IMPLICATIONS OF TAX EVASION ON THE ECONOMIC DEVELOPMENT OF THIRD WORLD

COUNTRIES

A Synthesis

Presented to the Faculty of the

Department of Accountancy

School of Accountancy, Management, Computing and Information Studies

In Partial Fulfillment

Of the Requirement of the Course

Accounting 505 (Synthesis)

Submitted by

Kryza Mae R. Delmendo

Submitted to

Ma’am Noreen Lab-as

May 9, 2020
 ABSTRACT

Tax evasion is a complicated trend and largely present in all types of economies, a third world country is
not an exception. While the developing countries struggle to improve, complications, tax evasion is one,
should be lessened or better yet stamped out. The issue of tax evasion has portrayed an inverse
relationship to economic development. As long as tax evasion persists, economic development would be
hindered.

Keywords: Tax Evasion, Economic Development, Third World Countries

INTRODUCTION

Tax plays a big role in financing government projects. Tax revenues are used for public services
and operation of the government thus being regarded as the lifeblood of the government. The collection of
taxes is enforced as it is a necessity for the government to operate. Tax is a burden in itself thus some
taxpayers resort to all means, be it legal or illegal, in order to reduce the amount to be paid.

Tax Evasion is the use of illegal methods to conceal and reduce taxable income in contrast to Tax
Avoidance wherein taxpayers make use of legal means in reducing their taxable income. The issue of tax
evasion has received a considerable attention from researchers and policy making institutions such as the
International Monetary Fund, United Nations and various organizations involved in the collection of
revenue over the past decades (Dalu, 2012). According to Hessing et al (1998), in recent years, policy
makers as well as social scientists have begun to recognize that income tax evasion is a behavioral
problem that seriously threatens the capacity of government to raise public revenue. The two groups that
do not comply with taxes include tax resisters and tax protesters. Palil et al (2016) point out that tax
resisters are concerned with not paying for the particular government policies they oppose while tax
protesters attempt to evade the payment of taxes by using trivial interpretations of tax laws.

The most apparent negative impact of tax evasion is reduced national revenues which would
affect the operations of the government. According to the most recent estimates from the International
Centre for Tax and Development, total tax revenues account for more than 80% of total government
revenue in about half of the countries in the world – and more than 50% in almost every country. Having
said that, tax really plays a big role in shaping government’s funds. Moreover, the data shows that
developed countries actually collect much higher tax revenue than developing countries despite
comparable statutory taxation rates, even after controlling for underlying differences in economic activity.
This suggests that cross-country heterogeneity in fiscal capacity is largely determined by differences in
compliance and efficiency of tax collection mechanisms. Both of these factors seem to be affected by the
strength of political institutions.
 Angel Gurría, the secretary general of the Organization for Economic Cooperation and
Development (OECD), an economic organization consisting of the world's richest nations, once estimated
that developing countries lose three times as much to tax evasion as they receive in foreign aid. The level
of taxation is very important for the development of current and future of a country and fiscal policy should
always be considered as an important factor in the behavior of participants and their ability to tax evasion
and informality (Ukaj, 2014). While the problem of tax evasion is as old as taxation itself, recent years
have seen a significant increase in research. Research has been undertaken by economists,
psychologists, sociologists, political scientists, lawyers, accountants and others (Spicer, 1986). This paper
examines research on the impact of tax evasion on the economic development of third world countries.
The concept and determinants of tax evasion and its effects will be considered. And to establish a
relationship between tax evasion and economic development of third world countries, the role of taxation
in the economy of third world countries and how its economic development and growth be affected by tax
evasion will be presented.

CONCEPT OF TAX EVASION

Section 7201 of the Internal Revenue Code reads, “Any person who willfully attempts in any
manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other
penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than
$100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together
with the costs of prosecution.” Tax evasion is using illegal means to avoid paying taxes or to reduce tax
due. Typically, tax evasion schemes involve an individual or corporation misrepresenting their income to
the Internal Revenue Service. Misrepresentation may take the form either of underreporting income,
inflating deductions, or hiding money and its interest altogether in offshore accounts (Legal Information
Institute).

The literature on tax evasion assumes that taxpayers wish to evade their taxes entirely and the
only reason they do not do so is that there is some non-zero probability of being caught by the
government (D’Souza, 2016). In his research, D’Souza also pointed out that in a developing country,
however, argue that taxpayers use tax evasion to compensate for imperfect financial markets as well as
government expenditure patterns that do not benefit them and that tax evasion increases when either
public goods are underprovided, or the government is sufficiently predatory, or the government directs
policies at groups that the taxpayer is not a member of. There is a shifting of allocation of his income
more in investments and away from government expenditure policies that are not beneficial to him.

DETERMINANTS OF TAX EVASION

Taxpayers have their own reasons why they opt to evade paying taxes. These factors if identified
can help government instrumentalities to develop policies to counter tax evasion. Yalama and Gumus
(2013) conducted a research to specifically identify determinants of tax evasion behavior and the results
indicate that taxational and fiscal factors, economic factors, demographic factors, administrative factors,
and other factors have statistically significant effects on tax evasion behavior. They also reiterated that tax
collecting agencies may demonstrate institutional inefficiencies, inadequate tax collection capabilities,
and personal management issues. Among taxpayers, many factors may lead to incomplete tax
compliance.

The research of Ameyaw and Dzaka assessed three factors that lead to tax evasion specifically
in Ghana, a third world country. Factors studied were Taxation and Fiscal Factors, Administrative Factors,
Economic Factors, specifically Income level and Income components, and Demographic Factors which
include gender, age, race and education. Results indicate that there is a positive effect of tax rates to tax
evasion and asserted that such upsurge in tax rates will eventually compel taxpayers to adopt
noncompliant behaviors hence affecting tax revenues needed to fund public expenditures.
Administrative factors captured no effect to tax evasion. Yet, a potential increment in penalties resulting
from tax evasion connote a corresponding decrease in taxpayers’ potential tax-evading behaviors and
an increase in tax audits automatically minimizes the rate at which taxpayers evade taxes.
Economic Factors indicated that higher income level attracts higher compliance while lower income
taxpayers connote lower compliance. High income earners are expected to exhibit his wealth by
complying to taxes whiles low income earners are expected to hide their actual income from tax officials
(Ameyaw and Dzaka, 2016). On the count of gender, female taxpayers are more compliant than their
male counterparts. Evasion of taxes is more unacceptable behavior to female taxpayers than their male
counterparts. With respect to age, it is believed that the aging taxpayers tend to be more compliant
than the younger taxpayers. Younger taxpayers are more risk seeking and less sensitive to penalties.
With regards to ethnicity, minimal research has been undertaken in accounting for the impact of
ethnicity on tax compliance. With reference to race, white folks are more compliant done non-whites but
argued that the results from was found to have a distortive effect. Taxpayers level of education has
a significant relationship with income level, perception of fairness in tax administration, sanction and
detections thus encouraging evasion of taxes if not controlled.

On the other hand, the work of Spicer and Lundstedt two decades ago asserted that there is no
significant relationship existing amongst tax evasion, tax penalties and detection probability. Allingham
and Sandmo asserted that increment in tax rates will exert fear into taxpayers’ hence encouraging tax
compliance. However, earlier research carried out indicated that an increase in tax rates will induce
taxpayers to evade taxes. It was also stressed that a rise in tax rates would shift the burden of tax
payments to few individuals complying to taxes thus, compelling taxpayers to adopt noncompliant
behaviors which could eventually affect the revenues needed by the government to fund its operations.
EFFECTS OF TAX EVASION

Tax Evasion is a problem that almost every country has. Non-compliant taxpayers that use illegal
means to have a reduced tax liability or even non-payment if caught would be faced with penalties. Yet,
the effect of tax evasion would reach more individuals and not just the persons involved. Its effects could
stretch to the poorest of the poor to economic growth of a country as most researchers enumerated. The
work of Manoj and Gopal (2009) has listed numerous effects of tax evasion. Among all the effects, they
highlight that equity is the most unfavorable one quoting “. A blue collar assembly line labourer pays tax.
A restaurant worker whose salary is the equivalent yet who gets some portion of his salary in tips does
not uncover it during payment of tax. Along these lines, one worker gains to the detriment of other. This is
horizontal disparity or inequity. A salaried employee in a company earns the same, as their incomes
appear to be equivalent for tax purposes”. Other listed effects of tax evasion in their paper are as follows,
Tax evasion misshapes economic efficiency. In sectors, that are less subject to the director’s
investigation, there will be more investment. That may be one motivation behind why certain
administration sector-activities for example, construction companies have developed so sensationally as
organization move crosswise over national boundaries in a globalized world economy. Similarly the
unorganized sector might try and avoid taxes much more easily than the organized sector. Small tax
payers have stayed extremely hard to assess and keep up a steady presence in regulatory corners. The
functional capacity, efficiency and effectiveness of a sector suffer because of tax evasion as inequity and
inefficiency can lead to lower government revenue. Capacity endures because of lower accessibility of
assets. The outcome could in all likelihood be an increase in tax rates, or the burden of distortive charges,
in this manner starting an endless loop of inequity and disparities. Tax evasion being under revealing of
pay suggests underestimation of GDP and all its proportionate large scale economic ramifications. Since
the denominator is under-evaluated, the proportion of assessment to GDP, the financial deficiency to
GDP, and open obligation to GDP are all over evaluated. The perceived higher GDP proportion prompts
false solace, yet overstated deflationary action might be made to rein back an overstated financial
shortfall or public debt ratio. Tax evasion has had a reducing effect on the economy’s growth. Reduction
in revenue and increase in inflation are the direct effects of tax evasion. There has been transferring of
funds or black money between India and other foreign countries through secret channels, affecting the
country’s reputation all around the world. There would be disequilibrium in the country as the rich get
richer and the poor becomes poorer. Due to tax evasion by the rich society of the economy, government
is forced to increase tax rates to increase the outcome of revenue every year. Tax evasion will lead to
poor standards of living for the BPL as government doesn’t have enough revenue to take welfare
measures.

A study conducted by Morse described Tax evasion as an epidemic on our nation’s ability to
operate. If this problem were to be alleviated in any way, our government would do better at serving as
our government. A pressing issue relating to this is the growing deficit of our government. If we as citizens
of this country and businesses would take more responsibility by paying our share of taxes to the
government, the country would be less at risk of bankruptcy and default (Morse, 2015). Morse tackled the
effects of tax evasion in the United States and it concluded that the United States deficit is the main
concern for economic effects. With a growing national debt, our ability as a nation to provide jobs,
healthcare, international relations, and unemployment relief diminishes substantially. If the deficit
continues to grow in this nature, our nation will be in serious trouble. If one nation were to collapse due to
its inability to cover losses generated by lack of tax collected, other nations would lose opportunities to do
business with that nation, thus causing those nations to lose revenue generated by tax collection.

ROLE OF TAXATION IN THE ECONOMY OF THIRD WORLD COUNTRIES

Economic Development requires fund in order to realize it and that fund must be raised from
somewhere. Government mostly rely on taxes to fund their operations thus, the role of tax revenue in the
economy of third world countries is as significant as it seems. As defined in the Merriam-Webster, A third
world is the aggregate of the underdeveloped nations of the world and a group of nations especially in
Africa and Asia not aligned with either the Communist or the non-Communist blocs. Third World countries
typically have inferior results to First World and Second World countries in the areas of gross domestic
product (GDP), GDP growth, GDP per capita, employment growth, and an unemployment rate. In these
countries, inferior production and labor market characteristics are usually paired with relatively low levels
of education, poor infrastructure, improper sanitation, limited access to health care, and lower costs of
living (Banton, 2020).

Third world countries are often closely monitored by the International Monetary Fund (IMF) and
World Bank as they are the ones providing global aid for the purposes of projects that help to improve
infrastructure and economic systems. Banton (2020) likewise, expressed that Third World countries can
also be the target of many investors seeking to identify potentially high returns through possible growth
opportunities though risks are also relatively higher. While Third World countries are generally
characterized as inferior economically, innovative and industrial breakthroughs can lead to substantial
improvements in a short amount of time. Given that definitions of third world countries, one notable
difference from developed countries is that they have more than enough funds to sustain their state’s
needs unlike developing countries. Accordingly, aside from International Monetary Fund and World Bank,
where else do these countries could acquire funds without being subjected to cost of interest is by
collecting contributions from its citizens, which obviously is the role of taxation.

The current situation shows that low-income countries typically collect taxes of between 10-20
percent of GDP, while the average for high-income countries is more like 40 percent (Besley and
Persson, 2014). Clearly there needs to be an organized effort to help developing countries increase their
tax revenue to match a similar level as developed nations. The current problem we have in the global tax
system, which affects the developing world particularly acutely, is one of chronic unfairness as
businesses that can afford to pay are failing to do so. The issue can be outlined by the findings from a
report commissioned by Concord. Concord, the European NGO confederation for relief and development,
found that in tax revenue alone, at least $100 billion was lost from developing countries through
insufficient international tax policies. One example study found that if corporations paid fair amounts of
tax, Honduras could “increase healthcare or education spending by 10-15 percent if the practice of profit
shifting by US multinationals was stopped”. Multinational companies are evading social responsibility
through their failure to contribute little or no tax. Corporate tax evasion strategies, referred to as ‘base
erosion and profit shifting’ (BEPS), can be done through measures such as transfer pricing manipulation.
Global Financial Integrity in Washington estimates the amount at several hundred billion dollars lost
annually due to transfer mispricing (Rolling, 2016).

There are several reasons for wanting to encourage global taxation. First of all, the
implementation of domestic taxation allows developing countries to begin to finance their own
infrastructure and hence to take control of their national development. In theory at least, higher tax
revenues should mean that the state is able to invest and deliver a comprehensive range of public
services such as schools, hospitals, the police force and social security. This allows a country to move
from dependence on foreign aid and to a more sustainable and long-term approach to development. In
order to fund the ambitious targets of the Sustainable Development Goals (SDGs), developing countries
can contribute through raising tax revenue at home.

There is also a deeper sociological reason behind taxation. Tax establishes a certain social bond
between the individual and the state. With the notion of the citizen and the state engaged in a ‘social
contract’ comes the responsibility of the individual and the government to cooperate and participate in
good governance. This issue of good governance, in the form of Government transparency and
accountability in handling tax revenue and spending it in the benefit of its citizens, must also be a priority
in addressing the economic situation of developing countries. Establishing a process of taxation could
help stimulate and regulate good governance in developing countries. One practical way in which
developed nations can empower the developing world to take charge of their own welfare is through such
things as training and equipping tax inspectors, investing in institutional infrastructure, ensuring tight legal
regulations, and supporting civil society groups (Rolling, 2016).

TAX EVASION AND ECONOMIC DEVELOPMENT OF THIRD WORLD COUNTRIES

The importance of taxation as discussed above showed that taxation is an important source of
funds for the government to finance its projects in the absence of a foreign aid. Acquisition of funds within
its territories saves a state from paying cost of interest, which could be big savings to developing
countries. The payment to guaranteed interest could be shift to government projects which is more
beneficial to its people. Taxation is one way of acquiring funds without relying to financial or international
aids, hence, if taxpayers would continuously resort to evading taxes, economic development of a third
world country could be jeopardized. Tax evasion and corruption can have ambiguous effects on economic
growth: tax evasion increases the amount of resources accumulated by entrepreneurs, but it also reduces
the amount of public services supplied by the government, thus leading to negative consequences for
economic growth (Coppier, 2009).

Economic development is defined as the process whereby simple, low-income national

economies are transformed into modern industrial economies. Factors that also defined it are human
resources, physical capital, natural resources and technology. Although the term is sometimes used as a
synonym for economic growth, generally it is employed to describe a change in a country’s economy
involving qualitative as well as quantitative improvements. Qualitative and quantitative improvements
comprise of per capita income and its rate of growth, life expectancy, infant mortality rates, and literacy
rates. Taxes fall under the category of per capita income. The model of Reed (2008), shows that tax
revenues negatively and significantly impacted growth of real personal income from 1970–1999. Reed’s
claim that there is a strong and consistent impact of tax revenues on personal income growth,
consequently, portraying a positive relationship. Meanwhile, a study conducted by Gale et al (2015) by
following the model of Reed, his results for a slightly different time period, indicated a result that are not
strong to an extension of the time period through 2006 or 2011, that the effect of tax revenues on
personal income growth differed dramatically between the 1977–1991 period (when it was negative) and
the 1992–2006 period (when it was non-negative and possibly positive), and that revenues from different
taxes have different effects on personal income growth. In addition, marginal tax rates generally have no
impact on employment and statistically significant but economically small effects on the rate of firm
formation (Gale et al, 2015).

Alternatively, the research of Terzić & Džakula (2019) focused on the relationship of tax evasion
on the functional economic and social environment of Bosnia and Herzegovina (BiH), a country branded
as a third world country. They concluded that tax evasion has multiplicative effects, it destroys the
reputation of institutions primarily and in particular the reputation of the tax administration, it poses a
threat to the tax system and rule of law, causing taxpayer’s distrust of the tax system itself. Thus, by
reducing tax evasion the situation in public finances improves substantially. The paper explored and
confirmed the thesis that tax evasion rate is in direct correlation with economic welfare of society, social
environment and economic activity. No progress can be expected with respect to the reduction of tax
evasion if the environment itself does not improve. A complex and changing business environment, as
well as changes within the environment of taxpayers themselves, open possibilities and exposure to the
risk for occurrence of tax evasion. The overall state of the economy of one state, macroeconomic
environment (economic movements) and institutional system of one country represent one of the
broadest factors that affect the tax evasion. Events in economic sphere are in close correlation with
taxation, and it also has synergetic effect to the overall economy (Terzić & Džakula, 2019). Furthermore,
Ukaj (2014) indicated in his paper that tax evasion reduce economic growth because it reduces the ability
of the government to deliver social good for the citizens and thereby generate inequality between those
who do evasion and those who pay tax thereby contributing to the creation of the motive for involvement
in the evasion of other businesses, and in many cases even the salaries of workers understatement.
Informality leads to unfair competition because informal businesses can sell their products and services at
the lowest rate with low, because that their obligations are low by tax avoidance; informality reduces the
chance of creating jobs in the formal sector, especially in countries where unemployment is high such as
Kosovo, because of the fear that they will lose their jobs, the employees accept to work illegally in some
cases their will, in many cases their minimal wages and working hours is due to longstanding struggle for
survival. Besides causing negative effects on the economic development of the informal employment due
to avoidance of income tax and pension contributions of employees this category, except that in the future
no pension benefits and health insurance, in fact in the long term it will raise the social cost for the state. It
showed that engaging in tax evasion has a direct effect on unemployment, which is a factor of an
economic development. If taxpayers would constantly opt to illegally reduce their tax payable,
unemployment would persist especially in a country where unemployment is high, a characteristic of a
third world country. Caballe and Panades (1997) cited in their paper that if there is a truthful revelation of
taxable amount, then a slight reduction in the costly inspection effort reduces negligibly the amount of
collected taxes whereas the resources liberated by the tax collection agency can be devoted to the
provision of growth enhancing public services, emphasis again on public services. They also added that
to raise the costly inspection effort results in fewer resources available for productive government
spending. It was also highlighted that if savings were increasing in the interest rate and greater
enforcement of tax collection would reinforce the positive growth effects of public capital since it would
directly stimulate a faster accumulation of private capital. Both private and public capitals are needed for
production. Public capital on the part of government for public projects designed to finance its operations
and private capital for providing additional investments and job opportunities. Caballe and Panades
(1997) shown that the effects of greater enforcement depend on the relative productivity of these two
types of capital. Even if greater enforcement leads to a reduction of saving since individuals will enjoy
less disposable income, the overall effect might be growth enhancing. This is so because enforcement
generates resources that are used to finance public capital formation. Public capital becomes a source of
endogenous growth because it allows private capital to keep its marginal productivity at a high level and,
thus, it stimulates savings.

CONCLUSION

Economic development are influenced by four factors namely, human resources, physical capital,
natural resources and technology. Third world countries are apparently lacking of these and that
taxpayers engaging in tax evasion would only make it worse and could hinder growth and development
for the reason that their unreported contribution could have been used by the government to support its
operations. Tax evasion reduces public funds that could be utilized for the improvement of what are
lacking in a developing country. This paper has determined consequences of tax evasion that are
consistent with earlier works. Thus, an inverse relationship of tax evasion and economic development can
be established. If tax evasion is not reduced and tax collection does not improve it follows that lags in
economic growth would persist because it reduces the ability of the government to deliver social good for
the citizens.

Taxes almost cover the public funds available for government operations. Unemployment could
be resolved by creating jobs and that can happen when government has enough public capital to finance
it and public services that are aimed for the betterment of the live of its citizens. These two could be
realized if funds adequate. The development of a third world country is dependent on how its government
spends its available funds and taxpayers have a responsibility as well, and that is to honestly report what
is due from them.

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