing on the decisions that people make than average tax rates. This is an interesting concept: would it hurt me more if you cut the little finger off my right hand after cutting my whole left hand off?

Third, say the authors, "governments should put more emphasis on legalising certain shadow economy activities". Their last prescription is far better - do away with needless regulations.

There is, however, one important aspect that they have missed. This is the legitimacy of the state or the legitimacy of the purposes for which it is seen to be collecting taxes.

In countries like India, this has become a major issue because although both average and marginal tax rates are now moderate, people are unsure about what exactly they are paying taxes for.

It is tempting to brush this under the overall rubric of good governance but that charade, it is commonly conceded, has now gone on for too long.

*Hiding in the Shadows: The Growth of the Undergound Economy Economic Issues series No. 30, IMF

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