Professor John HudsonProfessor John Hudson

University of BathUniversity of Bathwww.bath.ac.uk/hssjrh/www.bath.ac.uk/hssjrh/

These notes will be placed on my web These notes will be placed on my web pagepage

BATH UNIVERSITYBATH UNIVERSITY

We will look at some resources for We will look at some resources for you then two pieces of research in you then two pieces of research in which we have been involved inwhich we have been involved in

A Model of UK EconomyA Model of UK Economy

www.bized.co.uk/virtual/economywww.bized.co.uk/virtual/economy Allows you to see the impact on Allows you to see the impact on

unemployment, growth, government unemployment, growth, government revenue etc of e.g. cutting tax on income or revenue etc of e.g. cutting tax on income or increasing VAT. Also the impact on various increasing VAT. Also the impact on various families of these changesfamilies of these changes

Has Case studies of these changesHas Case studies of these changes A dictionary of economicsA dictionary of economics A set of biographies on the great economistsA set of biographies on the great economists

TAXATION COSTSThe first known system of taxation was in Ancient Egypt around

3000 BC - 2800 BC in the first dynasty of the Old Kingdom.[

Records from the time document that the pharaoh would conduct a biennial tour of the kingdom, collecting tax revenues from the

people. Early taxation is also described in the Bible.

In Genesis it states "But when the crop comes in, give a fifth of it to Pharaoh. The other four-fifths you may keep as seed for the fields

and as food for yourselves and your households and your children.“

We need tax to fund the state, hospitals, education and so on. But taxation imposes costs

ADMINISTRATIVE COSTSADMINISTRATIVE COSTS

These are the costs incurred by These are the costs incurred by governments in the collection of governments in the collection of taxes. The costs of tax inspectors, taxes. The costs of tax inspectors, etc. etc.

But there are also costs incurred by But there are also costs incurred by people who pay taxes:people who pay taxes:

COMPLIANCE COSTS OF COMPLIANCE COSTS OF TAXATIONTAXATION

These are the costs on the individual of These are the costs on the individual of paying taxes, e.g. the costs on you of paying taxes, e.g. the costs on you of filling in your tax forms.filling in your tax forms.

For some taxes such as VAT these are For some taxes such as VAT these are substantial and may amount to say 3% of substantial and may amount to say 3% of revenue collected. revenue collected.

At Bath we did work for the tax authorities At Bath we did work for the tax authorities on the compliance costs on firms of on the compliance costs on firms of collecting income tax for government: collecting income tax for government:

The firm – in my case Bath University The firm – in my case Bath University – takes, from my salary, tax and a – takes, from my salary, tax and a month or so later gives it to the month or so later gives it to the government. government.

We sent questionnaires to several We sent questionnaires to several thousand businesses in the UK and thousand businesses in the UK and found:found:

These costs penalise small business These costs penalise small business more than large because of economies of more than large because of economies of scale.scale.

Are particular great for part time, Are particular great for part time, seasonal workers and firms where seasonal workers and firms where workers tend to change a lot as some workers tend to change a lot as some leave and new ones arrive leave and new ones arrive

IMPACTIMPACT

Because of this work the UK government is Because of this work the UK government is now committed to minimizing compliance now committed to minimizing compliance costs and to make the paying of taxes as costs and to make the paying of taxes as simple as possible.simple as possible.

But doing large questionnaires is expensive But doing large questionnaires is expensive and the results quickly become out of date. and the results quickly become out of date.

The Dutch have developed a technique The Dutch have developed a technique based on what they call the MISTRAL modelbased on what they call the MISTRAL model

First the Dutch….First the Dutch….

This attempts to estimate the costs of e.g. paying This attempts to estimate the costs of e.g. paying VAT by examining all the actions involved and (i) VAT by examining all the actions involved and (i) estimating the amount of time each action costs estimating the amount of time each action costs and (ii) putting a money value on this time.and (ii) putting a money value on this time.

They have done this with every single piece of They have done this with every single piece of work firms have to do for the government – e.g. work firms have to do for the government – e.g. health and safety, environmental laws, etc.health and safety, environmental laws, etc.

And the Dutch government are committed to And the Dutch government are committed to keeping the burden on business of compliance keeping the burden on business of compliance with government activities stay fixed below a with government activities stay fixed below a certain amount. certain amount.

……. Then the EU. Then the EU

The EU as a whole is also taking an interest The EU as a whole is also taking an interest in this and soon the approach will spread in this and soon the approach will spread throughout the UK including Slovakia.throughout the UK including Slovakia.

Andre Nijsen is the person who developed Andre Nijsen is the person who developed MISTRAL. He retires next year and I am MISTRAL. He retires next year and I am editing a book to celebrate his contribution. editing a book to celebrate his contribution. It will probably be published in 2008 and will It will probably be published in 2008 and will represent an up to date account of this type represent an up to date account of this type of work across the worldof work across the world

EXCESS BURDEN OF EXCESS BURDEN OF TAXATIONTAXATION

In economics, the In economics, the excess burdenexcess burden of of taxation, also known as the taxation, also known as the distortionary distortionary costcost or or deadweight lossdeadweight loss of taxation, is the of taxation, is the economic loss society suffers as the result of economic loss society suffers as the result of a tax, over and above the revenue it collects.a tax, over and above the revenue it collects.

Administrative & compliance costs are part of Administrative & compliance costs are part of these but there are more involved with… these but there are more involved with…

Distortions which occur because people or Distortions which occur because people or firms firms change their behaviourchange their behaviour in order to in order to reduce the amount of tax they must pay. reduce the amount of tax they must pay.

The cost of a distortion is usually The cost of a distortion is usually measured as the amount that would measured as the amount that would have to be paid to the people have to be paid to the people affected by it, in order to make them affected by it, in order to make them indifferent to its presence.indifferent to its presence.

The Tax =P3-P2 shifts the supply curve The Tax =P3-P2 shifts the supply curve upwardsupwards

P3

increasing price from P1 to P2. Government increasing price from P1 to P2. Government revenue is the square P2-P3-Q2revenue is the square P2-P3-Q2

P3

But the lost profits to the firm is P3-P2 PLUS But the lost profits to the firm is P3-P2 PLUS their share of the orange shaded area. their share of the orange shaded area.

(equals the difference in revenue less the (equals the difference in revenue less the difference in cost)difference in cost)

P3

And for the consumer the cost in terms of And for the consumer the cost in terms of having to change their expenditure plans is having to change their expenditure plans is

P1-P2-Q2 PLUS their share of the orange P1-P2-Q2 PLUS their share of the orange shaded areashaded area

P3

The tax has forced people to change their The tax has forced people to change their behaviour buying less of a product it behaviour buying less of a product it benefited both firm to produce and benefited both firm to produce and

consumer to buy. consumer to buy.

P3

Of course the government gains revenue Of course the government gains revenue from the tax, but not as much as firms and from the tax, but not as much as firms and

consumers have lost. The DEADWEIGHT consumers have lost. The DEADWEIGHT LOSS is the range shaded areaLOSS is the range shaded area

P3

Who Pays Taxes?Who Pays Taxes?

Depends on slopes of the Depends on slopes of the curves or elasticities, here the curves or elasticities, here the

price rises a lot and the price rises a lot and the consumer pays.consumer pays.

But here the firm cannot pass But here the firm cannot pass the price increase on and it is the price increase on and it is

the firm who pays.the firm who pays.Inelastic supply, elastic demand

TAX EVASIONTAX EVASION

Tax evasion is against the law, it is Tax evasion is against the law, it is when people/firms evade paying taxes when people/firms evade paying taxes the law says they should. They are part the law says they should. They are part of the ‘of the ‘shadow economy’shadow economy’..

Tax avoidance is not against the law it is Tax avoidance is not against the law it is about using the law to pay as little tax about using the law to pay as little tax as you have to, by e.g. basing your firm as you have to, by e.g. basing your firm in Lichtenstein where taxes are low.in Lichtenstein where taxes are low.

Various estimates of the Various estimates of the shadow economy in Selected shadow economy in Selected

Countries.Countries. YearYear 1999/20001999/2000 2002/20032002/2003 CountryCountry BulgariaBulgaria 36.9%36.9% 38.3%38.3% Czech Rep.Czech Rep. 19.1%19.1% 20.1%20.1% HungaryHungary 25.1%25.1% 26.2%26.2% LatviaLatvia 39.9%39.9% 41.3%41.3% PolandPoland 27.6%27.6% 28.9%28.9% RomaniaRomania 34.4%34.4% 37.4%37.4% Slovak Rep.Slovak Rep. 18.9%18.9% 20.2%20.2% SloveniaSlovenia 27.1%27.1% 29.4%29.4% USAUSA 8.7%8.7% 8.4% 8.4% UKUK 12.7%12.7% 12.2%12.2% GermanyGermany 16.0%16.0% 16.8%16.8% SwedenSweden 19.2%19.2% 18.3%18.3% PhillipinesPhillipines 43.4%43.4% 45.6%45.6% Notes: Sources SE: Schneider and Enste (2000), Schneider (2004)Notes: Sources SE: Schneider and Enste (2000), Schneider (2004)

M OrviskM Orviskáá, A. Čaplánová, J. Medved & J. Hudson, A Cross , A. Čaplánová, J. Medved & J. Hudson, A Cross Section Approach to Measuring the Shadow Economy Section Approach to Measuring the Shadow Economy

(2006), (2006), Journal of Policy Modeling, Vol. Journal of Policy Modeling, Vol. 28, pp. 713-724. 28, pp. 713-724.

The size of the shadow economy has been investigated by a number of different methods.

We have developed a method based on the amount of cash people have in their pocket (people engaged in ths shadow economy tend not to use banks, but carry cash)

The analysis suggests that the relative figures are: Slovakia 23.2% Czech Republic 21.8%

Why People PAY TaxesWhy People PAY Taxes

Fear of getting caughtFear of getting caught Social DisgraceSocial Disgrace Civic DutyCivic Duty They obey the lawThey obey the law They do not have the opportunityThey do not have the opportunity

The Standard Economic The Standard Economic ApproachApproach

Is that people pay taxes out of fear of Is that people pay taxes out of fear of the consequences of getting caught. the consequences of getting caught. In this sense the fine or penalty you In this sense the fine or penalty you have to pay if caught is ‘the price of have to pay if caught is ‘the price of breaking the law’breaking the law’

This seems to narrow and ignores the This seems to narrow and ignores the fact that people pay taxes for other fact that people pay taxes for other reasons:reasons:

Why People PAY TaxesWhy People PAY Taxes

Fear of getting caughtFear of getting caught Social DisgraceSocial Disgrace Civic DutyCivic Duty They obey the lawThey obey the law They do not have the opportunityThey do not have the opportunity

Think a bit:Think a bit:

output in Slovakia is about 20% greater output in Slovakia is about 20% greater than the official figures.than the official figures.

About the same proportion of taxes are About the same proportion of taxes are not paid, meaning all honest citizens have not paid, meaning all honest citizens have to pay more and …..to pay more and …..

Your schools and health service are not as Your schools and health service are not as good as they should be because the good as they should be because the government cannot fund them as much as government cannot fund them as much as if everyone paid taxes.if everyone paid taxes.

Policies to reduce the shadow Policies to reduce the shadow economyeconomy

Increased frequency of tax audits and greater Increased frequency of tax audits and greater fines are two obvious measures which in many, fines are two obvious measures which in many, perhaps most, countries would be justified. perhaps most, countries would be justified.

Targeting audits at the likely participant in the Targeting audits at the likely participant in the shadow economy is another. One obvious shadow economy is another. One obvious example would be to target dishonest citizens, example would be to target dishonest citizens, i.e. those who have been found to have broken i.e. those who have been found to have broken the law within some other context (speeding on the law within some other context (speeding on the motorway). the motorway).

Publishing the identity of those found to have Publishing the identity of those found to have participated in the shadow economy, hence participated in the shadow economy, hence adding the social costs (your friends know you are adding the social costs (your friends know you are a ‘bad person’) may also be an effective strategy. a ‘bad person’) may also be an effective strategy.

AND FINALLY:AND FINALLY:

Of course the banks play a part in Of course the banks play a part in the shadow economy; particularly the shadow economy; particularly with the mafia and the laundering of with the mafia and the laundering of money. The EU are aware of this and money. The EU are aware of this and attempting to deal with it in a attempting to deal with it in a number of ways which will affect all number of ways which will affect all banks in all EU countries.banks in all EU countries.

But that is another storyBut that is another story