Introduction

7.1 New Zealand, like many other jurisdictions, relies on a tax system based on voluntary compliance. Taxpayers are expected to understand and comply with their tax obligations.

7.2 Under such a tax system, it is inevitable that some taxpayers will fail to comply with their tax obligations. For example, some people will seek to evade tax by submitting false tax returns that conceal taxable activities from the Inland Revenue Department. Other taxpayers will evade tax unintentionally because they do not understand their obligations. In this case, the taxpayer does not deliberately set out to submit a false return. However, such taxpayers will still file a false return if they are not reminded of their tax obligations either in their tax return, or in supplementary information provided by the Inland Revenue Department.

7.3 Although it is not feasible to eliminate tax evasion completely, it is important to keep the level of evasion under control. Increases in the level of evasion can threaten the integrity of the tax system. In particular, tax evasion undermines the ability of the government to raise revenue in an equitable and efficient manner. Individuals and businesses that evade tax in effect shift their tax burden onto those taxpayers who comply with their tax obligations. This shift results in an inequitable distribution of the tax burden, and disadvantages those businesses that choose to comply with their tax obligations.

7.4 In practice it is extremely difficult to monitor the level of tax evasion in New Zealand. This difficulty arises because tax evasion involves economic activities that are part of what is usually referred to as the ‘hidden’ economy.

7.5 This chapter begins with a discussion of what is meant by the hidden economy and explains how estimates of the size of the hidden economy in New Zealand have been used to obtain an indication of the overall level of tax evasion. This introduction is followed by a discussion of what is being done to reduce the level of tax evasion. The chapter concludes with a description of the committee’s recommended approach to reducing tax evasion.

What is meant by the hidden economy?

7.6 As noted above, tax evasion involves economic activities that are hidden from Inland Revenue. In the course of evading tax, taxpayers either intentionally or unintentionally fail to take into account certain taxable activities when completing their tax returns. These hidden economic activities comprise part of what is usually referred to as the hidden or black economy.

7.7 The hidden or black economy comprises economic activities that are not measured in official statistics, including both legal and illegal activities.

7.8 For example, national statistics exclude certain legal market transactions that have deliberately hidden from authorities, such as the income that taxpayers have failed to declare to the Inland Revenue Department. Certain legal non-market activities, such as the unpaid housework, are also excluded because they are difficult to measure.

7.9 National statistics also exclude certain unreported illegal market activities, such the trade in illegal drugs, as well as illegal non-market activities, such as drugs produced for personal consumption.

7.10 Tax evasion typically involves a range of hidden economic activities, including both legal and illegal transactions, as well as market and non-market transactions. For example, the total level of tax evaded in New Zealand includes the tax evaded on income from unreported legal activities such as income earned from cash jobs, as well as income from unreported illegal activities such as prostitution, illegal gambling, and trade in illicit drugs.

7.11 Not all of the economic activities that comprise the hidden economy involve taxable transactions. For example, unpaid housework does not give rise to assessable income.

7.12 As a result, the total value of taxable economic activity on which tax is evaded will be less than the total size of the hidden economy. This feature means that estimates of the size of the hidden economy need to be adjusted in order to obtain estimates of the level of tax evasion. This result can be achieved either by excluding the value of non-taxable activities from estimates of the size of the hidden economy, or by adopting a narrower definition of the hidden economy that excludes non-taxable transactions.

Research on the estimated size of the hidden economy

7.13 The Inland Revenue Department commissioned three papers on the hidden economy from Professor DE Giles of the University of Victoria in British Columbia. The papers comprise the first serious attempt to estimate the size of the hidden economy in New Zealand and its interaction with the tax system¹³¹. The study covered the years 1968 to 1994.

7.14 The commissioned work estimated the economy-wide level of unmeasured market activity. This measure excluded non-market activities such as housework that are not subject to tax.

7.15 Of ficials advised the committee that the estimated long-run average size of the hidden economy was 8.8 per cent of GDP, while in 1994 it was 11.3 per cent. For 1994 the level of tax evasion was estimated to be $3.2 billion. A casual examination of the time series reveals that the size of the hidden economy fluctuates over time with a rising trend, as shown in figure 1. The research established a positive correlation between the business cycle and the hidden economy, so it is not surprising that the hidden economy was large in 1994 when the business cycle was near its peak, as it was in 1987.

7.16 No estimates exist of the size of the hidden economy or the level of tax evasion in New Zealand after 1994. Providing a reliable estimate would entail re-estimating the model using data for the years after 1994. Any attempts to estimate the size of the hidden economy after 1994 without re-estimating the model would require an assumption as to the proportionate size of the hidden economy. This assumption would affect the reliability of the figures, given the fluctuations shown in figure 1.

Figure 1: Hidden economy as percentage of gdp

Source: Inland Revenue (NZ)

7.17 Professor Giles also investigated the relationship between the level and mix of taxation (that is, direct and indirect taxation as a share of total taxation) and the size of the hidden economy. The studies found that:

A decrease in the tax/GDP ratio from its current level slightly reduces the hidden economy/GDP ratio.

An increase in the proportion of indirect tax to direct tax from its current proportion reduces the hidden economy.

The introduction of GST in 1986 had a noticeable impact in reducing the size of the hidden economy relative to GDP.

If the government were to reduce tax rates to zero, the hidden economy would still remain at 4 per cent - 4.5 per cent of GDP¹³².

The rate of economic growth, unemployment, inflation and government regulation were found to be significant contributors to the size of the hidden economy.

7.18 These results point to some interesting conclusions. First, on its own, reducing the tax/GDP ratio is not particularly effective as a means of minimising the hidden economy given the substantial tax revenue foregone for only slight gains in reducing the hidden economy. Several reasons exist for modifying the statutory tax rates and the tax bases to which they are applied. These reasons include lessening the economic distortions caused by taxes and redistributing income. It follows that reductions in the size of the hidden economy caused by lower tax levels are best seen as a beneficial side effect of such a policy, rather than a prime reason for their introduction.

7.19 Secondly, getting rid of taxation does not get rid of the hidden economy. This finding implies that a significant proportion of income is unreported for reasons other than taxation, such as criminal activity or avoiding other forms of government regulation.

7.20 Finally, many other influences on the size of the hidden economy proved significant in the research. Aside from the rate of economic growth, unemployment, inflation and government regulation were found to be significant contributors to the size of the hidden economy. The government addresses these issues as part of its wider economic policy.

7.21 Internationally, New Zealand’s hidden economy is in line with most OECD countries in terms of both the 1994 estimate of 11.3 per cent of GDP and the long-run average of 8.8 per cent of GDP. The estimates range from approximately 27 per cent of GDP for Italy to 6 per cent of GDP for Switzerland for 1994. Generally, the hidden economy has been growing in most OECD countries.

Figure 2: Size of hidden economy as percentage of
gdp in various countries

Source: Giles, D 1998 ‘The Underground Economy: Minimizing the Size of Government’ in Grubel H, ed, How to Spend the Fiscal Dividend: The Optimal Size of Government, Fraser Institute, Vancouver (forthcoming).

7.22 Officials cautioned the committee about comparisons between studies and across countries. There is wide variation in estimates of size of the hidden economy depending upon the country concerned, the availability of data and the method employed in estimating it. Park (1979) and Feige (1982), for example, estimated the size of the hidden economy in the United States at 4 per cent and 33 per cent of GDP respectively for 1978¹³³. These results show, as noted by Professor Giles in his paper, that not only does the evidence ‘suggest variation over time and across countries for the relative size of the hidden economy, but it is also rather imprecise’¹³⁴.

What is being done to reduce the level of tax evasion?

7.23 Since 1984, successive governments have introduced a range of initiatives that have reduced the scope for tax evasion in New Zealand.

7.24 For example, reductions in the rates of income tax, in combination with the introduction of the GST regime, significantly reduced both the incentive and opportunities for many taxpayers to evade tax. In particular, these changes discouraged the willingness of businesses registered for GST purposes to pay cash to suppliers of their inputs, as this would result in the loss of their input tax credits.

7.25 The broadening of the tax base, and reduction in tax rates, also enabled a significant extension of withholding tax regimes. This extension included the introduction of the dividend imputation regime, and the subsequent introduction of a resident withholding tax on interest and dividend income. These measures significantly reduced the scope for individuals to evade tax on their interest and dividend income.

7.26 More recently, the Inland Revenue Department has been seeking to encourage compliance by simplifying the tax system. This process involves a range of activities including:

The implementation of phase one of the project, Directions: Customer Requirements. This project improved the accuracy of the resident withholding tax system in order to reduce the number of taxpayers required to file tax returns.

The beginning of phase two of the project, which is directed at reducing compliance costs for businesses, especially small businesses.

The rewriting of the Income Tax Act to improve the ability of taxpayers to determine, calculate and satisfy their income tax obligations.

The introduction of a system of binding rulings to help taxpayers determine how the tax system applies in particular circumstances.

The planned introduction of legislation to codify the practice of self-assessment.

7.27 In addition, the Inland Revenue Department has been pursuing a range of initiatives aimed at discouraging non-compliance. These initiatives include:

introducing more effective penalty provisions;

making more effective use of information provided through the binding rulings system to identify potential threats to the tax base;

implementing legislation to ensure that stolen money is taxable;

implementing a wide range of compliance improvement initiatives.

7.28 The department’s compliance improvement strategy is designed to identify key risks and compliance improvement opportunities and to maximise net revenue over time. The factors considered in the assessment of risk include the revenue at risk, the number of taxpayers involved, the opportunity for non-compliance, and the likelihood of the risk continuing.

7.29 Under the compliance improvement strategy, the Inland Revenue Department has planned the following initiatives.

Improving society’s compliance attitudes toward tax compliance by promoting to the community the consequences to the evader and to society generally of people cheating on their tax obligations. The nature of such community awareness programmes is discussed in more detail in the committee’s recommendations at the end of this chapter, as well as in chapter 16.

Improving Inland Revenue presence by, for example, co-locating staff with other agencies and enabling staff to work from home in areas where there is no office presence by the department.

Improving detection capability and investigating the effectiveness of conducting random audits.

Utilising intelligence collected from the several customer segments of the department.

Conducting research into the compliance of immigrants who have English as their second language by testing the extent to which their businesses are included in the tax system.

Improving staff capability by training new staff and retaining those audit staff with existing experience and by being more competitive in the employment market for these skills.

7.30 The audit selection process complements the compliance improvement strategy by a continuous review of large corporations and by individually selecting taxpayers for audit. The selection criteria include abnormal financial ratios or trading results, prior audit results and selected industry audits based on risk.

7.31 The Special Audit section of the department audits illegal activities, such as drug dealing and white-collar crime. This work is difficult and often dangerous. The committee commends the work done by the Special Audit staff and recognises the valuable contribution they make. The committee notes that the resources of Special Audit doubled in 1996 and a review of those resources is being conducted at present with a view to an increase.

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Footnotes

¹³¹The most recent available information on Professor Giles' research on the hidden economy can be found on his website http://web.uvic.ca/econ/economet_he.html. Back
¹³² See para 7.19 Back
¹³³Feige E, 1982 "A New Perspective on Macroeconomic Phenomena: The Theory and Measurement of the Unobserved Economy in the United States: Causes, Consequences and Implications", in Walker M, (ed) International Burden of Government, Vancouver, pages 112-136. Park T, 1979 "Reconcilia-tion Between Personal Income and Taxable Income 1947-77" mimeo, Bureau of Economic Analysis, Washington DC. Back
¹³⁴ Giles D, 1996 "Measuring the Size of the Hidden Economy and the Tax Gap in New Zealand: an Econometric Analysis", Working Paper 5a, Inland Revenue Department (NZ). Back