BEST PRACTICES TO CONTROL

UNDERGROUND ECONOMY IN THE WORLD

JAPAN
Consumption Tax (Yasukōchi, 20 Dec 2014)
In 1982 size of the underground economy was said to be in between 30 and 50
trillion yen. As compared to GNP of Japan in 1982, which is about 170 trillion
yen, the underground economy is approximately 17 to 30 percent as large as the
surface economy. Consequently Japanese Government identified a mechanism
to avoid underground economy as under the present tax mechanism, the rate of
tax evasion tends to increase. It was difficult to tax income resulting from
economic activities. Thus they replaced it with tax on consumption and it
proved to be a more appropriate tax collection system. The idea of establishing
the general consumption tax also became the banner of the tax authority and
promoted the adjustment of the balance between direct and indirect tax
revenues.

UNITED STATES
Tax Payer Identification System (Yasukōchi, 20 Dec 2014)
United States is also a victim of underground economy. In this computer age
where almost all economic activities and transactions are either wholly
automated or semi automated, still there are people who bypass the official
system and operate in shadows. Government in response to these informal
activities introduced the concept of Tax Payer Identification System. In this
system all the US residents will be allotted a TIN irrespective of being a US
citizen or not. TIN will used to track down all the activities of individuals in US
and thus has proved to be an effective tool for monitoring and stabilizing
economy. Now the only issue is whether such a system may be an invasion of
privacy or not
A TIN may be:

 a Social Security number (SSN)

 an Individual Taxpayer Identification Number (ITIN)
 an Employer Identification Number (EIN), also known as a FEIN (Federal
Employer Identification Number)
 an Adoption Taxpayer Identification Number, used as a temporary number for a
child for whom the adopting parents cannot obtain an SSN[3]
 a Preparer Tax Identification Number, used by paid preparers of U.S. tax
returns[4]
SSNs are used by individuals who have (or had) the right to work in the United States.
ITINs are used by aliens who may or may not have the right to work in the US, such as
aliens on temporary visas and non-resident aliens with US income. Often people need
the identification number because they have been advised by a bank that no account
will be opened without a number, even if the account is being opened by a non-profit
organization.
EINs are used by employers, sole proprietors, corporations, LLCs, partnerships, non-
profit associations, trusts, estates of decedents, government agencies, certain
individuals, and other business entities.

Quality of Public Institutions (K.Goel, W.Saunoris, & Schneider, 2017)

The standard of government institutions is another major factor for the development
of the informal sector. In particular, a bureaucratic system with highly corrupt
government officials seems to be associated with larger unofficial activity, while a
good rule of law by securing property rights and contract enforceability increases the
benefits of being formal. A certain level of taxation, mostly spent in productive public
services, characterizes efficient policies. In fact, the production in the formal sector
benefits from a higher provision of productive public services and is negatively
affected by taxation, while the shadow economy reacts in the opposite way. An
informal sector developing as a consequence of the failure of political institutions in
promoting an efficient market economy, and entrepreneurs going underground, as
there is an inefficient public goods provision, may reduce if institutions can be
strengthened and fiscal policy gets closer to the median voter’s preferences. So in
order to cope with this situation the US officials have taken several measures for the
uplift of public institutions through better control over corruption and providing
customer value for money.
 POLAND
(Bojarski, 2004)
https://doi.org/10.1108/13590790410809176

The Polish Government has implemented several measures in order to control the
underground economy. Some of which are stated below:

Creation of strict regulatory environment

Underground Economy was regulated through:
 The Penal Fiscal Code
 The Act On Counteracting Introduction of Property Values Derived From Illegal
Sources Into Financial Circulation
 The Criminal Code

According to these regulations underground economy consists of:

 Tax Fraud
 Obtaining VAT under false pretences
 Excise Manipulation

In order to control the violations a combination of disciplinary actions were

introduced. Such as:
 Fine
 Restriction of Liberty
 Deprivation of Liberty or Imprisonment

Formation of Financial Intelligence Unit

Another important step taken by the Polish Government was creation of an institution
whose tasks were the collection, storage and analysis of information obtained from
banks in order to monitor the activities of all present and potential tax payers known
as the FIU, Financial Intelligence Unit.
 CANADA
(Alexeev, et al., 1997)
https://www.fraserinstitute.org/sites/default/files/UndergroundEconomy.pdf

In order to cope with the problem of underground economy, The Canadians have
come up with a concept of user taxes/fees.

“What are user taxes/fees?”

User taxes/fees are payments for specific and clearly identified units of goods
or services such as so many cubic metres of water delivered to a specific
outlet, parking permits valid for given streets for limited time periods, fishing
or hunting licences for particular seasons, and so on.

User fees/taxes are an appropriate way of charging goods and services

provided by government for private use especially when their provision cannot
be privatized. How? User fees/taxes act as pricing mechanisms and thus help
to allocate resources optimally over various goods and services. Proper pricing
would set the fees/taxes to cover the costs of producing these goods and
services for private use. Any excess cost, associated with the inefficiency
subsidy arising from public production, should be raised from general
revenues.

“How can user taxes/ fees help in controlling underground economy?”

It is argued that greater use of user fees and taxes be done to finance governments in Canada.
This should somewhat slake the thirst for general tax revenues and income taxes in particular,
opening the way for reduced tax rates that would diminish incentives for tax evasion and thus
the size of the underground economy.
 INTERNATIONAL MONETARY FUND
(Russell, 2010)

Underground Economy has affected several countries thus causing authorities like IMF to
conduct a detail research over it in order to devise effective measures for controlling it.
Following are some measures suggested by IMF for the fight against underground economy:

Tax policy
At Tax policy level, these countries should focus on: simplifying tax laws; reducing taxes on
micro and small businesses; reducing barriers to entry into the formal economy such as costs,
time, and procedures; allowing more flexible hiring and firing of workers (e.g., through
temporary contracts); and improving and expanding the coverage of social services and health
programs.

Tax administration
At Tax Administration level, priority should be given to developing integrated
compliance management strategies that address the underlying causes of non-
compliance and reflect an appropriate balance of assistance, encouragement, and
enforcement activities. The shadow economy is largely centered in the micro and small
business sectors, and the large number of potential participants means that it is not
logistically feasible for revenue agencies to rely on audit as the sole compliance
improvement lever. The shadow economy manifests in a range of non-compliant
behaviors which are driven by a variety of underlying causes. Revenue agencies should
therefore develop mitigation strategies that respond to the most serious of these
behaviors through a balanced set of measures aimed at engaging with the community
to: (a) reduce community tolerance for the shadow economy; (b) provide targeted
assistance to promote voluntary compliance; (c) encourage self regulation; and (d)
demonstrate a visible and credible detection and enforcement capability.
 Creating Awareness

Raise community understanding of the role played by taxes in achieving social equity
objectives and providing essential public services and infrastructure. This message is
really about the important role of taxation in good government and should therefore be
undertaken at the whole of government level rather than by revenue agencies. This will
require a sustained medium-term campaign aimed at explaining in simple terms the
overall program of taxes and transfer payments, rather than to try to market the
benefits of any single tax or transfer mechanism. The key theme of this campaign is that
“taxes are the price we pay for a civilized society”. Strong discipline around expenditure
decisions is also important in securing community support for the overall tax regime.

Encourage Self Regulation

Voluntary compliance should be encouraged through a range
of incentives that recognize and reward good compliance
behavior. Incentives may include:
 Remission guidelines for penalties and interest that recognize a good
compliance record;
 Less-onerous reporting requirements, and easier access to extended filing
periods and payment installment arrangements for taxpayers with a record of
good compliance
 On-line self-help tools to promote accurate reporting of complex obligations
e.g., A decision support system for determining the employment status of
workers (i.e., are they employees or contractors?)
 Pre-filling of tax returns with data obtained from third parties – e.g., income
from salaries and wages; interest dividends; social service payments; credits for
tax payments withheld from salaries and wages or other payments; and credits
or offsets from other transactions.

Self-regulation can also be promoted through effective liaison with key intermediaries
and other external stakeholders in the tax system including tax agents and other tax
practitioners, banks and other financial institutions, industry, business and professional
associations, and business service providers.
Demonstrate a highly visible and credible detection and
enforcement capability
To complete the shadow economy strategy, tax agencies need to complement the
education, assistance and encouragement activities with a highly visible and credible
program to detect and deal with non-compliance. This requires the development of
effective intelligence gathering, risk identification and analysis, and case selection
capabilities - and a skilled compliance workforce. The enforcement program should aim
to:
Identify people operating outside the system. Revenue agencies should develop an
effective detection program to identify shadow economy operators who attempt to
avoid regulation of their activities by staying completely under the government’s radar.
This program will typically include:
 Conducting regular unannounced on-site visits to locations such as industrial
estates, shopping districts, markets and fairs, restaurant precincts, taxi ranks,
etc. to check that operators are registered in the system
 Matching the revenue agency’s active taxpayer register against third party data
bases for trades and professional associations (e.g. architects, lawyers,
entertainers, and professional sportsmen) to identify unregistered operators.
test-checking the validity of tax invoices to ensure the supplier is registered;
 Introducing reporting arrangements for business-to-business transactions under
which a business must report any purchases from a supplier who does not quote
a valid tax identification number. This arrangement can be complemented by a
withholding requirement
 Monitor compliance by new registrations. New registrations represent a critical
control point for both shadow economy and fraud prevention purposes. In the
context of the shadow economy, revenue agencies should implement a range of
filtering mechanisms to distinguish between operators that are genuinely first-
time businesses (i.e., have no previous experience in operating a business) and
new start-ups which are controlled by experienced operators.
 Identify businesses regularly declaring losses or unrealistically low income.
Business operators who understate income and contribute little or nothing in
the way of taxes gain an unfair advantage over competitors. It is important
that revenue agencies take visible and effective action to detect and deal with
these cases. Revenue agencies should identify such cases using data matching
and data mining capabilities. In industries for which performance benchmarks
have been established, taxpayers falling outside the benchmark limits should
also be selected for review. It will not be cost effective to audit every case, so
 revenue agencies should adopt a differentiated response depending on the level
of risk assessed. The aim is to “touch” as many taxpayers in the risk pool as
possible. Revenue agencies should: Select the high risk cases for audit
verification
 Introduce tailored reporting arrangements for trades or industries in which tax
avoidance practices are endemic (e.g., building and construction, IT service
providers). This approach has been adopted in a number of countries to manage
the risks related to sub-contractors in the construction industry and is supported
by the OECD. An example is the Contract Payments Reporting System
introduced in Canada in 1999. Under this reporting system all entities, including
government departments and agencies, are required to report the total amount
paid to each contractor on an annual basis. Canada then matches the
information reported against income tax records to identify: contractors who
are not registered; contractors who have not filed returns; contractors who
have under reported income; and taxpayers who have received government
benefit payments to which they were not entitled.