It’s time to focus on hidden economy

  • Business
  • Monday, 01 Jul 2019

AmBank Group chief economist Anthony Dass(pic), who is projecting a 4.5% GDP growth this year for Malaysia, said the economic growth hinges largely on domestic demand and private investment. To this end, he told StarBiz it is imperative for the government to arrest the alarming decline in private-sector investments which has slid from 6.9% in the third quarter of last year (3Q18) to 0.4% in 1Q19.

A TAX officer went to buy a bicycle for his kid. The seller asked if he would like to get a receipt and pay the tax, which will result in higher price, or buy the bicycle without the receipt and purchase it at a lower price. So, the tax inspector paused and thought for a moment on, “What should I do?”

Is this something new in developing countries, including Malaysia ?

Certainly, this is not new. Tax administrators, and most other people, grapple with this issue every day.

As a result, it has created a larger “hidden economy” which undermines the tax collections and reduce the association of this “hidden” economy with higher tax collection.

I believe Malaysia is no exception to this scenario.

Little emphasis on hidden economy

Put it in a simple language, hidden economy comprises of those economic and business activities that are deemed illegal, either because the goods or services traded are unlawful in nature or because transactions fail to comply with governmental reporting requirements.

Some primary examples of this economic activities include untaxed labour, untaxed sale of physical goods and smuggling of goods into a country to avoid paying duties at the border.

Human trafficking operations as do the markets for endangered animal species, antiquities and illegally-harvested human organs, sale of street drugs, illegal prostitution and many more fall into this category of the economic activities.

Now, depending on the context, the impact of hidden economy can range from being harmful to helpful. Harmful scenario happens when the country is sitting on a large hidden economy. The money not collected in the form of tax by the government will affect government’s expenditure in driving both the economic growth and public programmes. For instance, if the tax officer bought the bicycle without a receipt.

At the same time, those who are involved in the hidden economic activities and decided to pay tax from their income is positive for the overall economic activity as it will stimulate demand. However, this is only true if the tax revenues collected are not being siphoned off by corrupt government officials.

Due to its masked nature, it will be difficult to determine the true extent of the money that changes hands through the hidden economy simply because their transactions are not reported. Also, by nature they are not subject to governmental oversight, and they, therefore, do not generate tax returns or appear in official statistical reports.

And logically, such activities from the hidden economy will distort the accuracy of the key economic measurements. Policies can go wrong, especially if the government is focusing on lowering its fiscal deficit by raising taxes and cutting expenditure and comfortably ignoring the impact from hidden economy.

In other words, the money spent by those involved in this economy that is not reported actually represents the breadth of their activities.

Acknowledging the complexity to measure the impact of the hidden economy, there are several ways to look at hidden economy’s role. A simple and possible way is to use the electricity consumption. It is a simple and straightforward approach. The electricity consumption is viewed as a single best indicator as it is reflected in physical units and has almost a very low alternative with other goods and services. Hence it will be difficult to hide.

So what happens here is that both the electricity consumption and economic growth should move in line, show a positive relationship. Now, any differences between the growth of electricity consumption and GDP can be said to have come from hidden economy. On that note, it will be relatively easy to construct a whole-time series of the share of the hidden economy in GDP.

While using the electricity approach is more to calculate the hidden economy in the overall economy, there are still a number of other ways the government can take measures to reduce the effect of this economic activity on skewing the economic growth numbers.

For instance, complex tax laws, weak tax enforcement and lack of incentives to make payments through formal banking channels are among the factors affecting the size of the hidden economy. Greater tax complexity imposes heavier compliance burdens on taxpayers, disincentivises tax compliance and encourages taxpayers to move into the shadows. Receipt-free cash transactions for goods and services increase the risk of tax evasion. So, a simpler and flatter tax structure will be desirable.

Although the availability of banking services and alternative payments have emerged, key sectors of the economy remain largely cash-based in almost all developing countries including Malaysia. And so, there is still a strong negative correlation between the use of electronic or formal payments and the size of the shadow economy. By encouraging greater use of e-payments, it will potentially reduce the size of hidden economy.

Governance-related factors like quality of regulation and control of corruption can help reduce the size of the hidden economy. Corruption leads to lower tax morale and poor trust in government, which in turn leads to larger hidden economy. It is important to remember that taxpayers’ trust in government is a fundamental driver of tax morale.

With the growing focus on technology, its readiness will have a significant impact on the hidden economy as it can shine light into the shadows of this economic activities. What can happen here is that it will allow tax administrators to have better access and information of the taxpayers’ financial transactions with banks and other institutions on a regular and automated basis. Such information can then be used to analyse the taxpayers’ behaviour and profiles and also aid in risk management.

By reducing personal and corporate income taxes, it will discourage inaccurate and incomplete tax filings. And then there is the tough love approach that is to implement high tax evasion penalties for those who under report.

The government should consider legalising some of the underground economic activities as a way to legitimately tax and raise revenue.

Finally, governments can stimulate the creation of higher-paying legal jobs, which would theoretically shrink the underground economy.

Malaysia is being saddled with high public debt while at the same time trying to lower its fiscal deficit. Being prudent on the expenditure side is welcoming. It can result in a negative should the policymakers overtrim on their expenditure by delaying payments or reimbursements, for instance.

Focus must also be on revenue. One way is to raise taxes or introduce some new revenue taxes, which may risk some backlash. Alternatively is to drive new areas of businesses while supporting existing businesses through incentives and export rebates.

Another area is to look at the leakages arising from the hidden economy. This segment has long been a burden in the form of tax collection, job market as we as social crime activities. Hence, it is probably the time for the authorities to look closely at this segment of the economic activities that can help improve tax collection.

Introducing flatter tax schedules characterised by fewer tax brackets, lower rates and simpler filing procedures will be a way forward. After all, the world is increasingly moving towards a simpler, flatter income tax systems, all of which will help reduce the size of the shadow economy. By having a simpler tax system and reinforced as we as accompanied by better government services, stronger legal system and weaker corruption, it will erode the hidden economy and improve revenue collection without burdening the people and genuine businesses.

In short, by addressing the hidden economy, it will help provide positive booster to the economic growth and at the same time, the government could become more sympathetic to the people and businesses in terms of the tax policies and incentives.

Anthony Dass is chief economist and head, AmBank Group Research, and adj. professor, faculty of economics, UNE, Australia

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