Tax evasion: lessons from Egypt

In my view, we should be taking a lesson from Egypt when it comes to dealing with tax evasion. I'll explain.

Studies claim that tax evasion among the self employed in Canada is common and the costs are high. What should be done? First, it depends if the government is concerned purely with inefficiency, or if its concern is inequality (which do not need to be trade-offs, as I've argued before here; and I'll point to my view on equality here). I'm going to address the aim of efficiency here, but I'll quickly explain why.

In a welfare state, the objective of an inequality-averse government would be to raise taxes to redistribute incomes, and thus auditing would be useful to protect the tax base. But there are drawbacks to making equality the only major priority. I won't get into the old equality debate again here, but here are a few thoughts: First, when are degrees of inequality aversion sufficient? And, how do we know if such a degree is attainable? Finally, it's worth repeating that, if efficiency is gained, equality does not need to be a trade-off.

My assumption henceforth is that efficiency is the government's concern when it comes to deterring tax evasion.

What actions can the government undertake to increase efficiency? Three possibilities: Do nothing, design an efficient auditing scheme, or cut taxes to a point where the self employed are more willing to pay (and, ultimately, adopt a low flat tax).

Do nothing

If efficiency is the major concern, nothing should be done, claims Simon C. Parker in The Economics of Self Employment and Entrepreneurship (2004: p. 248). Audits are expensive for the government and for the individuals who prepare the tax reports for audits. [edit: My hurried fingers pasted the wrong quote here. Sorry. Intended quote:] "These costs impose deadweight losses on the economy." Parker concludes that a government would be more efficient to not audit.

Design an efficient auditing scheme

Herb J. Schuetze (2002) disagrees. He finds that (at least in Canada) a discriminatory method of auditing would be most effective in reducing tax evasion.

Excerpt from Schuetze's paper "Profiles of Noncompliance Among the Self Employed" (2002, p 19-20) (The entire paper can be found here. Click on "research"):

Even though pre-tax wages will adjust to equalize after-tax wages, too many resources, in terms of efficiency, will be allocated to occupations which provide the greatest opportunities for noncompliance. This result also suggests an obvious strategy for the development of an effective tax audit system. One which targets the self-employed in construction and service occupations is likely to be more effective.

...A tax audit scheme targeting groups which have been found to conceal income the most (such as self employed households headed by younger males or those in the construction and service occupations) is likely to be an effective tool in reducing noncompliance.

He acknowledges a disadvantage:

Clearly, such a policy, if continued for a period of time, would lead to the misrepresentation of occupation and other characteristics by self-employed tax filers to avoid being audited. However, if the information from these audits is used effectively, policies can be designed to reduce noncompliance.

Such a well-designed auditing scheme might be attractive, but perhaps its major disadvantage (other than the one pointed out by Schuetze) is that it's not simplistic. Simplicity in self-employed tax treatment, or any tax treatment for that matter, should be an objective within any economy. By the way, The World Bank agrees with this sentiment (link via The Heritage Foundation) :

Complicated tax systems can lead to high evasion, even when rates are low. ... A better way to meet revenue targets is to encourage tax compliance by keeping rates moderate.

Lower taxes

In my mind, the best solution would be to take a lesson from Egypt. That is, lower taxes to a point where the self employed are willing to pay (zero would be the ultimate). By extension, if taxes for the self employed are to be lower, taxes for all business should be lower. A flat tax seems to be the most efficient, but I digress. Let's get back to Egypt.

Excerpt from "TAX: Abrupt halt to haggling." The Financial Times, Dec. 11:

"The existing culture as far as the tax authority was concerned was a story of predation." says Youssef Boutros Ghali, the finance minister. "Anything the tax authority could squeeze out, it did. But now we have affected a fundamental change of attitude. We have given up predation and established a partnership through a law that is transparent rather than fuzzy and through reducing the tax rate to what people would be willing to part with."

The new law set the top rate at 20 per cent for both individuals and companies, down from 42 per cent. It offered a total amnesty to those who had never filed a return in their lives, regardless of how long they had been earning, if they presented themselves before the end of March 2006.

The law also introduced self-assessment, changing at one fell swoop a system based on the assumption that the tax payer is always a liar, to one in which inspectors have to believe properly-maintained records presented to them, unless they can come up with evidence of wrongdoing.

At the same time penalties for tax evasion have been seriously stiffened. Mr Boutros Ghali says the impact in the first year has been dramatic, with 2.6m returns filed, up from 1.7m in 2005.

The finance ministry had been expecting receipts to drop by 12 per cent in the first year and by 7 per cent in the second before climbing back to their original level at the time the legislation was introduced. Instead, tax receipts have grown by 17 per cent - a reflection of both the wider tax base, and the buoyant economy.

....It is still not uncommon for middle class professionals to argue privately that they should not pay tax, citing examples of official corruption or waste, or to justify tax
evasion by saying that they make no use of the subsidized and generally bad health and education services provided by the government and that, instead, they pay exorbitant fees at private schools and hospitals.

Tax inspectors also say that under-reporting is still rife. One cited the example of a doctor who charged him personally $20 when he went for a consultation, but when he filed his return he listed his fee as less than $4.

No one has any doubts that it will take years for a new tax culture to take roots. But there is agreement that new law is definitely a start.

Now Mr Boutros Ghali says that, with an improved computerised system, and freed of the necessity to check the records of every single taxpayer, his 39,000 inspectors will have more time to chase evaders.

Perhaps we could do better to take our complex tax systems to the trash and keep an eye on Egypt.