How to Estimate Tax Losses and Boost Growth by Reducing the Share of Informal Employment
Digital Tax Technologies
Trusted Global Tax Gap Advisor & Digital Solution Provider for Tax Administrations
By Anatoly Gaverdovskiy
The Shadow Economy and Informal Employment
Informal employment is a key component of the shadow economy. This occurs when an employer hires an employee but does not complete an employment contract and pays in cash without deducting applicable taxes or insurance premiums. Based on the total number of employed people from the population census or the identity database, and the number of formally employed citizens from the tax administration, we can estimate the share of informal employment in the country.
Share of informal employment by country (in percent), latest year | Source: ILO estimates
This figure must be determined in order to grasp the true scope of the country's shadow economy. It's also essential to consider those who work part-time. People may have a primary place of employment where they are formally employed and a secondary?job where they work informally, such as in the evenings or on weekends.
When an employer officially employs an employee but only specifies the statutory minimum wage in the employment contract and pays the rest in cash under an oral agreement, this is known as "gray" wages. Informal employment and "gray" wages are problems that exist in every country, but the scale of the problem varies.
Calculating the Tax Revenue Losses Caused by Informal Employment
Let us calculate the state's tax losses because of informal employment. We will count all amounts in US dollars for ease of calculation, but you can convert them to any national currency if you prefer. We will use the following tax rates as a starting point:
Related to the personal income of the employee:
Employer's income under the general taxation system:
Employer's income under the simplified taxation system (for micro and small businesses):
Let us say a company hires one illegal worker and pays him $200 per month in cash. The tax loss would be:
The total losses would be:
Think that our fictional state has a population of ten million people, with six million working in both the formal and informal sectors. Only 3 million people are officially employed and pay taxes on their entire wage, while remaining 3 million people work for their employers informally. In this scenario the state would lose $3-4 billion in annual tax revenue.
Methods to reduce the share of the informal employment
Informal employment is a knot that tax administrations must untangle on a regular basis. Punishment, fines, and prohibitions, as many countries have discovered, do not solve the problem. Instead of focusing on the consequences, authorities should direct efforts toward identifying the causes of informal employment and developing a step-by-step transformation of the country's economic and legal system to eliminate them.
Let us have a look at the major steps that lead to a decrease in the share of the informal employment in the country.
Changes in the Accrual of Income Taxes and Social Contributions
Unreasonably high insurance deductions and payroll taxes are the primary cause of informal employment. The progressive rate of taxes and social contributions stifles the motivation to increase employee salaries. Low wages result in a decrease in the country's standard of living and consumption, which has a negative impact on GDP. As a first step, we can recommend switching to a flat income tax accrual scale and a flat or regressive social contribution scale, which encourages employers to increase the official amount of wages paid to employees.
In several countries, the government has set preferential tax rates for certain industries. Creating special conditions for the high-tech sector, for example, stimulates its growth, but creates a sense of inequality for other industries that try to exploit this loophole. Some banks, for example, have morphed into IT firms with banking licenses.
Shifting Responsibility for Paying Income Taxes to Employees
The employee can take responsibility for paying tax on his earnings in the second step. Yes, this adds to the tax administration's burden as the number of taxpayers grows, but the digitalization of data processing and accounting systems addresses these issues. There is also the question of instituting tax payment periods to ensure that tax administration receives tax payments on a consistent and timely basis.
When the employer acts as a tax agent, the frequency of payment of taxes and social payments coincides with the timing of the payment of wages. When individuals pay taxes, they usually do it once a year. Allowing monthly tax payments is necessary to reduce the financial burden of one-time payment of the sizeable sum of money.
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Including of social contributions in the rate of corporate income tax (CIT) is the third step. Because enterprises will pay insurance premium only after receiving income, this model is more honest and transparent for them. This is a financial incentive to hire more employees, pay them more, and encourage them to bring in more customers and profits.
This model will be particularly appealing to companies in the investment stage of their development: a reasonable tax policy does not force entrepreneurs to hide profits to maintain the illusion of their market position and financial situation.
An integrated combination of the second and third steps can reduce the employer's tax and insurance burden on payroll, allowing him to invest his resources directly in the remuneration of his employees.
The revision and reorganization of the state's business and tax reporting requirements is the next critical step. It is necessary to appoint a single agency, such as the tax administration, to receive and process all information regarding business activities. Instead of sending requests directly to the subjects of business activity, other institutions should send all requests to this single source of data.
The agency should simplify the reporting forms by combining them with payroll reporting, converting them to electronic format, and reducing the number of useless documents.
The last step could be the dismissal of wage and employee tax reporting in favor of a system of automatic tax accruals based on incoming primary data on wage payments. This step will lead to the development of an electronic payment system in the country if we create enough incentives for moving all transactions in a non-cash form.
Refusing to accept cash and digitizing business transactions will aid tax authorities in tracing shadow financial flows while complicating the operational and economic activities of informal economy participants. Simultaneously, the use of cryptocurrencies and the rise of cybercrime open the door to electronic financial transactions that are not subject to the legal framework or the control of tax authorities. It is necessary to consider this risk while also developing a set of regulations for these financial channels.
The digitalization of the tax system leads to the prevention of corruption, besides creating an appropriate tax policy and favorable business environment. Because there is no way to "negotiate" with the automated system, it forces businesses to come out of the shadows and move toward legalization, because the risk of getting into serious trouble eventually outweighs the benefit of hiding income.
How to Reduce Informal Employment in the Digital Economy
In the previous articles, we looked in depth at the risks of tax administration in the digital economy and informal employment, as well as practical examples of how to overcome them:
As the digital economy strengthens, tax authorities must find new ways to combat income concealment and tax evasion by digital platforms, including those operating from foreign jurisdictions without local company incorporation and actively employing informal workers.
To meet these challenges, they should find the answers to the many complex questions. What kind of taxation should digital platforms and their providers face? Individuals, self-employed and individual entrepreneurs, who are they? Do they pay taxes, and if so, at what rate?
The service market reacts painfully to any attempts by the state to bring order to these market segments. If you put a little pressure on cab drivers, they will immediately disappear into the shadows and work "underground," with no legalization or payment of taxes. Thus, it will be more productive to focus tax enforcement on digital platforms like Uber or Airbnb, which are the primary source of income for many self-employed and informally employed individuals. This step will help legalize aggregator platforms and their providers at the same time as establishing control over all transactions and payments.
Often, the tax administration views a digital platform as an adversary that evades taxes on purpose and assists its suppliers in crossing that line. In real life, whether a tax resident of the country, the digital platforms prefer to operate legally. But they will not be able to do so if competitors operate in the shadows, offering customers better terms and prices at the expense of tax savings.
To completely bring this sector out of the shadows and enable a fair competition, tax administration of digital platforms and ecosystems must be consistent, cover all niche markets, and account for all loopholes. It is possible to conduct relevant studies and surveys to determine which conditions are acceptable to taxpayers. To make it easier for digital platforms to become legal, it is necessary to develop a simple and clear tax registration and de-registration procedure, as well as reasonable tax rates.
Platform users may be employed part time or in a combination of jobs. It is critical to keep the reporting system as simple as possible, choose convenient periods for tax accrual and payment (e.g., calendar month), and make available tax payments by bank cards.
As a result, doing business legally and paying taxes should be simple and painless, and the amount of taxes paid will be insignificant compared to overall earnings. Premiums for social insurance should be voluntary or set at a low level. Taxpayers should pay them on the monthly basis to make it less noticeable and burdensome.
A digital platform should be responsible for providing data to the tax authorities to calculate the taxable base and to ensure that taxpayers are properly registered and de-registered. Dealing with tax authorities, reporting, and filing returns deters many taxpayers, contributing to their shady behavior.
It would be reasonable to delegate the operational functions of tax control to the digital platforms. They have sufficient resources to prevent its users from operating without official registration and payment of taxes on the platform's income.
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