Taxing Income Use: A Strategy for Addressing the Underground Economy

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1. Introduction

The underground economy, a pervasive phenomenon across the globe, encompasses a wide array of economic activities that remain unreported to governmental authorities. This includes not only illegal transactions such as drug dealing and trade in stolen goods but also legal activities conducted without the necessary licenses or the payment of taxes, such as unreported self-employment income and off-the-books labor. The scale of this hidden sector is substantial, with global estimates reaching trillions of dollars annually and the U.S. underground economy representing a significant portion of its Gross Domestic Product (GDP), leading to considerable losses in potential tax revenue. Traditional income-based taxation systems face inherent limitations in effectively capturing the income generated within this clandestine economy due to its very nature of being concealed from official records. In response to these challenges, the concept of taxing the use of income, rather than its generation, has emerged as a potentially viable alternative or a complementary approach to enhance the taxation of underground economic activity. This report aims to analyze the theoretical underpinnings, potential mechanisms, benefits, challenges, and overall feasibility of implementing a tax system focused on income use to more effectively address the complexities of the underground economy.

2. The Nature and Scale of the Underground Economy

The underground economy, also referred to as the shadow economy, black market, or informal economy, is characterized by economic transactions in goods or services that are not reported to the government, thereby evading tax collectors and regulators. This sector encompasses a wide range of activities, from illegal operations like drug trafficking and illegal gambling to legal but unreported income from self-employment, barter, and cash-based businesses. The motivations for participating in the underground economy are diverse, often driven by a desire to avoid taxes, governmental regulations, labor laws, and administrative burdens, or to engage in activities that are themselves illegal.

Estimates of the size of the underground economy vary, but they consistently point to its significant economic footprint. Globally, it has been estimated to amount to approximately $2 trillion per year. In the United States, estimates range from 6.4% to 12% of GDP, which translates to between $1.7 trillion and $3.2 trillion based on 2023 GDP figures. This substantial scale results in considerable losses of tax revenue for governments worldwide, hindering their ability to fund public services and programs. Accurately measuring the underground economy is inherently challenging due to its concealed nature. By definition, its activities are not included in official government records. As a result, researchers and tax authorities rely on indirect methods to estimate its size, such as sample surveys, tax audits, discrepancies between national income and expenditure statistics, labor force statistics, and monetary approaches.

Note: This table presents a selection of estimates to illustrate the scale and variation of the underground economy.

The difficulty in obtaining precise measurements and the significant scale of the underground economy highlight the need for exploring alternative and complementary approaches to taxation that can effectively capture this often-hidden economic activity.

3. Limitations of Traditional Income Tax in Addressing the Underground Economy

Traditional income tax systems, which primarily rely on individuals and businesses voluntarily reporting their income, face significant challenges in effectively taxing the underground economy. A core feature of the underground economy is the intentional failure to report income to government authorities, thereby evading income tax obligations. This is often facilitated through the use of cash transactions, which leave no easily traceable records, and other schemes designed to conceal financial activities and true tax liabilities from government agencies. For instance, cash-intensive businesses may pocket customer payments without reporting them, and off-the-books workers accept cash payments to avoid income and payroll taxes.

The ability of tax authorities to detect and penalize participation in the underground economy is also limited. Relatively low IRS audit rates mean that many individuals and businesses involved in unreported income activities are unlikely to be caught. Moreover, the difficulty in auditing cash-based businesses, due to the lack of accurate records, further compounds this challenge. The motivation to operate within the underground economy can also be amplified by the perceived burdens of the formal economy. High tax rates and complex regulatory frameworks may incentivize individuals and businesses to move their activities underground to avoid these costs, especially when the capability of the government to enforce compliance is weak. This creates a cycle where the desire to evade high taxes or cumbersome regulations pushes economic activity into the shadow economy, further eroding the tax base for the formal sector.

4. Taxing the Use of Income: Theoretical Basis and Potential Mechanisms

Given the limitations of traditional income tax in addressing the underground economy, taxing the use of income presents a conceptually different approach. The theoretical basis for this strategy often rests on the idea that taxation should be based on what individuals take out of the common economic pool (consumption) rather than solely on what they contribute (income). Consumption is seen by many economists as a more accurate reflection of an individual’s economic well-being and ability to pay taxes, as it represents the ultimate aim of economic activity. Several potential mechanisms could be employed to tax the use of income: 

• Increased Consumption Taxes: Implementing or increasing broad-based consumption taxes, such as a Value Added Tax (VAT) or a retail sales tax, directly taxes spending on goods and services. A VAT, levied at each stage of production based on the value added, is widely used in many countries. Raising the rate or broadening the base of existing retail sales taxes could also capture a larger share of consumer expenditure. Additionally, excise taxes on specific goods or services, particularly those frequently transacted in the underground economy, could be considered.

   

• Taxes on Asset Acquisition: Taxing the purchase of significant assets, such as real estate, vehicles, and luxury goods, could serve as an indirect way to tax undeclared income when it is used for investment or conspicuous consumption. Increased scrutiny could also focus on linking such acquisitions with declared income to identify potential discrepancies.

   

• Increased Scrutiny of Wealth Accumulation: Implementing wealth taxes, levied annually on an individual’s or household’s net worth above a certain threshold, could target the accumulation of wealth derived from both declared and undeclared income. Tax authorities could also focus on identifying inconsistencies between reported income and observed wealth accumulation or spending patterns.

5. Potential Benefits of Taxing Income Use for the Underground Economy

Taxing the use of income offers several potential benefits in the effort to capture economic activity within the underground economy. Firstly, consumption taxes, by their nature, have a broader reach than income taxes, as they capture spending regardless of the source of the income. This means that even if income generation goes unreported and untaxed, its eventual use in purchasing goods or services could still be subject to taxation. Secondly, if the use of income is consistently taxed, the incentive to conceal its generation might diminish. If individuals and businesses know that their spending will be taxed regardless of whether their income was declared, the advantage of operating in the shadows to avoid income tax becomes less compelling. Finally, a system that taxes the use of income could lead to a fairer tax system overall. By capturing consumption funded by undeclared income, it ensures that participants in the underground economy contribute to public finances based on their level of economic activity, even if they evade traditional income taxes.

6. Challenges and Considerations in Implementing a Use-Based Tax System

Despite the potential benefits, implementing a system that taxes the use of income to address the underground economy presents several significant challenges and considerations. One of the primary hurdles is the implementation complexity associated with tracking and taxing all forms of income use. Establishing the necessary administrative infrastructure and processes to effectively monitor and collect taxes on a broad range of consumption and asset acquisitions could be highly demanding. Furthermore, the economic impact of high consumption taxes needs careful consideration. Such taxes can be regressive, disproportionately affecting lower-income individuals who spend a larger percentage of their income on essential goods and services. Similarly, taxes on asset acquisition could potentially hinder investment and economic growth by increasing the cost of capital and discouraging the accumulation of assets.

It is also important to recognize that individuals and businesses might find ways to evade use-based taxes as well. For example, underreporting sales in a sales tax system or structuring consumption in ways to avoid triggering taxes are potential avenues for evasion. Furthermore, the introduction of new forms of taxation can often face political and public resistance, making their implementation challenging. Finally, given that the underground economy often has cross-border elements, effective taxation would likely require international cooperation to track and address these activities.

7. Existing Tax Mechanisms and Strategies Targeting Income Use

Many countries around the world already employ tax mechanisms that inherently tax the use of income. A prominent example is the Value Added Tax (VAT), which operates as a consumption tax levied on the value added at each stage of production and distribution, ultimately borne by the final consumer. Tax authorities worldwide also employ a range of strategies to directly combat the underground economy. These include strengthening audits and investigations, particularly in sectors known for high levels of unreported income. Information sharing between government agencies at the national and international levels is also crucial for detecting and addressing cross-border underground activities. The increasing use of digitalization and technology allows tax authorities to track transactions more effectively and identify potential discrepancies. Some governments offer tax amnesties to provide opportunities for individuals and businesses to declare previously hidden income. Efforts to improve overall tax compliance involve simplifying tax systems and increasing public awareness of tax obligations. More direct measures include mandating limits on cash use and taxing cash withdrawals and deposits, as well as requiring the issuance of tax invoices and implementing electronic invoicing systems. Accessing third-party data and applying withholding taxes are also common strategies. Targeted enforcement programs focusing on specific industries with high rates of non-compliance are another approach.

8. Academic and Governmental Analyses

The concept of taxing income use to address the underground economy has been a subject of considerable academic and governmental analysis. Academic research has explored the complex relationship between taxation and the underground economy, with studies indicating that factors such as the level and complexity of tax rates, the burden of social security contributions, and the intensity of regulations in the official economy can significantly influence the size of the shadow sector. Some models suggest that raising tax rates too high can inadvertently drive more economic activity underground, reducing the overall tax base. The choice between taxing income and consumption has also been a recurring theme, with varying conclusions on which approach is more effective in different contexts, particularly when considering the impact on the underground economy.

Governmental bodies, including the IMF, World Bank, and OECD, have extensively analyzed the shadow economy, its impact on tax revenues, and strategies for combating it. These reports often highlight the significant revenue losses associated with the shadow economy and emphasize the need for comprehensive strategies involving improved tax administration, reduced tax complexity, incentives for formalization, and the use of technology. Discussions on the feasibility and effectiveness of focusing on taxing income use, particularly through consumption taxes like VAT, are prevalent in these analyses. While VAT is recognized as an efficient revenue-raising tool, its potential regressivity is a major concern, leading to considerations of compensatory measures or alternative designs like progressive VAT systems. Some research suggests that in developing countries with large informal sectors, uniform consumption taxes can surprisingly be progressive due to the higher proportion of formal consumption among wealthier households.

9. Comparing the Effectiveness of Taxing Income Generation vs. Income Use

Both taxing income generation and taxing income use have distinct strengths and weaknesses when considered in the context of the underground economy. Income tax, in its ideal form, can be highly progressive, allowing for the tax burden to be distributed based on the ability to pay, and it directly targets the earnings from economic activity. However, its effectiveness in addressing the underground economy is significantly hampered by the inherent concealment of income and the challenges in enforcement.

Taxing income use, on the other hand, offers the potential to capture a broader range of economic activity, including income generated within the underground economy that might otherwise go untaxed. By focusing on consumption or asset acquisition, authorities can indirectly tax income regardless of its reporting status. However, use-based taxation also presents weaknesses. Consumption taxes, particularly sales taxes, can be regressive, placing a heavier burden on lower-income households. Both income and consumption taxes are susceptible to evasion, although the methods and opportunities for evasion differ. When comparing VAT and sales tax in the context of the underground economy, VAT’s multi-stage collection process is often argued to be less prone to large-scale evasion at the retail level compared to a single-stage sales tax.

10. Conclusion and Policy Implications

Taxing the use of income presents a compelling strategy for addressing the persistent challenge of the underground economy, offering a potential pathway to capture economic activity that often evades traditional income-based taxation. While the theoretical basis for taxing consumption or wealth accumulation is well-established, the practical implementation faces significant hurdles, including administrative complexities, potential negative economic impacts such as regressivity, and the risk of new forms of tax evasion.

Among the various mechanisms for taxing income use, a well-designed VAT appears to be a promising option. Its multi-stage collection process can reduce the risk of large-scale evasion, and with careful consideration of its design, including potential rebates or tiered rates, its regressive impact can be mitigated. Policymakers should explore the feasibility of a gradual shift towards a greater reliance on consumption-based taxes, ensuring that the transition is carefully managed and that measures are in place to protect vulnerable populations from disproportionate burdens.

Investing in strengthening tax administration and enforcement remains crucial for both income and consumption taxes. This includes leveraging technological advancements for better transaction tracking and data analysis, as well as fostering greater international cooperation to address the cross-border nature of some underground economic activities. Further research and pilot programs are needed to rigorously test the effectiveness of different use-based tax mechanisms in capturing underground economic activity and to understand their broader economic and social consequences. Complementary measures, such as targeted taxes on asset acquisitions or wealth accumulation, could also play a role in addressing the longer-term use of undeclared income. Finally, efforts to simplify the overall tax system and reduce burdensome regulations may decrease the incentives for individuals and businesses to operate in the underground economy in the first place.

In conclusion, while taxing income use is not a panacea, it represents a valuable tool in a broader strategy to enhance tax revenue and fairness in the face of the enduring challenge posed by the underground economy. A balanced and evidence-based approach, combining elements of both income and consumption taxation, alongside robust enforcement and careful consideration of economic and social impacts, is essential for effective policymaking in this complex area.