The RM300bil shadow economy

Hendrik Stoel

THE weak results of British American Tobacco Bhd (BAT Malaysia) and the sharp comments made by its outgoing managing director Hendrik Stoel against the government on Feb 20 highlights the need for Malaysia to act promptly to reduce its huge shadow economy.

For the full year of 2019, BAT Malaysia’s net profit fell 26.96% year-on-year to RM343.81mil, while revenue declined 11.14% to RM2.51bil. This marks the group’s fourth consecutive year of decline in performance.

The MNC has cast blame on illegal cigarette trade that it said currently makes up 63% of the total industry volume, up from 33.5% in 2015.“The legal (cigarette) industry has diminished by almost 40% in the span of four years since 2015 due to the illegal cigarettes trade.

“Although there was an uptick in enforcement actions over the year, the inconsistent efforts proved insufficient to dent the ultra-high levels of illegal cigarettes.

“We anticipate that this will continue to negatively impact BAT Malaysia’s financial performance, punishing our shareholders and investors, ” said Stoel in a statement after releasing company results.

He added BAT Malaysia’s investors “have lost confidence in the Malaysian government’s resolve and ability” to tackle the illicit cigarettes trade problem.

“This problem has become so large and so endemic that it has impacted all segments of society, from businesses to the lives and health of Malaysians, ” Stoel added.

It is clear from Stoel’s (pic) remarks that BAT Malaysia – which has often highlighted the issue of illegal cigarette – is a casualty of the largely ignored shadow economy.

There may be many other companies sharing the same predicament in Malaysia.

Informal economy How large is Malaysia’s shadow economy or informal economy that covers all economic activities and services hidden from tax authorities?

It is about RM300bil or 21% of GDP, according to data released by former Finance Minister Lim Guan Eng in January.

In developing countries, it is estimated that the shadow economy accounts for about 36% of GDP, with the size ranging from 25% to 60% in South America and within 13-50% in Asia.

Lim had disclosed the Finance Ministry was looking into tapping income tax revenue from the shadow economy.

Indeed, many company owners are being investigated by the tax authorities for avoidance of tax payments in the past years.

It is even more urgent for the tax authorities to work harder now, given that the economic growth of the country is projected to be lower than official forecast due to the adverse impact from the on-going Covid-19 virus epidemic in China.

But to be fair, there are a lot of challenges faced in tackling the shadow economy. Many complex and disruptive forces are at play.

The rapid globalisation, fast evolving business environment shaped by the deployment of digitalised technology as well as the rise of gig and sharing economy would have make it more complex for the tax authorities to track, measure and control the shadow economy.

However, no authorities should use this excuse to shirk responsibility.

Based on the IMF policy paper, Malaysia’s size of shadow economy has been trending lower – from 37.5% of GDP in 1991 to 31.1% in 2000,30.2% in 2010 and 26.1% in 2015.

But there is no cause to cheer or celebrate when compared with nearby countries.

Malaysia’s average ratio during the 1991-2015 period was 31.5% – higher than Singapore (11.9%), Australia (12.1%), China (14.7%), Hong Kong (14.7%), Vietnam (18.7%), India (23.9%), Indonesia (24.1%) and South Korea (25.7%). And according to Lim, based on World Bank figures for 2017, although the size of Malaysia’s economy was RM1.4 trillion, the tax-to-GDP ratio was only 13.1%.

This puts Malaysia below countries such as Vietnam, Chile, Poland and South Korea, for which the ratio was 19%, 17.4%, 16.8% and 15.4% respectively.

Lack of market surveillance and enforcement on illegal activities, rise in corruption and lack of taxpayers’ consciousness are among factors that encourage shadow economy to flourish.

Erosion of tax base

The presence of a large shadow economy deters the development of an inclusive economic growth development as it deprives potential high tax revenue collection to finance productive development projects such as healthcare, education and public transportation as well as socio-economic communities.

Shadow economy’s adverse economic and social implications are an erosion of tax base, price and competition distortions in the market place, the influx of lower quality goods that pose health hazard to consumers, rampant corruptions and the degradation of economic and social institutions, which affect productivity and lower economic growth.

As the informal sector does not pay tax, this creates unfair playing field for registered tax paying businesses and individuals.

Malaysia reckoned that the presence of a large tax gap estimated 20% (which measures the difference between total taxes owed and taxes paid on time) and shadow economy of 21% of GDP would restrain the government’s budget operation to fund economic development.Although Malaysia’s nominal GDP had increased by an average of 7.3% per annum in 2011-2018, tax revenue collection had paced slower at 6.0% per annum.

Tax revenue to GDP ratio had declined progressively from 15.6% in 2012 to 12.0% in 2018 and 11.8% in January-September 2019.

This issue of shadow economy matters now due to the persistent years of budget deficits and a narrow tax base, as the government simply isn’t collecting enough revenue to meet high level of development expenditure and obligated operating expenses.

If the informal sectors and unregistered individual taxpayers are captured in the tax net, tax revenue will be boosted.

With the local shadow economy of RM300bil, a 1% tax collection will translate into RM3bil additional revenue.

To plug the tax leakages via shadow economy, the government should reduce the complexity of the tax system, make simpler tax filing process and adopting a policy to incenticise formal payments for business transactions.Using ICT solutions, including Big Data analytic and Artificial Intelligence, the government can improve tax enforcement and plug tax evasion The government can consider the following initiative and strategies to tackle the shadow economy and raise tax revenue:

> Raise community awareness through education about the importance of taxation policy in supporting socio-economic development and providing essential public services and infrastructure. The tax agencies must engage the community to identify and reject shadow economy operators.

> Reinforce taxpayers’ fiduciary duty through education. Taxpayers have to fulfil their duty of paying taxes if they are convinced that the tax money is being utilised accountably for productive economic development.

> Implement effective identification and registration of taxpayers, which include the use of biometrics and blockchain technology. In 2019, eligible Malaysian taxpayers of 3.503 million only made up 22.39% of total workforce of 15.642 million.

> Tax administration to undertake soft approaches involving other government agencies, including local authorities, to track and influence behaviour of informal sectors to pay taxes. These include devising an effective mechanism to share data information and sources on the business of shadow agents.

> Set up a task force to monitor the activities of sharing and gig economy. But while the sharing and gig economy can yield positive economic effects, they also risk expanding the shadow economy as existing and new activities may go unreported. Hence, the tax administrations may have to explore the possible options and solutions to facilitate the growth of online intermediaries, sharing economy and gig agents while fulfilling their tax obligations.

> Accelerate the growth of cashless payments. Since the passive shadow economy is caused by cash payments, it could be reduced by promoting electronic payments, or through other measures aimed at increasing the share of cash transactions being registered.

> Limit the amount of cash transactions, increase labour inspections at building sites and introduce higher penalties for counterfeiting of products and smuggling.

Lee Heng Guie is senior economist and executive director of Socio-Economic Research Centre, a private think-tank set up by the Associated Chinese Chambers of Commerce and Industries of Malaysia. The views expressed here are the writer’s own.