Canada's Underground Economy: Measurement and Implications

Rolf Mirus and Roger S. Smith

Introduction

Arecent headline in the Globe and Mail read, "US Tax Cheating Worth $150 Billion"; a regional newspaper featured the "Under-the-Table Economy" over a full two pages, and the Ontario Legislature's Standing Committee on Finance and Economic Affairs devoted more than a day to hearing expert evidence on tax evasion practices. These and other signs of heightened interest in the underground economic phenomenon raise some important questions.

How can our reported unemployment statistics be giving an accurate picture of labour market conditions when there is so much more economic activity than is being reported? Does the inflation rate truly reflect the prices Canadian households are paying? Are countries with large underground economies paying too little when their contributions to international organizations are based on official measures of GDP?

How will honest taxpayers react to mounting evidence that many others are not paying their share? Are we becoming a society in which it is widely acceptable to evade the GST? Should we be happy that the underground economy provides low prices for the poor (and the rich)? Could governments be basing policies on flawed statistics? Is a self-assessment system of taxation feasible in the long run when more and more people are seeing their neighbours participate in the underground economy?

The answers to these questions will in part depend on our assessment of the size of the underground economy. Moreover, actions to address this phenomenon will require comprehension of its underlying causes. Our aim here is to define what constitutes the underground economy, discuss some issues related to measuring its size and growth, and explore its causes and the implications for business and policy decision makers.

The underground economy:what is it?

As is well understood, the need to maintain a record of national production represents significant challenges for the government agencies charged with this task. One of the conventions among national income accounts statisticians is therefore to focus on market transactions for final goods and services, ignoring the considerable amount of output produced in the home.

The "observed economy," to use our term for officially measured output, can be computed by totalling all expenditures for newly produced goods and services that are not resold in any form. Typically, this includes consumer spending, investment spending by businesses, government expenditures at all levels for such goods and services (but not for transfer payments), and net exports. An alternative but economically equivalent approach is to focus on the cost of producing the output, inasmuch as costs are income for someone else, and arrive at total production, or GDP, by totalling all forms of income received.

The first hint of measuring difficulties comes when the income approach leads to a smaller GDP than the expenditure approach. This discrepancy suggests that, for example, some income is spent on consumer goods and thus captured in the expenditure measure of GDP, but not declared as taxable and hence not reflected in the income measure of GDP. However, this discrepancy loses its value as a proxy variable for unreported income when we realize that underreported retail sales-as a result of turning off the cash register, for example-can bias the expenditure measure in the downward direction. This possibility alerts us to the likelihood of unobserved economic activity that should be included in our GDP measure.

Testimony before the Ontario Legislature's Standing Committee pointed out that reported jewellery sales per capita were 33 percent higher in the US than in Canada and that Quebec sales were only 60 percent of Ontario's despite similar incomes and tastes. The absence of a sales tax on jewellery in the US explains the first difference and particular attitudes towards taxes in Quebec explain the second, suggested the expert witness, who had conducted a detailed investigation for the industry association. These results indicated that as much as two thirds of the jewellery trade might be "underground." Table 1 may be helpful for developing a better feel for what could be a reasonable consensus definition of the underground economy.

Click here to view Table 1: A Taxonomy of Types of Underground Economic Activity

Illegal activities are not part of our GDP concept, although courts have ruled that resulting income is nevertheless taxable. And some illegal income is actually reflected in GDP because expenditures based on such income are included. Legal activities, whether money- or barter-based, should be included in GDP but may go unreported. The latter group involves the production of goods and services but may be structured as barter to leave no record and so succeed in evading taxes. A working definition of the underground economy would therefore be: economic activity which would generally be taxable were it reported to the tax authorities. Thus, the underground economy would include unreported rental incomes, skimming by owners of businesses, barter activities, off-the-books employment, and unreported income from home-produced goods.

How to measure the underground economy?

Obviously, anyone partaking in the underground economy is trying to escape detection: this makes measuring the phenomenon extremely difficult. If, however, we are to decide whether Canada's underground economy is worth worrying about or is growing so that it will be worth worrying about, or both, we must have an information base. Several approaches have been used to arrive at estimates, or "guesstimates," each with advantages and drawbacks. For example, it is plausible to expect estimates based on interviews and surveys, even when confidentiality is assured, to turn up a relatively small underground economy: respondents can be expected to err on the side of caution.

As already indicated, the discrepancy between the expenditure and income approaches to GDP compilation also yields a flawed estimate. Time use or availability studies, on the other hand, can provide some useful information. Statistics Canada researchers pondered how many additional hours could realistically be worked by occupations likely to have opportunities for unobserved economic activity and then added up the probable extra output. Since this approach does not cover the entire economy, its results, namely that there may be 2.9 to 3.5 percent more GDP than officially reported, can be viewed as a lower boundary for the then (1985) underground economy. In terms of 1992 GDP, this would have meant $20-24 billion.

Another frequently used approach for estimating the underground economy relies on an indirect route, attributing the increase in the ratio of currency to demand deposits over some base year to a need to hold cash for underground transactions. This approach results in a rather large underground economy for Canada, 21.6 percent for 1990 based on the 1937-1939 currency ratio. It is probably true that this type of estimate is biased in the upward direction due to the fact that the currency deposit ratio has increased, in part because financial innovations have substantially reduced the need to hold demand deposits. On the other hand, this approach does not capture cheque- and barter-based transactions.

The transactions method pioneered by Wisconsin economics professor Edgar Feige relies on the assumption that the ratio of total economic transactions to final transactions (GDP) is historically stable. This ratio permits us to estimate what GDP would have been had all final transactions been properly recorded. The underground economy, then, is the difference between the transactions-method estimate of GDP and the official GDP figure. On that basis, Canada's underground economy was in the order of 20 percent of GDP in 1984, the last year for which the necessary data on cheque clearing are available.

This method includes not only cash but also cheques as media of exchange in the underground economy-for example, a customer cheque endorsed by a contractor and used to settle a bill for building supplies. In other respects, however, this way of sizing the underground economy requires assumptions about the life of banknotes, the extent of purely financial transactions, and the structure of the economy that make it hard to accept its results as definitive.

Work on this topic by Vito Tanzi of the IMF uses a modified currency ratio method and relates it to the tax burden. This approach asks what the currency to deposit ratio would have been had historical taxation levels been maintained. For Canada in 1990, an extra $5 billion in currency were attributable to tax hikes since 1965. Multiplying this extra currency by the turnover speed of money (M1) produces an estimate of 12.8 percent of extra GDP that goes unmeasured and is tax-induced.

While the monetary approaches have been the domain of academics, some studies by the US Internal Revenue Service (IRS) have by and large resulted in the range of outcomes discussed so far. The latest of these was based on the Taxpayer Compliance Measurement Program that subjected 55,000 tax files to a detailed examination to identify amounts of income that should have been reported over and above what actually was reported. The IRS found unreported legal income of US$585 billion and illegal income of US$88 billion for 1992. These estimates also relied on audits and special surveys and assumed no change in non-compliance since 1982.

If Canadians behave similarly in an economy one tenth the size of the US, we get a $73 billion estimate for Canada (US$0.8/$) which translates as 10.6 percent of GDP. In the Canadian setting, Peter Spiro of the Ontario Ministry of Finance has found that since the introduction of the GST in 1991 cash holdings have inexplicably soared. This finding is entirely consistent with a boost in the size of the underground economy.

Further corroboration of this order of magnitude for the money-based (legal and illegal) part of the phenomenon under discussion in Canada has recently been produced by IMF researchers. Studying real per-capita currency holdings for eight countries with freely convertible currencies, they hypothesized that technology like credit cards and electronic transfer mechanisms should have reduced these holdings by 10 percent between 1970 and 1990. For Canada, this reasoning produced $4.7 billion in extra currency for 1990, and therefore, after multiplication by a turnover speed of 15 (M1), approximately $70 billion in additional GDP. This amounts to saying that whatever underground economy may have existed in 1970, it has grown by another 10.5 percent of GDP since.

All in all, then, a number of approaches suggest significant growth and an order of magnitude of 12 to 15 percent of GDP for Canada's underground economy when we include illegal activities but exclude barter-based transactions which our definition says should be counted.

Causes and implications

Granted that the above size and growth estimates are surrounded by large margins of error, it is nonetheless obvious that a federal deficit of $45 billion makes an additional unrecorded output of $70 to $100 billion the focus of some attention. Among the factors that may have caused the growth of the underground economy, personal taxes must figure prominently. As a share of personal income net of transfers, personal income tax rose from 15.2 percent in 1976 to 19.7 percent in 1990. There was a pronounced increase between 1980 and 1991 in Canada's total tax revenue as a share of GDP from less than 32 percent to almost 38 percent, and that was before the impact of the switch to the GST.

This same general period has also seen a decline in confidence in government and a higher unemployment rate that makes more people available for informal work. Additionally, the percentage of self-employed in the unincorporated and incorporated sectors grew from 11.1 in 1976 to 14.5 of total employment in 1990. While the small-business sector has thus proven itself to be the engine of growth, it may also be a breeding ground for much underground economic activity. In the US and the UK, only 60 to 65 percent of income in the self-employment sector is actually reported. This percentage is not likely to be much different for Canada.

Two other contributing causes of the underground economy are to be found in immigration and the globalization of portfolio investment. As regards immigration, annual newcomer numbers doubled between 1981 and 1992, while business immigrant numbers even quadrupled. Immigrants have to learn about our tax system, and again, US studies provide evidence that underground economic activity is more prevalent in recent immigrant communities because of their small-business nature and their tendency to foster informal business relationships. With respect to the increasing globalization of investment portfolios, the IMF recently observed that "reported portfolio investment income is the fastest growing, and now the largest, of all individual current account discrepancies." In plain English, worldwide interest and dividends reported as paid by corporations exceed those reported as income received by $33 billion, and that was in 1984!

Should we care? What can be done? A recent calculation by David Perry of the Canadian Tax Foundation shows that a 15 percent underground economy means $28.6 billion in forgone revenue: $15.8 billion at the federal level, $11.5 billion at the provincial level, and $1.3 billion for the Canada and Quebec Pension Plans. So much additional revenue potential in the face of massive deficits means that the Department of Finance cares. Clearly, we must care too when, as a result of widely observed underground economic practices, the tax system is perceived as unfair, attitudes deteriorate, and support for the public sector erodes. Yet quelling this growing underground economy is no easy task, especially as it has tended to establish itself slowly over time as a mindset with a powerful momentum.

Here, then, is a list of some things that can be done:

     1.     Broaden the tax base and lower tax rates to reduce the economic incentive to go underground. This may mean including food in the GST base and reducing RRSP deduction limits in return for lower rates of basic income tax.

     2.     Simplify the administration of the various taxes, including integration of the federal and provincial sales taxes.

     3.     Consider tougher enforcement. This is already happening as more auditors are being put to work by Revenue Canada. However, in response, we may expect some income-generating activity to be shifted to the non-taxable, do-it-yourself sector. In other words, don't expect miracles!

     4.     Increase international cooperation for the sharing of tax information. We already have this cooperation with the US, but big capital flows to and from Asia and Europe suggest that investment income reporting will become a more significant issue with those regions as well.

     5.     Build a better information base for the underground economy with the resources of Statistics Canada, the Department of Finance, and Revenue Canada.

There are, of course, some positive aspects to the underground economy, not least being the evidence that a more vital economy exists than we are led to believe by the official statistics. Its existence and growth, despite our lack of consensus on its extent, send a message to policy makers about the limits to which taxation can be pushed.

Assessing the Size of the Underground Economy: The Statistics Canada Perspective

Philip M. Smith

Introduction

Asubstantial body of opinion exists in Canada to the effect that a variously defined underground economy accounts for a large and growing share of total economic activity in the country. The news media have given the topic considerable attention in recent years.-- Among many recent examples which can be cited are the story "Underground economy runs deep, " in the June 24, 1993 issue of the Vancouver Sun; the August 9, 1993 cover story in Maclean's entitled "Cheaters: How Dodging Taxes Feeds a Growing Underground Economy, " and a feature item on the November 5, 1993 edition of the program "W5" on CTV.Note --Yet much uncertainty remains about how significant this phenomenon really is.

A conclusion that the underground economy is large and growing has some serious implications: the recession and rising unemployment of the early 1990s may have been illusory, a sizeable portion of the population may be evading their fair share of the tax burden, and Canada's statistical system may be leading the country astray. A contrary conclusion also has important implications, especially if propensities for tax cheating are influenced by public pronouncements about its supposed prevalence. There is an urgent need to settle this matter one way or the other.

Unfortunately, this is no simple task. By its very nature, the underground economy defies measurement. Several methods have been tried to infer its approximate size, but none has attained wide acceptance. Some approaches-in particular, those relying on the assumed existence of a stable relationship between unreported economic activity and the stock of money-tend to indicate a large and growing underground economy, most often in the range of 10 to 25 percent of the observed economy. Other methods, based on more direct measurement techniques, point to a much smaller, albeit non-negligible underground economy, typically in the range of 1 to 5 percent of GDP.

We will consider four alternative definitions of the underground economy and examine the available evidence about its size. Statistics Canada believes that the underground economy is far smaller than the money demand studies have suggested.

Definitions

There are several definitions of the underground economy in common use,-- There are also many alternative adjectives -black, cash, covert, dual, grey, hidden, illegal, informal, invisible, irregular, marginal, moonlight, parallel, second, shadow, subterranean, twilight, under-the-table, unobserved, unofficial, unrecorded, unreported-which some people treat as synonymous and others use to draw distinctions. In this paper I use one term throughout: the underground economy.Note-- serving various objectives. The public authorities are naturally most interested in sales or income not reported for tax or regulatory purposes, whereas statisticians are more concerned about economic activities belonging, but not captured, in the official GDP estimates. The differences in the various definitions of the underground economy turn on some questions of classification, which are schematized in Table 1.

Click here to view Table 1: Classification of Production Activities with Examples

There is an important distinction here between market-based and non-market-based activities. Most transactions included in the national accounts are market-based and monetary in nature. Household work, for example, is not included in GDP although it is quantified and valued separately by Statistics Canada. Non-market activities are included in a few exceptional cases totalling about 6 percent of GDP,-- The exceptions are net rent on owner-occupied dwellings, food and lodging provided to employees in lieu of wages, food consumed directly on farms, income in kind to members of religious organizations, estimated services rendered by financial institutions without specific charge, and capital consumption allowances on residential property and government-owned capital goods.Note-- but the general rule admits only market-based economic activities. Since the tax base is confined to the market economy as well, most definitions of the underground economy will consider none but market-based activity.

GDP is explicitly a measure of economic output and so excludes transfers and capital gains and losses, which are not production. In this respect, the tax base differs somewhat. Although most of its components are domestic factor incomes or final sales, the tax base can also include other types of transactions-examples being capital gains, inheritances, and some transactions involving goods and services not produced domestically in the current period. Transactions of this kind are not part of domestic production and thus by definition are excluded from GDP. For example, cross-border shopping has no net effect on GDP, although it is part of the tax base. It enters personal expenditures for consumer goods and services and is netted out of GDP via imports. Trading margins on inported and used goods are treated as the production of services in GDP, but the base value of such goods, before margins, is netted out.Note Most researchers also exclude these transactions from their definitions of the underground econmy, although Revenue Canada auditors would be unlikely to follow this practice.

A second important distinction is made between legal and illegal transactions. In the present context, the latter mean the production and sale of goods and services that are themselves illegal, such as certain narcotic drugs, some kinds of pornography, and solicitation for prostitution. Transactions that involve licit commodities being covertly traded to avoid tax or regulation are not deemed illegal for our purposes. In principle, GDP includes all production without regard for legality, though in practice there is usually no way of reliably measuring illegal output. Like the national accounts production boundary, the tax base makes no distinction between legal and illegal income.

At the most general level, the underground economy may be defined as the portion of the total economy that is unobserved due to the efforts of some businesses and households to keep their activities undetected. More specific definitions hinge on what is meant by "the total economy" and who the "observer" may be. Four different definitions of "underground economy" can be formulated on the basis of our classification of production activities (Table 2).

Click here to view Table 2: Alternative Definitions of the Underground Economy

The first definition is based on what is, in practice, the production boundary for the Canadian national accounts. The second is identical to the first except that it also includes illegal activities (as defined above) that properly belong within the national accounts production boundary. The third definition is identical to the second except that the "observer" is the tax collector rather than the statistician. The reason for the distinction between definitions 2 and 3 is that the portion of market-based production missed in the national accounts is smaller than the portion that goes undeclared for tax purposes. Finally, a fourth definition broadens the production boundary to include non-market activities, household and volunteer work in particular. --The term "underground economy" is less appropriate for this fourth definition, since household and volunteer work are by no means covert. One of the other terms alluded to in note 2 above, such as "invisible" economy, might be more suitable.Note

Available estimates for Canada

The international literature on the extent of the underground economy has been multiplying rapidly over the past fifteen years or so. In Canada, interest developed more slowly at first than in other countries, but the topic has come to be the focus of considerable attention.-- For selected readings on the size and implications of the underground economy in other countries, see Feige (1989) and United Nations (1992).Note

Click here to view Table 3: Estimates of the Underground Economy in Canada

The earliest published Canadian study was by Rolf Mirus and Roger Smith (1981), --Some unpublished work on the topic has also been done at the Bank of Canada and the federal Department of Finance.Note --who reported widely varying estimates of the size of the underground economy based on hypotheses about the demand for money similar to those used for the United States by Gutmann (1977), Feige (1979), and Tanzi (1980). Subsequently, Mirus (1984) provided additional estimates that were also based on assumptions about the relationship between the stock of money and the level of underground economic activity.

In these Canadian studies as well as in subsequent work by the same researchers, the applicable definition of "underground economy" is the second one, which includes all production activity missed in the official GDP estimates (including illegal activities) but excludes the portion captured in those statistics and missed by the tax authorities. In a volume published by the Royal Commission on the Economic Union and Development Prospects for Canada, Mireille Éthier (1985) reported another set of estimates based on the Tanzi approach.

In 1986, Seymour Berger of Statistics Canada published estimates of the size of the underground economy that were based on another methodology, similar in some ways to the one used by Carol Carson (1984) for the United States. In this procedure, the components of the income- and expenditure-based GNP estimates were considered separately and informed judgements were made in each case, based on expert knowledge about the quality of the surveys and other information sources used to derive the national accounts estimates, about how much unrecorded activity might exist. Berger concluded, as did Carson for the US, that the underground economy was considerably smaller than the money demand studies were indicating.

Three Université Laval economists-Fortin, Fréchette, and Noreau (1987)-tried a different approach: a direct survey of the 1986 underground economy. Their questionnaire, administered anonymously and completed by 2,134 respondents, contained questions on both the demand and the supply aspects of the underground economy. Some 31 percent of respondents acknowledged some kind of participation in the underground economy as purchasers or suppliers of goods and services. The average declared income of covert workers was about half that of the sample average, suggesting that underground activity is most often a part-time, low-income occupation. The Laval results pointed to total underground production equivalent to 1.4 percent of Quebec GDP.

Toward the end of the decade, Gilles Paquet (1989) reviewed the available evidence and offered his personal assessment that

the underground economy broadly defined might represent, in the most conservative estimates, approximately one third of measured GDP and in the higher estimates as much as 100 per cent of measured GDP. It must be repeated that all such measurements are extremely conservative and that they do not begin to gauge the real size of the underground economy. Emphasis on page 4 of original.Note

It is hard to know what to make of this opinion, since Paquet provided no explanation of how his estimates were derived or why they were so much larger than all other published estimates.

More recently, Karoleff, Mirus, and Smith (1993) reported updated estimates based on the money demand approach placing the size of the underground economy in 1990 at 15 to 22 percent of GDP. Peter Spiro (1993) examined whether the introduction of the Goods and Services Tax in 1991 might have prompted a sharp increase in the underground economy and concluded, using an econometric equation for money demand, that the covert sector might have increased by 0.8 percent of GDP by 1992. Spiro did not, however, provide any estimate of the overall size of the underground economy.

The Statistics Canada perspective

In the light of all this, Statistics Canada took a fresh look at the size of the underground economy, focussing primarily on the first definition in Table 2. For the year 1992, the components of expenditure-based GDP were examined one by one for an assessment of how much spending might be missed at maximum, given the sources of information and statistical methods presently in use. Table 4 provides a summary of the analytical results that are summarized in the next few pages.

Click here to view Table 4: Upper Limit on Underground Transactions Potentially Missing from Expenditure-Based GDP, 1992

For some components-government expenditure, business plant and equipment investment outlays, inventory change, transfer costs on residential housing-there are strong a priori reasons for believing that the underground economy is not significantly skewing our official statistics. Governments do not make purchases underground. Business investment outlays are tax-deductible and financed openly in the capital markets: it is difficult to imagine why companies would deliberately understate their investments.-- Machinery and equipment supply flows are also observed in the imports data and manufacturers' production survey responses. Non-residential construction activity is also monitored with information about construction materials shipments, building permits, the value of contracts awarded, and employment in the construction industry. Moreover, most non-residential construction is highly visible: hydroelectric projects, oil and gas drilling, office towers, shopping malls, roads, bridges, pipelines, and so on. Thre are many ways to cross-check the data for business investment spending.Note --Transfer costs-essentially, real-estate commissions-are measured in a way that precludes their being affected by underground transactions, even if some real-estate agents or companies are underreporting income to Revenue Canada.-- An average commission rate is applied to the reported value of sales obtained from the Canadian Real Estate Association. The industry is self-regulating and monitored by provincial governments through the land registry system.Note

The export sector contains few goods or services concerning which underground activity is evident or suspected. Nevertheless, a review of the commodity detail for exports suggests that total exports might be understated by at most $1.1 billion, 0.6 percent, due to the underground economy. The case of imports is somewhat special, since this component is subtracted in the GDP calculation. Rather than implying an understatement of GDP, missed transactions would indicate that GDP is either overstated, if the imported goods and services still show up elsewhere in final demand, or unaffected.

One of the main sectors where underground activity is likely to be important is residential construction. New residential construction is essentially measured as the product of number of housing starts and average house value, appropriate allowances being made for construction lags. Starts are difficult if not impossible to hide, and the Canada Mortgage and Housing Corporation housing starts statistics are reliable. Average values, however, are taken from building permits and thus liable to some undervaluation. Assuming that, at a maximum, single dwellings and mobile homes might be undervalued by 10 percent and semi-detached row and apartment dwellings by 5 percent --Since municipalities issue the building permits and have a strong interest in ensuring they are not undervalued, the problem is not likely to be severe. Moreover, an adjustment for undercoverage is already built into the national accounts estimates.Note-- implies an understatement that may conceivably be as great as $1.9 billion or 9 percent of the toal measured amount.

For alterations and improvements to existing dwellings, there is reason to believe that the existing national accounts estimates are not subject to much, if any, undervaluation bias despite the fact that this activity is highly prone to tax evasion. The estimates derive from three basic data sources-an annual demand-side survey of 25,000 households, a survey of building materials sales by wholesale dealers, and building permits data-that can be cross-checked against one another. If, nevertheless, we insist on assuming a maximum 20 percent understatement of contract work for households-accounting for most spending on alterations and improvements, with landlords, tenants, and cottage owners representing a small share-we come up with an underestimation of up to $1.7 billion, or 13.9 percent of the measured total.

In the vast arena of consumer expenditure-60 percent of GDP-potential underestimation can be gauged from a detailed commodity breakdown (Table 5). --The national accounts estimates for consumer expenditure are built up from many different data sources (see Statistics Canada, 1990, pp. 128-130). One important source is the Survey of Family Expenditures that involves detailed, face-to-face interviews with a random sample of about 10,000 households. In the most recent survey, for 1992, the response rate was 73 percent. Now it seems reasonable to assume that households heavily involved in the underground economy are likely to be non-respondents. Therefore, since the survey imputes income and expenditure values to non-respondents based on average reported values for respondents, the presence of underground activity would bias the results in a downward direction only if the average income and outlay of underground economy participants were significantly higher than those of respondents. The results of this deman-side survey are unaffected by the "skimming" problem alluded to in the paragraph.Note-- Three categories of commodities are identified: (1) those for which underground transactions are nonexistent or very unlikely to cause GDP measurement problems, (2) those for which underground transactions may cause us moderate measurement problems, mainly due to the "skimming" of business receipts, and (3) the ones that lend themselves comparatively easily to underground transactions and with which we could thus have serious measurement problems.

Click here to view Table 5: Potential Understatement Due to Underground Transactions in Personal Expenditure on consumer Goods and Services, 1992

The first group, labelled in Table 5 as showing "no significant impact due to underground transactions," includes new motor vehicles, electricity, natural gas fuels, air transport, water charges, medical and hospital care, communications, cable television, urban transit, provincial lottery tickets, financial services, and the services provided by non-profit organizations. Overall, this group of commodities accounted for $187.1 billion in 1992 consumer spending, 45 percent of the total. Now these goods and services are virtually impossible to purchase "under the table." In most instances, the businesses selling them are large corporations or government business enterprises, companies unlikely to systematically understate their receipts. This first group also includes commodities for which the national accounts estimates are imputations.

The second group, labelled "impact primarily from 'skimming' of business receipts," includes items rarely purchased on the black market but often distributed by small businesses. Measured consumer spending on all commodities in this group amounted to $204.2 billion in 1992, or 49 percent of total personal expenditure. Small businesses selling these commodities may engage in "skimming"-the practice by which otherwise legitimate businesses fail to declare a fraction of their business receipts to Revenue Canada and presumably to Statistics Canada. For the portion of total sales to households-- Unrecorded sales to other businesses do not affect the measurement of GDP since they are intermediate rather than final output.Note-- that is accounted for by small business-defined as all unincorporated businesses, without regard to sales, plus all incorporated businesses with annual sales below $1 million-some arbitrary assumptions, considered to be on the high side, are made: 15 percent skimming of gross business receipts inretail trade and taxicabs and 25 percent skimming of gross receipts for vending-machine operators, direct sellers, and selected businesses in services.

The above percentages are then applied to sales revenues for these types of businesses as reported to Revenue Canada. The results are distributed by commodity using information from the Statistics Canada Retail Commodity Survey. In the case of paid rent, an important commodity in this category, undercoverage cannot be very substantial in the national accounts because of the measurement technique used. --The method involves multiplying the total stock of dwellings, obtained from the census and updated with housing starts data, by a survey-determined average market rent. Because rent imputed on owner-occupied dwellings is included as well as paid rent, undeclared rents (such as on basement apartments) are captured nevertheless (although they may be misclassified as imputed rather than paid).Note-- Overall, the assumptions about skimming imply a potential GDP understatement of $10.9 billion, or 5.7 percent of the before-tax value of consumer spending on this category of commodities.

The third and final group, labelled in Table 5 as receiving "significant impact due to underground transactions," includes a select list of nine categories in which unreported sales are likely to be fairly common. These commodities accounted for $28.2 billion in measured 1992 consumer spending. The most significant items in the group are alcoholic beverages, tobacco products, services associated with alcoholic beverages, and domestic and household services. For alcoholic beverages, the analysis considers illegal production of wine and the smuggling of spirits, using information provided by the Liquor Control Board of Ontario and the Association of Canadian Distillers, as well as markups on contraband spirits and wine by licensees. Tobacco smuggling is also analyzed, and since most contraband tobacco is produced legitimately in Canada, exported to the United States, and smuggled back into the country, the extent of smuggling can be tracked quite accurately from tobacco exports data. The potential undercoveragefor the nine commodities taken together is calculated at $4.0 billion, or 18.1 percent of total pre-tax expenditure for the group.

For total personal expenditure on consumer goods and services, the results suggest that underground activity might be causing a maximum understatement of $14.8 billion, or 3.8 percent of spending before sales tax-3.5 percent of total consumer outlays. Half this sum is attributable to food and non-alcoholic beverages, alcoholic beverages and associated services, tobacco, and restaurant meals: most of the remainder is spread over a range of commodities distributed by small, unincorporated retailers or producers.

Assembling all the results, Gervais concluded that $18.4 billion, or 2.7 percent of GDP, was a reasonable upper limit on the possible size of the underground economy not captured in GDP as of 1992. However, she cautioned:

It is only an estimate, not a measure, of the maximum value of the portion of underground production which may still be missing from GDP. Not all underground transactions constitute economic production, and therefore not all belong in GDP. Of the transactions that do belong, some are measured (even if undeclared or unreported), while others are missing. The 2.7 percent represents the upper limit of what could possibly be missing, not what is actually missing (which would be much less). If Statistics Canada was convinced that this amount was really missing, it would add it to GDP.

Reconciling the estimates

When considering the range of estimates of the extent of underground economic activity, it is important to recognize that definitions of this economy differ in the various studies and that these definitional differences may substantially account for the variances in estimated magnitudes.

The upper-bound estimates developed by Berger and Gervais-- A large part of the Berger (1986) upper-bound estimate of 3.5 percent of GNP (3.4 percent of GDP) for 1981 was accounted for by suspected undercoverage of alterations and improvements to residential dwellings. Subsequently, the national accounts underwent an extraordinary historical revision to correct this problem. Adjusting Berger's estimate for this revision to the accounts yields an upper limit of 2.5 percent of GDP for 1981, slightly lower than the Gervais estimate for 1992.Note-- correspond to the first definition in Table 2 and constitute assessments of how much might be missing from Canadian GDP as it is presently measured. The indirect estimates from Karoleff, Mirus, and Smith, based on money demand functions, are market production-type estimates as well, but they also include illegal production. They are tied to official GDP estimates via their velocity of money assumptions and therefore correspond to the second definition of the underground ecoomy.

How much of the difference between the double-digit estimates of Karoleff, Mirus, and Smith and the single-digit estimates of Berger and Gervais can be attributed to illegal activity? Unfortunately, there is little statistical information in Canada about the value of illegal production. Blades (1992), in his review of attempts to measure the underground economy in OECD countries, cites evidence that illegal production activity amounts to only about 0.1 percent of GDP in France and 1.5 percent of GDP in the United States. Noting that more things are illegal in the United States than in many other OECD countries and that heroin "is still essentially an American problem," he concludes (p. 13):

For these reasons, it can be asserted with some confidence that for most OECD countries the inclusion of illegal production in GDP could not possibly add more than 1 percent and, on the evidence from France, probably much less than this.

Some detailed Statistics Canada calculations of a few years ago suggested that illicit domestic drug production and distribution margins in 1984 were between $1.3 and $2.7 billion, or 0.3 to 0.6 percent of GDP.-- The analysis, conducted by M.S. Gupta, examined the market for heroin, cocaine, marijuana, hashish, and chemical drugs, using partial information from Health and Welfare Canada, the Addiction Research Foundation of Ontario, and the Royal Canadian Mounted Police. Reasonable assumptions were developed for numbers of users, average dosage per user per day, and average market price per dosage. Note --Including an arbitrary allowance for other illegal goods and services and adding a full 1 percent of GDP to the Gervais estimate for 1992 yields just 3.7 percent of GDP for the second definition, still much smaller than in estimates based on money demand. The survey-based estimate reported by Fortin, Fréchette, and Noreau (1987) is associated with the third definition, which considers the underground economy from Revenue Canada's perspective. It differs in principle from Karoleff, Mirus, and Smith in including the portion of the Revenue Canada underground economy that is captured in the official GDP statistics. The national accounts estimates take full advantage of income, sales, and customs and excise tax data, but they also rely on other sources of information, notably household and establishment surveys.

How significant is this amount of undeclared (for tax purposes) but recorded (for national accounts purposes) activity? Table 6 shows a comparison of factor income statistics from the two sources. While adjustments have been made for conceptual differences between the national accounts and Revenue Canada income definitions, the comparison remains imperfect. The true amount of income from these sources that is captured in the national accounts but undeclared to Revenue Canada is probably somewhat smaller than indicated.-- Total "other employment income" as reported on the personal income tax form, $1.9 billion in 1991, is omitted from this comparison. It includes several transfer-type items which do not belong in national accounts labour income, but it also includes tips, which are thought to be substantially underreported and do belong in labour income. Unfortunately, no tabulations are available for tips separately. However, the national accounts estimate for tips in 1991 is $2.1 billion. For farm income, thre are a great many conceptual differences between the national accounts and personal income tax definitions relating to, among other things, cash versus accrual accounting and the measurement of depreciation.Note-- Assuming that the discrepancy is about 1.5 percent of GDP in 1992, then the size of the underground economy based on the third definition would be a maximum of 5.2 percent of GDP (3.7 percent for the second definition plus 1.5 percent). This upper bound is substantially higher-- It would probably be higher still if account were taken of the difference between corporation profits and miscellaneous investment income as measured in the national accounts and the corresponding income aggregates as indicated by tax compilations. However, it is extremely difficult to properly compare these aggregates.Note --than the conceptually comparable direct-survey estimate from Fortin, Fréchette, and Noreau of just 1.4 percent of GDP, which is appropriately viewed as a lower bound.

Click here to view Table 6: GDP Income Components National Account Versus Revenue Canada

Finally, Paquet makes it clear in his commentary that his 100 percent of GDP estimate, if not his 33 percent estimate, applies to the fourth and broadest definition of the underground economy. How does this compare with other estimates?

Recent work by Chandler (1994) on the imputed value of household work provides three alternative estimates of the extent of this kind of activity. The first, 41.4 percent of GDP, uses a replacement cost approach: time spent working in the home is valued in terms of the potential cost of similar services in the marketplace. The second estimate, 46.3 percent of GDP, is based on an opportunity cost: the time spent is valued in terms of the forgone gross earnings of the person doing the work. The third estimate, 30.6 percent of GDP, is similar to the second but relies on forgone earnings net of income tax as the basis of valuation. For our present purposes, the first approach using a replacement cost estimate is the most appropriate.

To this must be added an estimate of the value of volunteer work, broadly defined to include unpaid work both for volunteer agencies and directly for other households. Statistics Canada's time use survey for 1992 --See Statistics Canada, Initial Data Release from the 1992 General Social Survey on Time Use, uncatalogued, April 1993.Note-- showed the amount of time spent on volunteer work as 1,175 million hours, equivalent to 4.7 percent of total hours spent on household work. No estimates are available for the value of this volunteer work, but if the same average value applied as in the case of household work, it would be equivalent to 2.0 percent of GDP. Using the fourth definition, then, the underground economy would be equivalent to 47.1 percent of GDP (3.7+41.4+2.0)-a significant number, but well short of Paquet's 100 percent "ballpark" figure.

Comments on the monetary approach

The attempt made here to compare various estimates of the size of the underground economy is less than fully successful because the huge gap between the indirect, money demand-based figures and the more direct statistical estimates remains largely unexplained. The two approaches are so different-one depending on monetary theories and the other on the statisticians' ability to assess the reliability of their product-that it will probably never be possible to properly reconcile them.

The money demand method is strictly a macro approach that tells us nothing about the differential impact of underground activity by sector, by industry, by commodity, or by region. Its validity cannot be tested by focussing on particular parts of the economy where underground activity is thought to be especially prevalent: the approach yields only an estimate of overall size. The procedure rests on strong assumptions about the relationship between the stock of money and economic activity, often with no econometric validity tests. In some of its variants, the size of the underground economy is estimated residually, which suggests vulnerability to the omitted variables problem.

For example, the Gutmann version relies on the assumption that the ratio of currency to demand deposits would have remained historically constant were it not for growth in the underground economy. To many observers, this has seemed an unreasonable ad hoc supposition, given the multitude of other factors that have influenced the choice between currency and demand deposits over time-among them, changing financial regulations, the growth of near banks, the introduction of credit and debit cards and changes in the cost and convenience of these cards over time, automatic teller machines, the arrival of the dollar coin, and a variety of other banking innovations.

The Feige method starts from Fisher's well-known payments-transactions identity (MV=PT).-- Irving Fisher, The Purchasing Power of Money: New York, Macmillan, 1911. "M" is the stock of money, "V' is its velocity of circulation, "P" is the price level, and "T" is the volume of monetary transactions.Note-- If we assume that PT, the value of transactions, is strictly proportional to total factor income, and then attempt to directly measure changes in the stock of money and its velocity over time, we can draw inferences about the growth of the overall economy and, by implication, its underground component. Now assuming proportionality between the total value of monetary transactions and total factor income is a questionable, though not uncommon, practice; and the picture is further clouded by the fact that the total volume of financial and non-financial transactions has expanded enormously during the postwar period, spurred by vastly improved computation, communications, and transportation technologies and the resuling market globalization.

Accordingly, the strict application of this approach has yielded estimates of the underground economy that are so big as to be easily recognized as grossly unreasonable. This has led practitioners to attempt to restrict the measure of transactions to exclude those involving income or asset transfers. It is unclear how the Fisher identity can be usefully interpreted when PT is defined in this limited way, since it is clearly impossible to similarly limit M, the money stock.-- Moreover, it is very difficult empirically to partition transactions effectively into distinct financial and non-financial categories. Karoleff, Mirus, and Smith (1993) found it necessary to exclude all transactions cleared in the main financial centres of Toronto, Montreal, Vancouver, and Calgary from their calculations in order to get results they believed were credible. Leaving out urban areas that account for one third of the total population and close to half of domestic economic activity seems a drastic solution to the probem.Note-- Other difficulties with this approach include the requirement for an independent time series measurement of velocity and the need for an estimate of the constant proportionality factor which, it is assumed, links the value of monetary transactions to total factor income.

The Tanzi approach contrasts with the Gutmann and Feige methods in that some of its underlying hypotheses are subjected to statistical testing and its parameters, rather than just assumed, are estimated econometrically--. The method still requires an unverifiable "starting point" assumption: a value for the size of the underground economy in some base period. Also required is an assumption about the relative velocities of money in the above- and below-ground economies.Note-- An explicit hypothesis is developed that relates the size of the underground economy to the average tax rate. Interestingly, this method has consistently yielded smaller estimates of the underground economy.

Conclusions

Statistics Canada holds that the underground market economy, depending on how it is defined, probably accounts for between 1 and 5 percent of GDP. By the narrowest definition-the portion of market-based production of legal goods and services that escapes detection in the official estimates of GDP due to the efforts of some businesses and households to keep their activities undetected-the underground economy is very unlikely to exceed 3 percent of measured GDP and is probably a lot smaller. It could conceivably account for 4 percent of GDP if we broadened the definition to include illegal production, or even as much as 5 percent if we included production activities unreported to Revenue Canada but captured by StatsCan. However, the size of the Canadian underground economy today could not possibly reach double digits as a percentage of GDP unless its definition was extended to encompass non-market production.

Because the underground economy is small in relation to the economy as a whole, then, the impact of its omission on measured GDP growth rates is quite small. This can be shown with an extreme example. If underground output represented 3 percent of the economy and was growing by 10 percent while the observed economy was declining by 2 percent, the overall "true" number would be -1.7 percent. Since there are so many basic factors influencing both-weather, political developments, social attitudes and trends, stock and bond market prices, and so on-it is difficult to imagine how a growth differential as large as this could occur. --Spiro (1993) estimates that the underground economy grew by 0.8 percent of GDP over the two-year period ending in 1992. If it was 3 percent of GDP in 1990, this would imply average annual growth of 14 percent when the observed economy was growing by just 0.7 and 1.9 percent in the two years (in nominal terms, unadjusted for inflation).Note If it did, however, the drop in real GDP would beoverstated by only 0.3 percent at most.

Still, at 3 percent of GDP the underground economy would represent $21 billion and at 5 percent, $36 billion, significant amounts that imply substantial unpaid federal, provincial, and municipal taxes. By commodity or by industry, its relative impact would be far from uniform. The underground economy is certainly not a factor to be ignored by either statisticians or tax collectors.

References

Barthelemy, Philippe, "The Macroeconomic Estimates of the Hidden Economy: A Critical Analysis," in Review of Income and Wealth, ser. 34, no. 2, June 1988, pp. 183-208.

Berger, Seymour, "The Unrecorded Economy: Concepts, Approach and Preliminary Estimates for Canada, 1981," in Canadian Statistical Review, Statistics Canada Catalogue 11-003E, April 1986.

Blades, Derek, "The Hidden Economy and the National Accounts," in United Nations Economic Commission for Europe, ed., Guide-Book to Statistics on the Hidden Economy: New York, 1992, pp. 3-20.

Cagan, P., "The Demand for Currency Relative to the Total Money Supply," in Journal of Political Economy, vol. 66, August 1958, pp. 303-328.

Carson, Carol, "The Underground Economy: An Introduction," in Survey of Current Business, vol. 64, nos 5 and 7, May and July 1984, pp. 21-37 and 106-118.

Chandler, William, "The Value of Household Work in Canada, 1992," in National Income and Expenditure Accounts, fourth quarter 1993, Statistics Canada Catalogue 13-001, April 1994, pp. xxxv-xlviii.

Denison, Edward F., "Is U.S. Growth Understated Because of the Underground Economy? Employment Ratios Suggest Not," in Review of Income and Wealth, ser. 28, no. 1, March 1982, pp. 1-16.

The Economist, "The Shadow Economy: Grossly Deceptive Product," September 19, 1987.

Éthier, Mireille, "The Underground Economy: A Review of the Economic Literature and New Estimates for Canada," in François Vaillancourt, ed., Income Distribution and Economic Security in Canada: Toronto, University of Toronto Press, 1985, pp. 77-109.

Feige, Edgar L., "How Big is the Irregular Economy?" in Challenge, vol. 22, November-December 1979, pp. 5-13.

----, ed., The Underground Economies: New York, Cambridge University Press, 1989.

Fortin, Bernard, Pierre Fréchette, and Joëlle Noreau, "Dimensions et caractéristiques des activités économiques non déclarées ŕ l'impôt," Université Laval, Cahier 8702, Québec, 1987.

Gervais, Gylliane, The Size of the Underground Economy: A Statistics Canada View, Statistics Canada, Catalogue No. 13-603, no. 2, June 1994.

Gutmann, P.M., "The Subterranean Economy," in Financial Analysts Journal, vol. 33 (1977) pp. 24-27 and 34.

Karoleff, Vladimir, Rolf Mirus, and Roger S. Smith, "Canada's Underground Economy Revisited: Update and Critique," paper presented at the 49th congress of the International Institute of Public Finance, Berlin, August 1993.

Macafee, K., "A Glimpse of the Hidden Economy in the National Accounts," in Economic Trends, February 1980, pp. 81-87.

Mirus, Rolf, "The Invisible Economy: Its Dimensions and Implications," in George Lermer, ed., Probing Leviathan, An Investigation of Government in the Economy: Vancouver, The Fraser Institute, 1984.

Mirus, Rolf and Roger S. Smith, "Canada's Irregular Economy," in Canadian Public Policy, vol. 7, no. 3, Summer 1981, pp. 444-453.

----, "Canada's Underground Economy," in Feige, Edgar L., ed., The Underground Economies: New York, Cambridge University Press, 1989, pp. 267-280.

Paquet, Gilles, "The Underground Economy," in Policy Options, January/February 1989, pp. 3-6.

Spiro, Peter S., "Evidence of a Post-GST Increase in the Underground Economy," in Canadian Tax Journal, vol. 41, no. 2, 1993, pp. 247-258.

Statistics Canada, A User Guide to the Canadian System of National Accounts, Catalogue 13-589E, November 1989.

----, Guide to the Income and Expenditure Accounts, Catalogue 13-603E, November 1990.

Tanzi, Vito, "The Underground Economy in the United States: Estimates and Implications," in Banco Nazionale del Lavoro Quarterly Review, vol. 135 (1980) pp. 427-453.

United Nations Economic Commission for Europe, ed., Guide-Book to Statistics on the Hidden Economy, New York, 1992.

Taxes, Deficits, and the Underground Economy

Peter S. Spiro

Introduction

There has been a groundswell of concern about the underground economy in Canada, to an extent not found in other countries. In 1993, some 77 articles featured the underground economy in magazines and newspapers listed in the Canadian Periodicals Index, as compared with half a dozen in 1992.-- By contrast, the US Business Periodicals Index contained only three references to the subject, and of these, one was about Canada.Note-- There is a widespread belief with very few dissenting that the underground economy is a growing problem in Canada and has contributed to a worsening of government deficits.

We also have a higher degree of consensus about the factors underlying the growth of the underground economy than about most other issues in economic policy. There is virtual unanimity among policy analysts on the important relationship between tax rates and the underground economy. In his 1994 pre-budget consultation document, Ontario's Minister of Finance stated:

The Government of Ontario understands...the fatigue taxpayers are feeling, and that there are limits to how much revenue the tax system can deliver. The Government is also aware of the problem of the underground economy and how it means honest taxpayers have to pick up more than their fair share of the cost of public services. --Ontario Ministry of Finance, Preparing for the Ontario Budget 1994, A Guide Book to Budget Consultations: Toronto, Queen's Printer for Ontario, February 1994.Note

There also appears to be a rare degree of unanimity on the empirical proposition that the underground economy has grown substantially as a percentage of GDP since early 1991. One key piece of evidence for this is the large increase in cash in circulation relative to reported incomes. There is also a tremendous amount of anecdotal evidence and consumer survey data, which is probably why the issue has attracted such widespread popular attention. Even Statistics Canada's analysis of discrepancies in the GDP data supports the view that the underground economy began growing in 1991.-- Gylliane Gervais, "The Size of the Underground Economy, "Statistics Canada Discussion Paper, February 1994, pp. 9 and 17.Note

Taxes are undeniably an important factor in the underground economy. Nevertheless, the connection is not as clear-cut or as easily quantifiable as many editorial writers have supposed. This article will marshal the relevant empirical literature to evaluate the likely contribution of various tax changes in the past few years to growth in the underground economy.

Effect of the GST

One hypothesis that has considerable support is that the introduction of the GST in 1991 sparked a substantial increase in the size of the underground economy in Canada. In an earlier article, this writer highlighted the increase in the ratio of cash in circulation to consumer expenditure that coincided with the coming of the GST. Even taking into account such other factors as declining interest rates, the growth in cash was extraordinary. The article offered the conservative estimate that the underground economy had increased as of mid-1992 by an amount of about 0.8 percent of GDP.-- Peter S. Spiro, "Evidence of a Post-GST Increase in the Underground Economy," in Canadian Tax Journal 1993, vol. 41, no. 2, pp. 247-258.Note

There is a problem with interpreting these data due to the issue of velocity of circulation, and considerable judgement needs to be applied in imputing growth in the underground economy from growth in cash. Probably, the cash to expenditure ratio is higher in the underground economy than in the legal economy. Among other things, participants in the underground economy who do well and want to save some of their money cannot invest in mutual funds: they have to hoard it in the form of cash until they can find some way to "launder" it. Logically, some of this excess cash may have gone into safety deposit boxes rather than more expenditure. --The growth in the relative proportion of $1,000 bills supports the view that some hoarding has taken place, as these notes are rarely seen in circulation. These $1,000s, with their $100 counterparts, grew from 39.4 percent of total cash outstanding in 1990 to 43.8 percent in 1992 (Bank of Canada Review, Spring 1993, Table K1).Note --Figure 1 updates the data and suggests growth in the underground economy of perhaps 2 percent of GDP from early 1991 to the end of 1993. It should be noted that the growth in the cash expenditure ratio shown in Figure 1 was 14.5 percent from 1991 to 1993. --The estimate that the underground economy has grown by only 2 percent thus makes considerable allowance for such factors as the declining velocity of cash. Econometric analysis that explains the derivation of this estimate is found in this author's article, "Estimating the Underground Economy: A Critical Evaluation of the Monetary Approach," Canadian Tax Journal 1994, vol. 42, no. 4, pp. 1059-1081.Note

Click here to view Figure 1: Cash Balance as a Percent of Consumer Expenditure

Besides the introduction of the GST, 1991 also saw large tobacco tax increases that contributed to growing sales of contraband cigarettes. Eventually, Statistics Canada began to estimate contraband cigarette sales by assuming that increased cigarette exports were all spirited back into the country clandestinely. By this measure, contraband accounted for about 15 percent of total 1991 cigarette sales in Canada--. Gylliane Gervais, op. cit., p. 37. This report indicates that StatsCan will add in these estimates of contraband sales when it revises its GDP figures.Note-- At a street price reported to be half the legal price, this traffic would have been worth about $700 to $800 million annually. Even so, however, it could account for only a relatively small fraction of the growth in the underground economy --Estimated to amount to $5.7 billion in consumer expenditures by Spiro, op. cit., p. 255.Note --as indicated by the growth in the currency ratio.

The GST was introduced in the midst of a severe recession, and this may also have had some effect on the amount of evasion. However, the recession is unlikely to have been an independent factor. There is no consensus in the literature as to whether a recession will spur growth in the underground economy. Some analysts point out that many of the services consumed in the underground economy are discretionary and that the underground share will therefore decline in recessions. Others argue that people receiving unemployment benefits will be tempted to cheat by working in the underground economy.

One critic, Don McIver, has suggested that the growth in Canada's currency ratio was due to such financial factors as the falling inflation rate.-- "Underground Mining," in Sunlife of Canada Analysis, November 30, 1993.Note He pointed to a large increase in the US cash ratio beginning about 1990-an increase that appears, as documented in recent studies by that country's Federal Reserve Board,-- Richard D. Porter, "Foreign Holdings of the U.S. Currency," Federal Reserve Board discussion paper, 1993. See also "More for Boris," in The Economist, November 27, 1993, p. 86.Note-- to have been due to the growing use of US currency as a medium of exchange in eastern Europe. Examination of the cash ratio in the United Kingdom, which also experienced substantial reductions in its inflation and interest rates in the period 1991-1993, shows that the cash ratio there continued to decline.

It has also been claimed that recent growth in GST revenue is inconsistent with the tax evasion hypothesis. For example, one pro-GST editorial has suggested that those who claim "the GST was behind the growth in tax evasion...might like to explain why GST revenue grew faster than the economy last year." --"Meet the new tax, same as the old tax," in the Globe and Mail, March 14, 1994, p. A12.Note-- In reality, the relationship between measured GDP and GST revenue growth in any particular year has no bearing on whether or not there is tax evasion. For one thing, large sectors of the economy, such as groceries and government-provided services, are exempt from the GST. The government sector grew much more slowly than GDP in the 1993/94 fiscal year, meaning that the part of GDP that carries the GST was growing faster than total GDP--. There is also a technical reason why net GST revenue would grow faster on average than GDP with inflation between 0 and 3 percent. GST revenue shown here is net of the low-income tax credits, which are increased only to the extent that CPI inflation exceeds 3 percent and would thus tend to grow more slowly than GDP in a low-inflation environment.Note --GST revenue grew about 4.7 percent while the estimated value of nominal GDP grew only 3.5 percent.

Table 1 looks at the history of GST revenue. The 1991/92 budget predicted GST revenue of $16.35 billion: the actual turned out to be much lower, partly because the GDP was below forecast. However, the GST collected was also smaller as a percentage of actual GDP than the budget had predicted. Even after adjusting for lower GDP growth than forecast, there was a $1 billion shortfall in fiscal 1993/94 relative to the initial GST revenue projection in the 1991/92 budget. This may actually be a useful lower bound estimate of the amount of evasion. Moreover, it is likely that GST-induced tax evasion has led to an underestimation of GDP itself, which would imply that the total amount of GST evaded is considerably more than $1 billion.

Click here to view Table 1: Federal Government GST Revenue

Effect of income tax rates

The question of the tax rate which maximizes revenues has been an important implicit question in the recent Canadian debate on taxes. Many critics of government policy have suggested that deficits would have been smaller had tax rates been lower. --This is an oft-repeated assertion. However as Horry, Palda, and Walker point out in Tax Facts 8 (The Fraser Institute, 1992, p.1), econometric studies suggest that "almost no country is at the point where an increase in tax rates will lead to less tax collected."Note

Defenders of the GST argue that high income tax rates spurred increased evasion, not the GST. For example, the Globe and Mail has opined that "the GST was said to be behind the growth in income tax evasion, as if 54 percent income tax rates had nothing to do with it."-- "Meet the new tax, same as the old tax," op.cit.Note It is true that there were also income tax rate increases in 1991 and we may legitimately ask what role they might have played in spurring the growth of the underground economy.

It should be noted that theoretical economic models do not state unambiguously that higher income tax rates lead to higher rates of evasion, particularly in systems with progressive rates. As with every other "price," there is both a substitution effect and an income effect. Higher tax rates do incite the temptation to cheat via the substitution effect, since the monetary gain increases. However, there is also the matter of risk aversion in the face of potential punishment and how the income effect interacts with it. For example, if higher-income people are more concerned about the risk of being caught and possibly going to jail and they are also the ones facing the highest tax rates, it is not obvious that higher tax rates do necessarily lead to higher rates of evasion.

International cross-section evidence on the relationship between taxation and the underground economy can be seen in Figure 2, which relies on admittedly crude estimates of the underground economy as a percentage of GDP in a dozen OECD countries.

Click here to view Figure 2: Relation Between the Underground Economy and Taxes as a Share of GDP

It is interesting to note that taxes are not the only factor conditioning the underground economy: societal norms in each country are also important. Some countries have large underground economies in spite of relatively low tax rates. If the Mediterranean countries in Figure 2 are excluded, however, we can pick out a distinct trend towards larger underground economies in tandem with higher total taxes as a percentage of GDP. In this group of countries, the underground economy rises roughly 0.25 percentage points for each percent of increase in taxes.

Econometric estimates abound for most types of behaviour, but empirical studies of tax evasion are particularly difficult. The critical problem is to obtain reliable data on the amount of tax evasion taking place. However, some enterprising US researchers have managed to conduct studies that may be applicable to Canada. In fact, the best data we have on tax evasion emanates from the United States. Once every 10 years, the US Internal Revenue Service (IRS) conducts audits of 50,000 randomly selected taxpayers to build a statistically valid tax evasion profile. The random nature of this procedure is important: ordinarily, tax audits concentrate on high income earners in expectation of higher returns in taxes recovered.

On one of these decennial occasions, Charles Clotfelter, with access to the individual data points of the IRS data set, conducted an econometric study on the effects the marginal tax rates of various individuals were liable to have on their rates of evasion.-- Charles Clotfelter, "Tax Evasion and Tax Rates: An Analysis of Individual Returns," in Review of Economics and Statistics, August 1983.Note-- Clotfelter found that marginal income tax rates did indeed influence evasion significantly. Clotfelter's preferred estimate implied that unreported income went up 0.2 percent for each percent of increase in the income tax rate.

A second US study used a more aggregate estimate of unreported income-the discrepancy between the national income estimates of personal income and the amount declared as income on tax returns submitted to the IRS. These researchers also found it "questionable whether the gain in revenue from reduced evasion would be large enough to offset the revenue loss due to lower tax rates.--" Stephen Crane and Farrokh Nourzad, "Inflation and Tax Evasion: An Empirical Analysis," in Review of Economics and Statistics, 1986, p. 221.Note-- Indeed, they found that the percentage of unreported income rises by only 0.05 percent for each percent of increase in the income tax rate.

Particularly at higher income levels, however, the presumption is that individuals do not resort to outright income tax evasion as much as to legal avoidance through tax reduction schemes. It is also assumed that higher tax rates will reduce work intensity and measured income and hence tax revenue. One study that attempted to take all these factors into account was done by the well-known supply-sider Lawrence Lindsay, who used a detailed microeconomic model of taxpayer behaviour to analyze the impacts of the US federal income tax cuts of 1981. He found that "at least one sixth, and probably one quarter, of the revenue loss ascribable to the 1981 tax law changes was recouped by changes in taxpayer behaviour over the period 1982-84--." Lawrence Lindsay, "Individual Taxpayer Response to Tax Cuts 1982-1984 with Implications for the Revenue Maximizing Tax Rate," Harvard Institute of Economic Research Discussion Paper no. 1288, December 1986.Note --It is interesting that Lindsay's upper limit estimate is not much larger than Clotfelter's reckoning that 20 percent of the revenue loss from a tax rate cut is recouped through increased compliance.

Some recent work by Martin Feldstein, an outlier relative to the studies mentioned so far, shows much stronger tax revenue increases from tax rate cuts. Feldstein has become a harsh critic of the Clinton administration's tax hikes for high earners, predicting virtually no net revenue increase for the US government--. Martin Feldstein, "Clinton's Path to Wilder Deficits," in the Wall Street Journal, February 23, 1993; and "The Effect of Marginal Tax Rates on Taxable Income: A Panel Study of the 1986 Tax Reform Act," National Bureau of Economic Research Working Paper no. 4496, October 1993.Note --He came to this conclusion by following a set of 4,000 individual taxpayers through the years before and after the 1986 tax reform and observing that income taxes collected from the highest income segment actually rose in spite of tax rate cuts. Unfortunately, Feldstein fails to account for the fact that his period of study covers an economic boom in which incomes at the higher end-e.g., lawyers and corporate executives-ballooned with performance bonuses. The nature of the economic cycle was probably the main reason for the rise in reported income from top earners.

What does this imply for the Canadian situation in the early 1990s? In 1991, the average combined federal and provincial marginal tax rate for incomes between $28,000 and $55,000 rose to 40.82 percent from 40.3 percent the year before. For incomes above $55,000, the rate rose to 46.98 percent from 44.95 percent the year before. Compared to the pre-reform rates of 1987, the 1990 rates represented a reduction for high earners who had previously faced a top marginal rate of 51 percent. For middle-income earners, the marginal rate in 1987 had been only 37.5 percent. In 1992, income tax rates were almost unchanged, declining 0.15 percent for the upper group and rising 0.13 percent for the middle group.-- These data are found in the 1990 to 1992 annual issues of the Canadian Tax Foundation's National Finances, in the table entitled "Combined Federal and Provincial Personal Income Tax Marginal Rates for Selected Fiscal Years."Note

The evidence from the IRS studies of tax compliance suggests that the bulk of tax evasion occurs among independent business owners with relatively modest incomes. This would imply that the tax rate applicable to middle-income earners is the one to watch. Between 1990 and 1991, that rate increased by only 0.5 percent. According to Clotfelter, this would mean a 0.1 percent reduction in reported income that would have amounted to roughly $600 million in 1991. Personal tax increases, therefore, do not appear to be a large enough factor to explain much of the rise in underground economic activity indicated by cash balances in 1991 and 1992.

Psycho-social factors behind GST resentment

There is a reason beyond mere pedantry for trying to establish the GST's role in the underground economy solidly and beyond reasonable doubt. If we feel convinced that the GST had a significant effect, we have acquired a significant lesson in the politics of tax design.

From a rational economist's viewpoint, the GST should not have had this effect. The federal finance department had even argued that the GST would have an opposite effect, actually reducing tax evasion. Gilles Paquet, among others, endorsed this view: "Since it would be a multi-stage tax, it would constitute, in all likelihood, a much better technique to catch cheaters." --"The Underground Economy, " in Policy Options, February 1989, p. 5.Note

In contrast to this view, we have a persuasive theoretical analysis by Jonathan Kesselman concluding that "a change in the tax mix will have little or no impact on total evasion or on the distribution of real net incomes between evaders and non-evaders." --"Evasion Effects of Changing the Tax Mix," in The Economic Record 69, June 1993, pp. 131-148.Note-- If Kesselman is correct, the GST would not have reduced evasion, but it should also not have contributed to a major increase in evasion.

The GST was imposed at the relatively low rate of 7 percent. It was replacing another tax, albeit a hidden one, and the Department of Finance was by and large correct in its claim that the switchover was revenue-neutral from the federal government's standpoint. Yet the GST overnight became the most unpopular tax imposed by a Canadian government in peacetime. Globe and Mail columnist Peter Cook commented that "the single most unpopular act of the late, unlamented Mulroney government was its introduction of the goods and services tax." --Globe and Mail, January 10,-- 1994.Note This was not just hindsight: during 1990, newspapers were full of headlines such as "Arguing the Case for a GST Revolt," "Two-thirds of Canadians still oppose tax," "GST `last straw'," "Individuals Crushed by Tax While Companies Get off Lightly," and "A Shopping List for GST Haters." --Respectively: Financial Post, January 30; Daily Commercial News, January 15; Financial Post, July 3; Financial Post, July 27: and Financial Times, September 24.Note --When Prime Minister Mulroney took the unprecedented step of increasing the size of the Senate to force the GST legislation through, the cover of Maclean's magazine screamed with the two-inch bold headline, "HOW MUCH CAN CANADA TAKE?"-- Maclean's, October 8, 1990.Note

So why did the GST cause such an outcry? Three broad lines of explanation can be suggested, and probably all have some merit: the visibility issue, perceived government overspending, and unfair taxation.

A GST defence popular with its supporters held that the general population in its ignorance could not be made to understand that the GST was just replacing another, less efficient tax. The old manufacturers' sales tax was invisible, while the GST was right up front. According to this argument, the mistake was making the GST visible, and no doubt a lot of Canadians agreed. Even before the reform proposal, however, large numbers of Canadians must have known about the existence of the MST and most of the rest must have been reached by the federal government's advertisements.

Part of the problem was that many of the pro-GST arguments emanating from the federal government consisted of half-truths. The GST may well have been revenue-neutral, but in that case why would it be expected to cause a substantial increase in the Consumer Price Index in the month it was introduced? The obvious answer is that the GST represented a major tax shift away from producers and onto consumers that has been estimated by Patrick Grady as representing $4.6 billion.-- "An Analysis of the Distributional Impact of the Goods and Services Tax," in Canadian Tax Journal, vol. 38, no. 3 (May-June 1990), pp. 632-643.Note-- The GST also came in on top of a string of income tax reforms that had shifted a larger share of the total tax burden to middle income taxpayers.-- Patrick Grady, "The Burden of Federal Tax Increases Under the Conservatives," in Canadian Business Economics, vol. 1, no. 1 (Fall 1992).Note

Who would have been the beneficiaries of this change? The federal government argued that it would make the country's exports more competitive and so create jobs for all Canadians. This claim was rendered ludicrous by events, as Bank of Canada policies led to a severely overvalued dollar, a plunge in Canadian competitiveness, and a massive hemorrhage of jobs. As things turned out, the switchover had no short-term beneficiaries. In other circumstances, the corporate sector would have benefited early, especially in industries where Canadian exporters were international price-takers. In the longer term, the benefits may well even have been more widely dispersed, with workers gaining some real wage increases. Even in the final general equilibrium, however, the return on capital and hence the highest income groups in society would probably have gained more than anyone else.-- This would generally be true if the international supply of equity capital to Canada is relatively inelastic with respect to the after-tax rate of return, which it seems to be. The vast bulk of international capital flows is in the form of interest-bearing securities, not equity. Taxes on profits fall more heavily on upper income groups. The Fraser Institute estimates that upper income groups pay 67 percent of taxes on profits. Canadians with incomes over $250,000 derive about 38 percent of their incomes from investments as against 14 percent for the average taxpayer (Department of National Revenue, Taxation Statistics 1993, Table 2).Note

A third anti-GST strand came from a general sense among Canadians of being overtaxed by governments that were careless with the money they received. The introduction of an additional layer of sales tax with large administrative costs for both government and taxpayers particularly rankled with people who were concerned about wasteful spending. By 1990, the term "tax revolt" was often heard. Kevin Avram, president of the Association of Saskatchewan Taxpayers, declared: "The root cause of the tax revolt triggered by the goods and services tax is excessive government spending." --"Forget tax reform, we need spending reform," in Canadian Speeches, November 1990, p. 13.Note --Another activist foretold widespread civil disobedience because "the middle class has reached a level of taxation that is too high to bear." --Maclean's, October 8, 1990, p. 26.Note --As already noted, these people were not speaking from ignorance. In spite of the vaunted revenue-neutral nature of the GST, it was part of a substantial increase in the tax burden on the middle class-the sort that sparks increased evasion.-- Michael Spicer and Lee Becker, "Fiscal Equity and Tax Evasion: An Experimental Approach," in National Tax Journal, vol. 33, no. 2.Note

The federal government ought to have taken the tax revolt warnings seriously. In a decentralized economy, taxes rely substantially on voluntary compliance by citizens. If they find a particular tax very unfair, they will refuse to pay it, and this seems to have happened with the GST.

Had a referendum been held on the GST issue, there is no doubt that it would have been resoundingly rejected. This is not a hypothetical suggestion, since in Switzerland the recent introduction of a VAT was actually the subject of a series of referenda.

It is reasonable to assume that Switzerland will have less trouble with evasion. In a society where people realize that the tax is a result of expressed consensus rather than arbitrary decree, their consciences are more likely to propel them into compliance. Psychological studies of taxpayer behaviour have found that evasion increases when people can convince themselves that a tax is unfair. For their own self-esteem, most people like to think of themselves as honest. Indeed, society could not function at all were this not the case, as there are never enough policemen to watch everybody, or police to watch the policemen. However, once people see themselves as being cheated by government, they feel justified in "cheating back."

The GST started out with a huge strike against it. Even with the wave of public opposition, however, compliance could have been increased with stronger enforcement. Studies do find that penalties for evasion work as deterrents. Holger Wolf has constructed an analytic model of tax revolts which shows that the attractiveness of cheating for any individual increases with the awareness that others will be cheating along with him. He suggests that this kind of revolt could possibly be nipped in the bud by a few symbolic, high-profile prosecutions before it gets out of hand.-- "Anti-Tax Revolutions and Symbolic Prosecutions," National Bureau of Economic Research Working Paper no. 4337, April 1993.Note

The underground economy and government deficits

It has been suggested in these pages that the growth in the underground economy since 1991 may have been as much as 2 percent of GDP. That would represent $14 billion in national income unreported for tax purposes. Based on typical tax rates, this implies a revenue loss of roughly $6 billion to all levels of government in Canada. A loss of this size would represent about 12 percent of the deficits incurred by all levels of government in 1993.

However, there is more than one type of connection between the underground economy and government deficits. Not only does the underground economy contribute to higher deficits, but high deficits may in turn further encourage people to participate in the underground economy. The accumulation of debt and the need to pay interest on that debt create a situation where tax rates are forced to increase without any corresponding increase in government services to the public.

Taxes as a percentage of GDP have been rising in Canada while government spending on current goods and services as a percentage of GDP has been on a declining trend since the early 1980s, interrupted by the recession. One of the main reasons for this is the growth of interest payments on the public debt, which is a particularly serious problem at the federal level but a growing problem in the 1990s for provincial governments as well. The growth of public-debt interest means that a large proportion of the taxes people are paying today goes to pay for services consumed in the past by people who may no longer be alive. Current taxpayers find it hard to derive pleasure from past deficits. Tax rates that increase without any offsetting benefits to taxpayers are going to be deeply resented, as psychological studies of tax evasion suggest. --Alm, Jackson and McKee, "Estimating the Determinants of Taxpayer Compliance with Experimental Data," in National Tax Journal, vol. 45, no. 1.Note

This is one reason why the Ricardian equivalence hypothesis, which claims that government deficits do not matter, cannot be correct. Proponents of Ricardian equivalence argue that individuals are forward-looking, anticipating the future tax burden resulting from higher government deficits, and will therefore increase their savings rates. Remarkably, the serious practical problems that arise with attempts to collect higher taxes seem to have eluded these theoreticians. --The issue is not addressed at all in the literature survey by John Seater, "Ricardian Equivalence," in Journal of Economic Literature, March 1993.Note

Continual growth in the proportion of GDP going to service the interest on the country's public debt requires either reduced government services or increased tax rates. Deficits should be considered a matter of great concern because of the increasing difficulty of paying the interest on a growing pool of public debt. This is a function both of the size of government deficits and of the real interest rate on the debt issued to finance these deficits. There is evidence that tight monetary policy in Canada over the past several years has exacerbated the problem by causing substantially higher real bond yields. Peter Spiro, "The Differential Between Canadian and US Long-Term Bond Yields," in Canadian Business Economics, Winter 1994.Note

Conclusions

This article has examined some possible factors behind the spurt of growth in the Canadian underground economy that began in 1991. The inescapable conclusion is that the GST was the primary catalyst triggering this growth.

While the GST was the culprit in this latest episode, other evidence supports the view that there was already a substantial underground economy in Canada before 1991. Econometric analysis from both Canada and the United States suggests that the large share of GDP taken by taxes in total (and in particular high rates of income tax) is the primary cause of the long-run growth in the underground economy.

Canadian Attitudes Towards Taxation

Bruce Flexman

Introduction

There is a great deal of controversy nowadays about the extent of Canada's underground economy and how we can measure it with any degree of accuracy. Some of the debate has focussed on the definition of this underground economy. Does it include only activities using illegal means to avoid paying tax? Or does it encompass activities in which individuals legally avoid taxes-for example, doing their own home repairs instead of hiring contractors. All things considered, it would seem that our definition of the underground economy should cover illegal practices only: it would be too difficult to separate self supply transactions undertaken for tax motives from those engaged in for other reasons.

The primary debate about the size of the underground economy in Canada, however, revolves around the methods used for arriving at estimates. Some commentators base their estimates on changes in the money supply. --See the papers in this volume by Rolf Mirus and Roger S. Smith, Faculty of Business, University of Alberta, "Canada's Underground Economy: Measurement and Implications," and Peter Spiro, Ontario Ministry of Finance, "Taxes, Deficits, and the Underground Economy."Note --Another approach measures reported and unreported activities in the Canadian economy sector by sector and attempts to estimate levels of underground activity within these sectors. See the paper in this volume by Philip Smith of Statistics Canada, "Assessing the Size of the Underground Economy: The Statistics Canada Perspective."Note Smith and Revenue Canada favour a microeconomic approach: estimates of levels of evasion in particular industry sectors provide a more focussed approach for targeting future audit activity.

But does the size of the underground economy really matter? If 5 percent or 20 percent of the Canadian gross domestic product turns out to be underground, how does this information help us to reduce this economy? The fact is that taking the measure of the underground economy is an important first step in building appropriate public policy to deal with tax evasion or cheating. If no attempt is made to quantify our subject and establish whether it is growing or shrinking, it will be that much more difficult for us to make a rational allocation of public resources to deal with the matter. It would also be very hard to evaluate measures taken to combat tax evasion without some sense of their effectiveness.

Is there a simpler way to establish our measurement? Canadians' perceptions of the underground economy draw mainly on anecdotal evidence. With the introduction of the GST, it has become commonplace to hear open talk of paying cash for goods or services to avoid this tax. During 1993, we saw numerous reports about tobacco smugglers and the huge profits they were earning. One could not help noticing the news clips of people openly purchasing contraband cigarettes. The evening news showed us snowmobiles laden with smuggled cigarettes crossing the St. Lawrence in the winter darkness. These anecdotes colour our perception of the underground economy, but do they help us to measure it?

Whatever the case, these perceptions of the size of the underground economy do have special significance. If people come to see tax cheating as acceptable, more of them may feel able to rationalize their own behaviour to evade taxes. Now our Canadian tax system is based on selfcompliance. Customs officers cannot check every vehicle crossing the border; Ottawa is not able to collect GST on every transaction and so has to enlist businesses to act as its agents. Taxpayers are responsible for preparing tax returns and reporting income, including income from such cash transactions as tips and gratuities and interest from foreign bank accounts. The government does not employ enough tax auditors to ensure that each return is checked in detail for compliance. A key ingredient of any tax system is the degree to which it encourages voluntary cooperation, and our Canadian system is still premised on a high degree of selfcompliance.

Does the anecdotal evidence suggest that this selfcompliance is being eroded? Are people losing faith in the basic fairness of their tax system? If there is an erosion of confidence, will this translate into a greater degree of evasion? A recent KPMG survey, outlined in greater detail below, captured the views of Canadians on these and other important questions about taxes and the underground economy. Certainly one of the most important of these questions is whether or not popular perceptions of the underground economy actually affect the level of Canadian tax cheating. Much taxpayer compliance is motivated by the penalties and other deterrents for people caught evading taxes. For certain types of cheating such as paying cash for services or purchasing contraband alcohol or tobacco, however, the penalties may be so remote that taxpayers' behaviour will be based more on their perceptions of what is right than on the existence of deterrents.

Businesses feeling that their competitors are not complying may feel forced to enter the underground economy. For individuals, the perception that many others are not paying their share of taxes may be the only rationalization needed for failing to report certain types of income where the chances of getting caught seem very slim.

Again, Canadians' perceptions of the extent of the underground economy are important in measuring its impact. If the underground economy is perceived to be large and growing, it may become a self- fulfilling prophecy. Canadian perceptions are also important tools for determining the causes of the underground economy and suggesting courses of action for containing it. The objective must be to change public perceptions about the underground economy in order to promote voluntary compliance. If we are to accomplish this, we have to track changes in public perceptions to determine how views are changing and whether our various initiatives are actually working.

We begin with the methodology used in our survey. Our results are then reviewed as they relate to popular perceptions and factors that may contribute to these perceptions. We go on to analyze these results to identify certain taxpayer profiles. The paper concludes by discussing the implications of the survey results for future steps to deal with the underground economy.

Survey methodology

The KPMG survey of attitudes towards taxation was undertaken by Canadian Facts, the country's largest such company, for our Centre for Government Foundation. The survey was national in scope, with respondents randomly chosen from different regions to ensure representativeness of the Canadian population. Some 1,025 Canadians were contacted by telephone during the week January 31 to February 5, 1994.

The survey identified respondents who were selfemployed. Chart 1 summarizes the profile of survey respondents with respect to employment status and regional locations. The survey also captured biographical information on respondents' ages, marital and employment status, education, language, and approximate incomes. Where appropriate, the survey questions were asked in different order to avoid any potential bias.

Click here to view Chart 1: Profile of Survey Respondents

It should be pointed out that the survey was conducted during a period of heightened awareness of tobacco smuggling. It was on February 9, 1994, shortly after the survey, that the federal government announced a reduction of taxes on cigarettes to combat the high-profile smuggling problem.

Survey results

(a) Extent of evasion

Respondents were asked: "To what extent, if any, do you feel that people are evading some of their full share of taxes? Would you say it is happening...a lot, a fair amount, a little, hardly at all, or don't know?" Chart 2 outlines the survey results from this question for all Canadians. It is disturbing that 61 percent of survey respondents felt that there was a lot or a fair amount of evasion. However, it is not clear whether they were making any distinction between tax evasion and legal tax avoidance. There is also no indication as to whether people thought that "a lot" or "a fair amount" meant more than 10 percent, more than 30 percent, or some other figure.

Click here to view Chart 2: Extent of Evasion

Respondents were then asked whether they agreed a lot, agreed a little, disagreed a little, or disagreed a lot with certain statements about taxation in Canada. They were also given the option of having no opinion. Chart 3 shows the responses to the statement: "Most people are honest and pay all the taxes that they should." This answer provides background for the extent of perceived evasion. Some 38 percent of respondents disagreed either a little or a lot with this statement: this group apparently feels that most people are dishonest and do not pay all the taxes they should. Respondents from Quebec and young people perceived higher levels of tax cheating among Canadians. Older taxpayers and respondents from British Columbia perceived lower levels than the average.

Click here to view Chart 3: Level of Honesty

Many taxpayers are complying out of fear of being caught for tax evasion. Respondents were asked their degree of agreement with the following statement: "Most people would cheat on their taxes if they knew they would get away with it." Not surprisingly, 72 percent agreed that with no risk of being caught, most Canadians would not be selfcomplying. Chart 4 summarizes these responses. The equivalent figure for respondents aged 18 to 24 was 85 percent as against 58 percent for senior citizens aged 65 and over.

Click here to view Chart 4: Tendency to Evade

(b) Evasion growth

Survey respondents were asked to compare what they perceived as the current level of evasion with their perceptions of five years before, and indicate whether they thought it had changed. As can be seen in Chart 5, 62 percent of respondents felt that the amount of tax evasion had increased either a little or a lot in the previous five years. This result reflects a heightened awareness of tax evasion. Only 5 percent of respondents felt there had been a decrease in tax evasion.

Click here to view Chart 5: Growth in Evasion

(c) Evasion preferences

Respondents were asked to comment on the level of certain types of tax evasion by others and state whether they would engage in them if they believed they would not be caught. The four ways of evading tax presented to respondents were as follows:

     (i)    not reporting some income on the income tax return;

     (ii)    purchasing liquor or cigarettes that had been smuggled into Canada;

     (iii)    avoiding the GST by having work done for cash; and

     (iv)    not declaring goods bought abroad when returning to Canada.

Chart 6 summarizes respondents' perceptions of the ways taxes were being evaded by other Canadians. The responses indicate that Canadians feel a significant proportion of the population are evading taxes, at least occasionally, in the ways outlined by the survey question. Clearly, income tax evasion by not reporting amounts on the personal return is seen as the least prevalent of these practices. This result is not surprising, given that there is less latitude for many Canadians to misreport income for tax purposes when information slips for such common income sources as wages and interest are provided to the government.

Click here to view Chart 6: Evasion by Others

Quebec respondents perceived higher levels of evasion than respondents in other provinces for smuggled liquor and cigarettes. Respondents from Ontario indicated the highest levels of evasion for cross-border shoppers and persons paying cash to avoid the GST.

Disturbingly, perceived levels of evasion by others differ with the respondents' ages. Younger respondents perceived much higher levels of tax evasion in the four scenarios presented.

Respondents also answered a hypothetical question on their own propensities for tax cheating. Survey respondents were asked if they had an opportunity during the next year and believed they would not be caught, they would engage in the following:

     (i)    not reporting income on their income tax returns;

     (ii)    purchasing, for themselves or others, liquor or cigarettes that had been smuggled into Canada;

     (iii)    avoiding the GST by having work done for cash; or

     (iv)    not declaring goods bought abroad when returning to Canada.

Chart 7 summarizes the national responses to this question. The results suggest that Canadians are prepared to avoid paying the GST but less inclined to fail to report income for tax purposes. Interestingly enough, very few respondents refused to reply to this question. It seems probable that failure to report income on a tax return is perceived as involving a higher risk of reprisal even though the question started with the premise that respondents believed they would not be caught: for some taxpayers, moreover, having to sign the tax return before filing may help to make failure to report income a disturbing prospect.

Click here to view Chart 7: Personal Evasion

The high levels of respondents prepared to avoid GST can be attributed, at least in part, to the unpopularity of this tax. Consumers may also feel that there is nothing illegal about paying cash to avoid GST since it is difficult for the government to prove intent.

Given the seriousness of tobacco smuggling in Quebec during 1993, Quebec respondents showed a much higher inclination to purchase smuggled cigarettes or alcohol. The responses show consistent differences in inclination to cheat based on respondents' ages. Younger respondents were much more prepared to evade tax than older taxpayers were in any of the scenarios presented. Chart 8 outlines these results.

Click here to view Chart 8: Evasion by Others

(d) Evasion acceptability

The final question of our underground economy survey dealt with the issue of the acceptability of evading income tax or GST as follows:

"Earlier on we talked about the evasion of taxes and the extent to which some people might cheat to avoid paying tax. In your view, is the evasion of income tax by other people something that is

     •   totally acceptable to you

     •   mildly acceptable to you

     •   mildly unacceptable to you

     •   totally unacceptable to you

     •   don't know?"

In an attempt to remove any order bias in responses, about half of respondents had the alternatives reversed, starting with "don't know" through to "totally acceptable to you." Once again, respondents indicated greater respect for the income tax system than for the GST. Of some concern is the fact that 19 percent of respondents were either mildly or totally accepting of income tax evasion and 32 percent were mildly or totally accepting of GST evasion by other people. See Chart 9 for the responses to this question.

Click here to view Chart 9: Social Acceptance

Consistent with earlier findings, older respondents, particularly senior citizens, found income tax or GST evasion more unacceptable than younger respondents did. Although the majority of Canadians find evasion unacceptable, it is both surprising and disturbing that significant numbers find evasion socially acceptable. Apparently, morality has been eroded where taxes are concerned-a situation partly attributable to the effects of the GST.

Survey results: other factors influencing the underground economy

A number of factors may affect a person's inclination to participate in the underground economy to avoid taxes. To the extent that the tax system is considered fair, it is reasonable to assume that more individuals will be inclined to comply voluntarily. If people feel that their tax dollars are not being used wisely, some may see evasion as the only way to control government expenditures. Perceived level of enforcement may be a strong deterrent for prospective tax evaders. Finally, certain design features of the tax system may spur a willingness to evade. Here, we will deal with the survey responses on factors that may influence the size of the underground economy.

(e) Fairness

Respondents were asked whether they agreed a lot, agreed a little, disagreed a little, or disagreed a lot with the following statement: "The present tax system is basically unfair to average Canadians."

Some 74 percent of respondents agreed with this statement either a little or a lot. Quebec respondents were particularly strong in their agreement: 84 percent agreed. Chart 10 summarizes the responses.

Click here to view Chart 10: Fairness

One would expect taxpayers to complain about the fairness of the tax system. We recognize that it would be more meaningful to track perceptions of taxing fairness over a period of time and measure any significant change. We encourage governments to initiate such tracking.

Chart 11 shows approximately three quarters of respondents agreeing that fewer people would try to avoid taxes if they were lower. In Quebec, 87 percent of respondents agreed. Responses may reflect the fact that tobacco smuggling was out of control at the time of the survey, particularly in Quebec.

Click here to view Chart 11: Tax Rates

(f) Fair value for taxes

The survey revealed that 86 percent of respondents felt their governments at all levels were wasting much of the money they raised in taxes. This attitude may be fuelling the growth of the underground economy. Chart 12 summarizes the responses.

Click here to view Chart 12: Government Waste

A similar question asked survey respondents whether they felt Canadians were getting good value for the taxes they paid to their governments. The survey results suggest that 31 percent of Canadians felt they were receiving value, while 61 percent disagreed to some extent. With ever-increasing government expenditures being used to service interest on debt accumulated from past deficits, it is not surprising that Canadians feel they are getting less value for the taxes they pay.

Click here to view Chart 13: Value for Money

(g) Enforcement

Levels of tax evasion reflect perceptions of perpetrators' chances of being caught. A tax administration that is visible in its efforts to catch and prosecute tax evaders sends a strong message to other taxpayers that the system is being operated effectively and that tax evaders run a significant risk of being caught. Respondents were almost evenly divided on whether they thought their chances of being caught for tax evasion were small. The question did not explore what types of tax evasion were more likely to escape detection. Chart 14 summarizes our survey results for this question.

Click here to view Chart 14: Detection

Canadians appear to be prepared to accept stronger medicine to deal with tax evasion and, by implication, the underground economy. Charts 15 and 16 indicate strong support for increased efforts by Revenue Canada to catch evaders and stiffer penalties for these offenders. Since most survey respondents would not have had much information about current levels of enforcement and penalties assessed to tax evaders, these responses are based on perceptions.

Click here to view Chart 15: Enforcement

Click here to view Chart 16: Penalties

Revenue Canada has only recently reintroduced its practice of publicizing taxpayers who are prosecuted and convicted for income tax evasion. Interestingly, the survey indicates a general concern among Canadians about the level of taxation and the use of their tax dollars, with significant numbers prepared to evade tax by different means and yet overwhelmingly supportive of increased enforcement and penalties. In the early 1980s, Revenue Canada was maligned for what was then seen as heavyhanded enforcement, and the department reacted with reduced publicity of these activities. However, this survey indicated public acceptance of more visible signs that Revenue Canada is maintaining a level playing field by ensuring that tax evaders are caught and penalized.

(h) Tax policy

At the time our survey was conducted, the government had just asked the House of Commons Standing Committee on Finance to recommend an alternative to replace the GST. The survey contained two questions dealing with tax policy and GST replacement. The first asked whether the mix of sales and income taxes should be revised: it was phrased as follows:

"As you know, governments raise money in two main ways. One way is to tax income, and the other is to tax purchases through a provincial sales tax or the GST. If we accept that the money has to be raised by taxation, which would be your personal preference for taxes that you pay?

     •   Less income and more tax on your purchases;

     •   Less tax on purchases and more income tax;

     •   The present balance between income tax and tax on purchases, or

     •   Don't know?"

No clear consensus emerged from the survey results. More than a third of respondents felt that the current balance was appropriate, while the remaining respondents expressing opinions were split almost evenly on whether there should be more income tax or more sales tax. As one would expect, higher-income respondents favoured more sales tax, while the less educated, unemployed, or part-time workers favoured more income taxes.

Click here to view Chart 17: Income Tax/GST Balance

The second question asked whether any sales tax replacing the GST should be visible-calculated separately-or folded into the sales price. The question was phrased as follows:

"The main taxes on purchases are provincial sales tax and the GST. If a new tax on purchases was introduced as a replacement for GST, it could be one where the tax was included in the price you saw in the store, or one where the tax was added to the price at the cash register. If we have to have a tax on purchases, would you prefer:

     •   A tax that is already included in the final price you see;

     •   A tax that is added separately when you pay, or

     •   Don't know?"

Chart 18 shows that Canadians overwhelmingly favour tax-included pricing. Respondents apparently felt that loss of tax visibility outweighed the inconvenience of having to deal with tax-extra pricing.

Click here to view Chart 18: GST Visibility

Taxpayer profiles

The survey on Canadian attitudes towards taxation contained 10 statements with which respondents were asked to indicate their degree of agreement or disagreement. An analysis of these belief statements identified three underlying factors: attitudes towards government and taxes, attitudes towards enforcement, and attitudes towards tax evasion. Using these three factors, the analysis segmented the population into the following four groups:

Click here to view Chart 19: Alarming Attitudes

(a) Model Citizens

Model Citizens tended to believe that Canadians received good value for their taxes, the present system was fair, Revenue Canada should increase its enforcement activities, and that people are not foolish to pay all their taxes. Model Citizens were likely to be higher-income individuals or graduates. This group represented 22 percent of the survey population.

(b) Honest but Resentful

People in the Honest but Resentful segment felt that the most people were honest and would not cheat. However, they believed that the system was unfair, taxes were squandered, and good value was not being received for taxes paid. Some 28 percent of the population fell into this segment.

(c) Upset and Envious

The Upset and Envious segment believed that taxes were unfair, wasted, and provided little value to taxpayers. They felt that most people avoided paying their full tax bill and wanted to see stronger action against cheaters. At 34 percent, this was the largest segment.

(d) Tax Anarchists

The Tax Anarchists were very similar to the Upset and Envious category under the headings of fairness, waste, and value for taxes. However, the Tax Anarchists believed that people were foolish to pay all their taxes and opposed Revenue Canada taking more enforcement initiatives or increasing penalties. This group represented 16 percent of the survey population. Not surprisingly, a high percentage of Tax Anarchists were self-employed.

Conclusions

Our survey provided a snapshot of Canadian attitudes towards taxation at a particular point in time. Such taxpayer attitudes should be considered by governments when formulating tax policy and evaluating measures to combat the underground economy. While that economy may be very difficult to quantify, the same cannot be said, fortunately, of taxpayer attitudes, so critical for a tax system that relies on selfcompliance.

A number of conclusions emerge from the survey results. First, any assault on the underground economy will be hampered by Canadian attitudes to government use of their tax dollars. Some 86 percent of Canadians believe that governments squander a lot of the money they collect in taxes. Less than one quarter of Canadians could be categorized as "model citizens." Half of our respondents were categorized as "upset and envious" or "tax anarchists."

Governments at all levels are facing a dilemma in this regard. The reality is that Canadians will necessarily receive less value for their tax dollars as more and more of government revenues are required to service the national debt and governments have to slash their operating deficits. Until governments are able to get their fiscal house in order, Canadian taxpayers will feel cheated of their tax dollars. This will only make the underground economy tougher to combat.

Canadians believe that evasion is growing and widespread-a view that is particularly prevalent among younger Canadians. The political opposition to the GST and the visibility of this tax have led to a perception of increased underground activity. While the GST was introduced as a more effective tax for dealing with the underground economy, it would appear that Canadians believe the opposite and are inclined to try avoiding the GST. Canadians have overwhelmingly indicated a preference for a less visible tax included in the base price of goods and services. This may encourage the government to mandate tax-included pricing for a GST replacement tax.

According to the survey, younger people are more inclined to evade taxes and see evasion as more widespread. Does this mean that younger people are more inclined to evade taxes because of their youth or that we have hatched more tax cheaters in the younger generation who will retain their cheating propensities as they age? If the latter is true, it is a very disturbing trend, especially given the fact that younger generations will inevitably inherit the problems of dealing with a sizeable national debt.

The survey found Canadians ready to accept tougher enforcement by Revenue Canada. But are they? A fiercer Revenue Canada will not necessarily attack tax cheaters only: all taxpayers may come under close scrutiny. This type of initiative might backfire if innocent taxpayers felt that Revenue Canada had become heavyhanded with taxpayers generally.

The experience of the early 1980s demonstrated the risks of aggressive enforcement. During this period, Revenue Canada made concerted efforts to unearth billions of dollars in uncollected taxes, and efforts by the department's auditors were highlighted and publicized. Public reaction was mobilized, and the Conservatives in Opposition were quick to call for curbing Revenue Canada's powers.

The same Conservatives then came to power on a platform that included taxpayers' rights, and Revenue Canada was duly curtailed. Now the department may be just as effective in enforcing the tax laws as it ever was, but Canadians appear to think otherwise. It is therefore important that Revenue Canada be more visible in its enforcement activities and ensure that clear cases of tax evasion are publicized and penalized.

Our survey indicated a surprisingly high social acceptance of tax evasion. Perhaps the political drama of the passage of the GST legislation had placed stress on respect for our tax laws. Whatever the cause, the survey showed that a significant number of Canadians find it acceptable to cheat on their taxes. Most importantly, the view is more prevalent among young people. This is the most disturbing conclusion to emerge from the survey. Where a certain level of compliance with the tax system is voluntary, any erosion of taxpayer morality will lead to a growing underground economy.

The attitudes of Canadians told us that our tax system was in trouble. While the survey reports perceptions and not actual levels of evasion, these perceptions may become realities if governments fail to come up with an effective response. Governments will have to adopt a strategic approach to the underground economy: the option of raising taxes to offset tax revenues lost underground is no longer viable.

A key element of this strategic approach must be to monitor taxpayer attitudes with a view to influencing them over time. While tax administration has historically focussed on the appropriate mix of enforcement and service to taxpayers, it must also nurture taxpayer morality as an investment in improved future compliance within the Canadian tax system.

Revenue Canada: A Sectoral Approach to Measuring the Underground Economy

Tim Gahagan

The matter of the underground economy is approached here from a tax practitioner's perspective. We will briefly examine some estimates of the size of the underground economy, dealing with their advantages and disadvantages and, in particular, their usefulness for detecting underreported or unreported income or sales.

There is a need in this area for the kinds of analysis and estimates that might be more helpful for tax compliance. While aggregate estimates are interesting and important from a broad public policy perspective, they do not have a level of precision or provide the detailed analysis required to identify specific sectors or areas where tax compliance might be an issue. They also do not deal with questions of behaviour and factors which affect it.

Size of the underground economy

Most, if not all, estimates of the underground economy are aggregate measures developed by looking at the economy as a whole. The difficulty, of course, is that one is trying to measure activity which is unmeasured or unreported. Because of this, assumptions have to be made that are open to a great deal of debate.

The following difficulties arise with aggregate measures:

     •   there is no one accepted methodology and, depending on assumptions, even the same approach can result in widely differing estimates;

     •   aggregate measures provide little insight or precision about specific areas where underground activity may be occurring;

     •   the wide variations exemplify the challenges and difficulties that characterize aggregate measurements collectively.

We will briefly review the major methods used, the first being the group using monetary aggregates. Tracking the velocity of cash and reported transactions, this approach infers the size of the underground by the traces they leave. The argument is that a shift in cash balances and cash in circulation suggests greater cash transactions. This involves assumptions about the velocity of money and the medium of exchange-cash, cheque, or barter. Of course, many factors might affect cash relative to total money supply, and estimates of the size of the underground economy using this approach also depend on the choice of base year for comparison.

A second method is to compare the national income measure with national expenditures and infer that the difference is a measure of hidden activity. This method yields estimates of perhaps 4 percent of GDP for the underground economy. The observed differences may reflect a range of factors. The study entitled "The Size of the Underground Economy: A Statistics Canada View", points out these issues.

A third method compares employment statistics. In Canada, this has been done by comparing the Labour Force Survey with the Survey of Employment, Payroll and Hours. Such comparisons reveal a growing variation between these surveys since 1991, but the reasons for this remain unclear. Some have argued that it reflects differences in methodology and coverage, particularly of the service sector. In any event, estimating the size of the underground economy requires knowledge of worker productivity in the informal economy, and such estimates are not readily available to give us an appropriate measurement.

A fourth approach is to use household surveys, extrapolate to the total population, and compare the results with other aggregate measures such as the national accounts. This approach may have problems of non-response and survey response bias-most people will not want to talk about activities they are not reporting.

Now these approaches yield a wide range of estimates of the size of the underground economy, ranging from a low of about 3 percent to in excess of 20 percent of GDP-discrepancies that have been the subject of much debate. Might it not be possible to reduce the range of estimates by concluding agreements on the methodologies and assumptions to be used? In the absence of consensus, we can only anticipate continued wide variations in estimates and thus unclear consequences for public policy.

From the standpoint of improving tax compliance, we might draw the following conclusions:

     •   first, none of these measures provides specific estimates of unreported or underreported income or sales;

     •   secondly, more precision is needed with respect to sectors and areas where non-reporting and underreporting may be problems;

     •   thirdly, less aggregate and more micro analysis might yield higher returns and improved explanations of the reasons and consequences of underground activity.

Sector-specific studies

From a tax practitioner's perspective, sector-specific or micro analysis may be more useful and hold more promise in terms of the quest for the underground economy. Sector studies such as one by the Canadian Homebuilders Association, which has estimated that up to 55 percent of home renovation activity is done "under the table," provide indicators of the seriousness of unreported income and sales in specific areas of the economy. Another example is the Quebec construction industry survey revealing that 25 million hours went unreported in 1991 at a cost of approximately $420 million. This type of detail is needed if we are to gain a better appreciation of the underground economy and formulate appropriate responses to its presence.

A related approach is to survey businesses and individuals. These can help identify areas of non-compliance and the characteristics of non-compliant individuals. For example, a survey by the Canadian Federation of Independent Business found that 25 percent of 11,000 small-business respondents felt that they were facing unfair competition from the underground economy. A further example is the KPMG Peat, Marwick, Thorne survey which found that 19 percent of taxpayers would evade income taxes given the opportunity and a low likelihood of being caught. KPMG also found a significant number who viewed tax evasion as socially acceptable.

Unfortunately, no prior survey benchmark is available to determine whether or not tax evasion is actually on the rise. However, the kinds of surveys mentioned above can provide useful insights into the extent of tax evasion, the characteristics of people who are not reporting, and the reasons behind the practice. Studies along these lines are at least somewhat effective at identifying underground activity and unreported or underreported income.

The approaches Revenue Canada uses for identifying possible problem areas include:

    •   historical analysis of compliance and trends,

    •   matching of information,

    •   using other sources of data,

    •   international exchange of information, and

    •   working cooperatively with the provinces.

These approaches, supplemented by sector-specific studies, can enable us to identify areas where underreported and unreported activities occur. As a result, Revenue Canada has now targeted its efforts to sectors where cash transactions are prevalent-construction, jewellery, restaurant/hospitality services, home renovations, car repairs, and other services. With the Matching Program, Revenue Canada is identifying non-registrants and non-filers and working with the provinces, industry associations, and other experts to improve our ability to identify specific sectors and their characteristics.

This may not be public attention-grabbing work, but it is what is needed to identify underreported and unreported income. It is not only advantageous but the only feasible way to proceed.

Conclusion

Aggregate estimates are interesting, but if they are to be helpful in broad policy terms, their methodological range and differences have to be narrowed. Even then, aggregate measurements may not be as helpful as sector-specific or micro studies that can yield the greater precision needed to guide action and allow us to understand what is going on.

Revenue Canada must, in its attention to underreported and unreported income and sales, be able to rely on much sharper analyses such as sector and compliance studies to best direct its enforcement activities.

A Provincial Perspective on Revenue Forecasting -Based on information available to April 15, 1994.Note

Lois McNabb

Our purpose here is to look at various factors that affect the accuracy of government revenue forecasts. Beginning with an overview of provincial revenue sources and the environment of revenue growth and forecast performance, we will go on to look at the accuracy of revenue forecasts in BC budgets and some evidence that the size of the underground economy is increasing.

Provincial revenue sources

Like most Canadian provinces, British Columbia levies a broad range of taxes that include personal income tax, corporation income and corporation capital taxes, a sales tax called the social service tax, property tax, and taxes on hotel accommodations, insurance premiums, and transfers of real property.

The province also collects royalties on the sale of natural resources and levies fees, licences, and fines. It receives transfers from the federal government to cover some of the costs of health care, postsecondary education, and social assistance: part of this revenue is received as income tax receipts and part through cash payments. Finally, the province collects revenue from government enterprises that include provincial liquor stores, the lottery corporation, and the power utility.

As shown in the 1994 provincial budget, revenue in 1994/95 was expected to total $18.7 billion. Of this total forecast, 62.6 percent was expected to come from taxation, 12.5 percent from federal government transfers, 9.7 percent from natural resources, 9.6 percent from other sources including fees, licences, and investment income, and 5.6 percent from provincial Crown corporations and enterprises (see Chart 1).

Click here to view Chart 1: Provincial Revenue by Source, 1994/95

Ten years previously, BC's revenue profile had been somewhat different. The main differences were in taxation revenue and federal contributions, which then comprised respectively 57 and 21 percent of the 1984/85 total.

Factors affecting provincial revenue growth and forecast performance

A number of factors affect the growth of provincial revenue and our ability to forecast it. These include:

    •    the stage of the economic cycle;

    •    structural changes in the economy and differences in the provincial economy from the rest of Canada;

    •    commodity prices and exchange rates;

    •    the quality and timeliness of provincial economic data;

    •    changes to the tax structure and revenue elasticity;

    •    federal offloading; and

    •    the underground economy, including the effects of higher taxes, cross-border shopping, and tax collection programs.

Stage of the economic cycle

The following chart shows the relationship between nominal gross domestic product (GDP) growth and overall growth in provincial government revenue. Revenue growth rates reflect the impact of changes in tax rates, which contributed to higher revenue growth than GDP growth in 1987/88 and 1988/89 and again in 1992/93 and 1993/94.

Click here to view Chart 2: Revenue Relationship to Economy

The stages of the British Columbia business cycle affect revenue collection. One way of looking at this is to measure the elasticity or responsiveness of revenue to the economic cycle, calculated as the ratio of the revenue growth rate to the growth rate of nominal GDP. Revenue elasticity may vary considerably, reflecting lags in the tax system and the varying sensitivities of individual revenue sources over the economic cycle. In general, revenue elasticity tends to be higher when the economy is picking up. Conversely, it will tend to be lower when the economy is in recession (see Chart 3).

Click here to view Chart 3: Economic Growth and Revenue Elasticity

In the early 1980s, British Columbia experienced its worst recession in half a century. In 1982/83, real GDP shrank 4.2 percent, nominal GDP increased 3 percent and revenue, adjusted for tax changes, fell 7.5 percent. The elasticity of total revenue, adjusted for tax changes and relative to GDP, was -1.06.

Difficult economic circumstances may encourage tax evasion, resulting in lower provincial revenues. For example, the unemployed may not report income because they might thereby forfeit unemployment insurance or income assistance benefits.

Structural changes

The shift to services

British Columbia's economy, originally resource-based, has matured to a broader, service-based structure. Although resource extraction and processing are still important, substantial diversification has occurred in markets and types of products-the service sector and secondary manufacturing. The province has been successful in finding new markets for its traditional products, while the service sector has now expanded beyond support to resource industries.

Chart 4 shows that in 1981, the service-producing sector (shaded areas) generated about 69 percent of total nominal output. By 1992, the service share of total nominal output had increased to 75 percent. Similarly, the service-producing industries' share of total employment increased from 70 percent in 1981 to 76 percent in 1992.

Click here to view Chart 4: British Columbia Nominal GDP by Industry

The growing importance of service industries may lead to slower growth in government revenues because in British Columbia, most services are not taxed, although the sales tax now applies to some labour and legal services.

Self-employment

Self-employed people represent a growing share of the British Columbia workforce. In 1981, just under 14 percent of the province's workforce was self-employed: by 1993, this percentage had risen to 18.

Between 1981 and 1993, the number of self-employed residents of British Columbia more than doubled. During the same period, the number of self-employed persons in Canada as a whole increased by only one fifth (see Chart 5). British Columbia has a higher proportion of self-employed people than the rest of the country.

Click here to view Chart 5: Self-Employment

The chart shows cyclical behaviour in the self-employed share of the workforce. The percentage of self-employed falls when economic growth is peaking and increases when economic growth slows down.

Self-employment may affect provincial revenue growth and forecasts in two ways. First, self-employed people are able to write off many of their expenses for income tax purposes and must provide for their own retirement income. Secondly, in a period of rapid growth in self-employment relative to paid employment, traditional relationships between government revenue and employment may break down: self-employed people initially generate less income than those in paid employment.

Commodity prices and exchange rates

Many British Columbian export commodities are priced in US dollars. The value of the Canadian dollar thus has a direct impact on the prices BC exporters receive. For example, as the value of the Canadian dollar appreciates, given no change in US-dollar lumber prices, lumber producers would get less for their product. Conversely, as the Canadian dollar depreciates, lumber exporters receive more.

The BC Council of Forest Industries estimates that every one-cent drop in our dollar over a period of one year adds $130 million to the value of forest product exports. --"Forest industry stands to log huge benefit from export as dollar dips," in the Vancouver Sun, April 7, 1994.Note-- How much of this added value translates into government revenue will depend on the exporters' behaviour. Part of the additional income may feed through to corporate profits and thus into corporate income tax. If, on the other hand, some of the additional income goes to wage increases, the province's personal income tax revenue will rise. Higher Canadian-dollar prices will also affect the stumpage rates charged on timber harvested on Crown land.

Because lumber prices can be volatile, revenue results vary significantly from budget forecasts even when our forecasts of volumes harvested are correct.

Quality and timeliness of provincial economic data

Forecasting government revenue is made more difficult by the lack of timely provincial economic data. The lags for such important economic data as nominal gross domestic product (GDP), personal income, and investment are longer than for the same data at the national level. These data are subject to revision over a five-year period and estimates can change quite significantly, particularly at turning points.

Initial estimates of provincial wages and salaries, for example, are made with survey information. More refined estimates are produced about three years later, when information on personal income tax collections becomes available. By then, of course, the more accurate information is of little use in forecasting. --Statistics Canada has since begun using administrative records to improve the quality and timeliness of provincial wage and salary data.Note

Changes in tax structure and revenue elasticity

Over the last decade, a number of changes in British Columbia's tax structure have affected the elasticity of government revenue. These include:

    •    The transfer of responsibility for school property taxes from local school boards to the provincial government. Business property taxes have been a provincial source since 1982/83 and residential taxes since 1990/91. This revenue source is stable and relatively unaffected by economic cycles.

    •    The property transfer tax on real-estate transactions was introduced in 1987/88. This tax can be as volatile as property markets.

    •    The provincial stumpage system was modified in October 1987, when the Comparative Value Pricing (CVP) System replaced the Rothery Pricing System. The CVP System determines stumpage based on the relative value of timber (i.e., high stumpage rates on high-quality timber; low rates on poor-quality timber). The Rothery system determined stumpage on a residual basis-the residual difference between selling prices and company operating costs. The changeover to CVP has mitigated the extreme sensitivity of provincial revenue to lumber price fluctuations: stumpage rates now change on the same percentage basis as lumber prices. Before, when stumpage rates were high and prices fell, stumpage absorbed most of the fall: now, stumpage is no longer the last claim on resource revenues and tends to be less volatile as a source of income than it used to be under the Rothery System. Changes announced in April 1994 increased revenue from stumpage by making the system more sensitive to price changes above US $25 per thousand board feet.

    •    The 1991 increase in the contribution limits for registered retirement savings plans (RRSPs) caused a significant increase in contributions by higher-income people and contributed to a slowdown in the growth of income tax revenue.

Elastic revenue sources include provincial income taxes and the social service tax. Less elastic or inelastic sources include the corporation capital tax that was reintroduced in 1992, tobacco and liquor taxes, and federal government contributions.

Federal offloading

Since 1982/83, the federal government has made successive changes that have reduced the rate of growth of federal transfers relative to the original formulas. The most significant reductions occurred in the 1990 federal budget, which froze the per-capita entitlement for Established Programs Financing contributions and placed a 5 percent cap on the growth of social assistance transfers under the Canada Assistance Plan.

Over the last decade, the federal government has provided a smaller and smaller share of the provincial costs of programs, and growth in federal transfers has become less sensitive to the economic cycle. As a result, federal cash transfers fell from 21 percent of revenue in 1984/85 to 12.5 per cent in 1994/95.

In addition to previous cutbacks to provincial transfers, the 1994 federal budget announced a unilateral freeze on Canada Assistance Plan transfers for the 1995/96 fiscal year, pending a planned reform of social security programs scheduled for 1996/97. The federal government has also declared its intention of saving $1.5 billion annually in transfer payments to all provinces, beginning in 1996/97.

The underground economy

Many commentators have suggested that the failure of governments to meet revenue targets is evidence of a growing underground economy. However, the underground economy is only one possible reason for a slowdown in the growth of government revenues. In fact, judging by British Columbia's experience relative to the rest of Canada, underperforming revenue forecasts likely have more to do with cyclical and structural developments than with the underground economy.

Three factors that may encourage underground activity are public resistance to higher taxes, cross-border shopping, and federal tax collection efforts.

Resistance to higher taxes

Although it is difficult to determine the point at which higher taxes will trigger a decline in tax revenue, anecdotal evidence and public opinion surveys suggest that further significant increases in some taxes may not be viable either economically or politically. Taxpayers tend to be increasingly skeptical and intolerant of tax increases when the benefits of government programs are remote and they perceive waste and inefficiency in public administration. This state of mind can lead to a drop in voluntary tax compliance.

One reason for the hostility may be a deterioration in the public finances. As Don Drummond has noted,-- See Don Drummond, "Five Questions about the Underground Economy," a paper presented to the Fraser Institute Conference on the Impact of the Underground Economy, April 21-22, 1994.Note-- from 1975/76 to 1986/87 Canadians received $1.12 worth of services for every dollar they paid in federal taxes. Based on federal budget data for 1994/95, however, Canadians now receive 99 cents in program spending for every dollar of federal taxes. With debt-servicing costs eating up a quarter of the expenditure budget, a federal move to balance the national budget through spending cuts would leave Canadians with only 75 cents' worth of services for every dollar of tax they paid.

The introduction of the goods and services tax (GST) in 1991 may have triggered a sharp increase in various kinds of tax evasion. This was the first general tax applied to services in Canada, and it offered greater opportunities for cheating, as there is often no evidence that services were performed.

A recent survey by the KPMG Centre for Government Foundation showed that while only 19 percent of Canadians would cheat on an income tax return if they believed they would not be caught, 49 percent would pay cash to avoid the GST. Forty-four percent of British Columbians said they would not pay the GST if they thought they would not be caught. --"Hostility to GST high, survey finds," in the Globe and Mail, March 25, 1994, p. B3. For more on the KPMG survey, see the paper by Bruce Flexman, "Canadian Attitudes Towards Taxation," elsewhere in this volume.Note-- Clearly, the British Columbia government will be affected by cheating on the GST if federal and provincial taxes are not paid on income arising from these transactions.

A second area of evasion is tobacco taxes. High tobacco taxes have created a huge black market in smuggled tobacco products, and in response the federal government and some provinces have lowered their taxes.

Rising income tax rates mean greater incentives for taxpayers to evade taxes, use tax avoidance schemes, or shelter income through tax-sheltered investments like RRSPs, thus contributing to slower growth in income tax revenue. Higher tax rates also affect personal decisions about work and leisure: people may not work as hard because the extra income after tax is too little to compensate them for lost leisure.

Cross-border shopping

In British Columbia as in the rest of Canada, most people live within a hundred miles of the United States border. High taxes may well boost cross-border shopping activity. However, the exchange rate also plays a significant role in decisions to buy south of the line. The purchases of choice are generally goods that are heavily taxed in Canada-gasoline, tobacco, alcohol-or high-priced due to government supply restrictions, for example on dairy and poultry products, or import tariffs affecting such items as shoes and clothing.

From 1990 to 1992, cross-border shopping was a major public issue in British Columbia. As proxied by the number of same-day auto trips to the US, the level of cross-border shopping increased substantially between 1986 and 1991 (see Chart 6). At the same time, the value of the Canadian dollar was appreciating relative to the US dollar, and Canadian prices tended to be higher anyway because of our smaller market and a multi-layered distribution system that increased margins between the manufacturer and the retailer. --See Ernst & Young, Responding to Cross Border Shopping: A Study of the Competitiveness of Distribution Channels in Canada: Report to the National Task Force on Cross Border Shopping, 1992.Note

Click here to view Chart 6: Same-Day Auto Trips By Candaian Residents to the U.S.

In the period 1991 to early 1994, however, the number of same-day trips to the US fell by 19.1 percent. Not coincidentally, the value of the Canadian dollar against its US counterpart fell 12.3 percent between January 1991 and December 1993. The increase in the prices of foreign goods resulting from the depreciation of the Canadian dollar appears to have more than offset the rise in general prices resulting from the implementation of the GST. Canadian retailing has also become more competitive.

The loss in tax revenue from cross-border shopping was less than some suggest because many of the items that were cheaper in the US-food and children's clothing, for example-are not subject to provincial sales taxes in BC. This suggests that the main tax losses were in taxes on fuel, tobacco, and alcoholic beverages. --Revenue Canada now collects provincial tax on tobacco and alcoholic beverages.Note

Federal tax collection efforts

Most provinces, including British Columbia, have tax collection agreements authorizing the federal government to collect personal and corporate income taxes on their behalf. Revenue Canada also collects provincial alcohol and tobacco taxes at the border on behalf of British Columbia.

While the tax collection agreements reduce administrative costs for British Columbia and taxpayers have to file only one income tax return, they do mean that British Columbia relies on the federal government to collect over 30 percent of the province's revenue. Thus, the federal government's tax collection and auditing efforts can have a large effect on provincial revenue.

From 1986 to 1991, data show a downward trend in personal income tax auditing by Revenue Canada. After that time, the tax department announced that it was intensifying its auditing thrust, although the British Columbia government continues to monitor the level of enforcement by Revenue Canada.

However, Revenue Canada did form special audit teams to focus on industries with low levels of compliance-construction, jewellery, hospitality, home renovation, car repair, and other service industries. The income tax and excise portions of Revenue Canada were combined, and the department is increasing the number of joint GST/income tax audits to cross-reference files and improve the identification of those not reporting income.

British Columbia's experience

Forecasting

Between 1982/83 and 1993/94, provincial government revenue was, on average, $93 million higher than budget forecasts. The actual results varied from $802 million under budget in 1982/83 to $939 million over budget in 1988/89.

Click here to view Chart 7: Comparison of Actual Revenue to Budget Forecast

The average absolute change-ignoring whether the change was positive or negative-between a budget revenue forecast and actual results over the years 1982-1994 was $408 million or 4.1 percent of the forecast. By the early 1990's, however, revenue forecasting accuracy was improving to average less than 2 per cent of actual revenue. --More recent information shows revenue 3.0 percent above budget in 1993/94, 4.3 percent above budget in 1994/95 and 1.7 percent below budget in 1995/96 (preliminary numbers).Note-- While changes in the fiscal balance can result from changes in either revenue or expenditure forecasts, revenue remains the most important source of error. In fact, in 10 of the 12 years 1982-1994, revenue changes explained most changes in the fiscal balance from budget forecast to year end-a situation that reflects the greater sensitivity of revenue to the economic cycle, but also the greater degree of government discretion and control over spending during the year.

In seven of those years, revenue was higher than budget. Between 1987/88 and 1989/90, revenue was much higher than expected due to unexpectedly strong growth in the economy and policy changes affecting revenue. When an economy is strengthening, it is difficult to forecast the magnitude of the improvement. When the economy is weakening, revenue growth tends to fall more quickly.

Finally, it is difficult to forecast exactly when the economy will reach such turning points or how sharp the turns will be. In 1988, for example, the provincial economy grew by 11.4 percent in nominal terms, significantly more than the original budget estimate of 6.9 percent, and thus contributed to a sharp revenue increase in 1988/89. Other factors contributing to revenue were mid-year policy changes such as the new stumpage system in 1987/88 and one-time asset sales as part of privatization initiatives.

Tobacco tax

When a taxpayer perceives that gains from tax evasion outweigh any associated risks and costs, this creates an incentive for underground activity. In Canada, high tobacco taxes in recent years have tilted the balance between the risks and benefits of evading taxes and led to widespread non-compliance.

As already noted, higher tobacco taxes created a huge black market in untaxed tobacco. The most serious problems occurred in Quebec and Ontario, where most of the contraband tobacco products were exported tax-free to the United States before being smuggled back into Canada. Following federal and provincial tax increases in 1991, the domestic sales of Canadian cigarettes declined by 14 percent in that year and 11 percent in 1992-far exceeding the historical 4 percent annual rate of decline in tobacco consumption. In British Columbia, taxable consumption declined 10 percent in 1991/92 and 6.5 percent in 1992/93 as compared with an average annual drop of 3.8 percent between 1986/87 and 1991/92.

Although the situation in British Columbia does not appear to have been as critical as it was in Quebec and Ontario, provincial finance ministry records suggest that about $75 million was lost to illegal activities in 1993/94, when tobacco tax receipts totalled $478 million. Estimated annual losses were about $450 million for Quebec and more than $1 billion for the federal government before these taxes were reduced in February 1994.

In an effort to combat tobacco smuggling, the federal government and five provinces-Quebec, Ontario, New Brunswick, Nova Scotia, and Prince Edward Island-reduced their tax rates to bring the price of a carton of cigarettes down to the $23 to $35 range. In British Columbia, the retail selling price of a carton of cigarettes was then about $46-roughly 50 percent above the selling price in 1989. Federal and provincial taxes accounted for about 78 percent of this price-$14 in federal taxes and duties and $22 in provincial levies.

Lower taxes in central and eastern Canada threatened to turn an international smuggling problem into an interprovincial one, creating new enforcement problems. However, British Columbia worked in cooperation with the other western provinces and northern territories to enforce current tax rates and ensure that smuggling did not increase. British Columbia's actions included requesting federal legislation to tighten the regulation of the interprovincial transportation of tobacco and working closely with Revenue Canada and the Royal Canadian Mounted Police on smuggling and the underground economy. The province has also considered the expansion of the tobacco marking program under which, since December 1993, manufacturers have been including a green tear strip in their cigarette packaging to certify that taxes were paid and the cigarettes were acquired through a legitimate wholesaler.-- This program was expanded in September 1994 and March 1995 and now applies to all loose tobacco, pre-proportioned toacco sticks and tobacco products sold tax-exempt to Status Indians.Note

British Columbia's tobacco enforcement efforts appear to be taking hold. Statistics on provincial tobacco sales from manufacturers to wholesalers indicate that the level of legitimate cigarettes entering the province has not decreased since the federal government and some eastern provinces lowered their tobacco rates. Meanwhile, the provincial enforcement drive had enjoyed such results as the seizure of a tractor-trailer carrying 50,000 cartons with a street value of $1 million.

Personal income tax

Personal income tax is the most important source of BC government revenue, generating an estimated $4.8 billion or one quarter of all revenue in 1994/95. Since 1984/85, personal income taxes have grown relatively faster than other revenue sources, reflecting increases in the tax rate, growth in personal incomes, and the effects of de-indexing deductions combined with the progressiveness of the tax system. Over the 10 years leading up to 1994/95, personal income tax revenues grew at an average annual rate of 10 percent as compared with 7 percent growth in personal incomes.

As a result of recession, however, personal income tax revenue growth slowed sharply in 1991 and 1992. In 1992/93, the government experienced an unexpected shortfall of almost 15 percent in personal income tax revenue due to unexpectedly low assessments for 1991 and downward revisions to the federal estimate of payments for 1992. A detailed analysis of tax-return data from Revenue Canada showed that these unexpectedly weak assessments were largely due to the effects of the recession, which prompted a structural shift in the workforce from full- to part-time employment and a decline in paid-employment hours worked that was a sign of more self-employment. A decline in interest rates has also contributed to a sharp drop in the investment component of assessed income.

British Columbia's high marginal tax rate may be providing an incentive for tax avoidance and evasion activities which include exploiting legal tax shelters such as RRSPs, underreporting income, and allocating taxable income to a lower-tax-rate province. Certainly, some policy analysts and business groups have expressed concern that recent increases in marginal tax rates (see Chart 8) will encourage high-income earners to locate elsewhere and take their tax payments with them. No estimate is available of the revenue loss to the province from such activities, however, and they do not appear to explain the slowdown in personal incomes in recent years.

Click here to view Chart 8: Major British Columbia Taxes Two-adult Families - 1991 and 1994

Advice for government revenue forecasters

Despite all our best efforts, revenue forecasting remains very much an art rather than a science. The writer's own experience suggests four pieces of advice for other forecasters:

     •     Be conservative: the consequences of overestimating revenue are much more serious than the consequences of coming in too low. This is because the public and the media focus on the deficit/surplus as the main fiscal policy indicator. A revenue shortfall will be seen as evidence of "incompetence" on the government's part, even though the deterioration in the fiscal balance may be out of the government's control. It is also much easier for a government to decide what to do with revenue windfalls than it is to figure out what expenditures to cut after ministry budgets have been set.

     •     Do sensitivity analysis: numerous factors can affect the accuracy of a revenue forecast. Even if your forecasts for GDP and employment turn out to be correct, revenue may not come in as expected. As pointed out in an article about forecasting by US state governments, getting to within 2 per cent on a revenue forecast is a good performance in stable times. "Cracks in the Crystal Ball," in Governing, December 1991, pp. 29-32.Note Politicians need to be reminded about a forecast's level of uncertainty so that they are aware of its upper and lower risks. Based on our BC forecasting experience, we assume a 3 percent band around the revenue forecast at the beginning of the fiscal year.

     •     Seek new sources of information: look for additional sources of economic data that may help your revenue forecast. For example, in recent years we have used information on full-time/part-time work, paid employment, and total paid hours worked in the province to help determine what will happen to personal income tax revenue. We have also collected more regional data for early signals of problems in the economy or with particular revenue sources.

     •     Obtain an independent check on the forecast: to avoid the danger of overlooking factors that might seriously affect the forecast, have it reviewed by someone from outside. In 1984, the State of Washington established its Economic and Revenue Forecast Council to provide an objective revenue forecast for both the executive and the legislative branches of government.

References

British Columbia, Ministry of Finance and Corporate Relations, 1993 British Columbia Economic and Statistical Review: Victoria, 1993 and subsequent editions.

British Columbia, Ministry of Finance and Corporate Relations, Budget 94: Victoria, 1994 and subsequent editions.

Drummond, Don, "Five Questions About the Underground Economy," paper presented to the Fraser Institute Conference on the Impact of the Underground Economy, April 21-22, 1994.

Ernst & Young, Responding to Cross Border Shopping. A Study of the Competitiveness of Distribution Channels in Canada: Report to the National Task Force on Cross Border Shopping, March 31, 1992.

Olberding, Douglas J., Revenue Forecasting and Estimating in the Midwest: A Report of the Midwestern Legislative Conference of the Council of State Governments, Lombard, Illinois, October 1992.

Shanahan, Eileen, "Cracks in the Crystal Ball," in Governing: Washington, DC, December 1991.

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