New Zealand’s relatively modest shadow economy

Dr Bryce Wilkinson
2 August, 2018

Two contradictory views about tax are common in New Zealand. One is outrage about tax avoidance; the other is denial that tax rates matter. Some hold both views.

Angst about untaxed capital gains on housing illustrates the first concern. So does the view that the likes of Google and Facebook should be paying a lot more tax.

Michael Cullen’s dismissal of Treasury’s 2005 tax advice illustrates the second view. As the then Minister of Finance, he dismissed it as an "ideological burb".

In fact, Treasury’s advice was mainstream. On the available evidence, high marginal tax rates reduce economic growth.

Why would people avoid tax if tax rates do not matter? Why do the rich hire tax lawyers and accountants? Why does IRD have to force people to follow tax demands?

As Minister of Finance, Dr Cullen was signalling that he did not want mainstream advice that did not suit his or his party’s ideology. He is not alone in this.

Many people arrange their affairs to avoid tax and/or to qualify for subsidies or benefits. Governments know this. This is why they impose fines and ‘corrective’ taxes. They want to change behaviour.

A related assertion is that current tax rates are not a problem because New Zealand is not a high tax country.

In fact, New Zealanders are much more heavily taxed today than in the past. During the 20th century, central government tax revenue skyrocketed. It rose from about 7% of GDP in 1900 to 30% in 2000. Per capita in 2017 dollars it rose from about $670 to $12,250. In contrast, local authority rates revenue roughly matched income growth.

General government tax receipts for the year ended March 2017 were $84 billion. That represents $49,250 per household. Inflation-adjusted, that would be the largest burden in New Zealand’s history.

Between 1991 and 2017, our general government tax revenue ratio to GDP averaged 33.6%. This was the highest in the OECD excluding high tax European countries. Switzerland was lower at 26.5%. Among Anglo-Saxon countries, only the United Kingdom came close. Australia’s burden was over 5 percentage points lower – at 28.3% of GDP. The US ratio was 26.3%.

Such statistics show that federal structures do not necessitate higher tax burdens. The Swiss case shows the same for a highly devolved system. Factors other than administrative scale cost savings determine tax burdens.

The Heritage Foundation’s 2018 database permits a more global perspective. It shows that 62 countries had populations of least 2 million people and GDP per capita of at least US$15,000 in 2015. Outside Europe, only Botswana had a higher tax revenue ratio to GDP than New Zealand.

At base governments must tax to fund their spending promises. They need to do this even if behaviour alters in ways that make the community worse off.

People might reduce work effort. They might invest for untaxed capital gains. They might set up tax shelters, join the barter economy, or work on a cash basis.

People will also seek to bypass constraining government regulations. They may do so in ways that reduce measured income.

Economists have long recognised that official estimates of GDP might be too low as a result.

A 2018 International Monetary Fund Working Paper assessed these issues. First it defined “shadow" economic activities. These are productive economic activities that circumvent government regulation, taxation or observation.

The income from these activities should count towards GDP. It would if the statistical authorities knew about it.

This definition encompasses unreported productive work. This might be to avoid tax or bypass labour market laws. The definition excludes ‘do-it-yourself’ work, criminal theft and organised crime.

Related terms are the shadow, gray, underground, informal, or parallel economies. These terms are often used as synonyms

The IMF Working Paper defines the shadow economy thus:

The shadow economy includes all economic activities which are hidden from official authorities for monetary, regulatory, and institutional reasons. Monetary reasons include avoiding paying taxes and all social security contributions, regulatory reasons include avoiding governmental bureaucracy or the burden of regulatory framework, while institutional reasons include corruption law, the quality of political institutions and weak rule of law.

Earlier IMF research estimated the proportion of workers working in shadow economy activities. Illegal immigrants may well do so. A 2000 paper put it at 30-48% in Italy and 20% in Sweden.

The paper found that the shadow economy had at least doubled in much of Europe in the two decades to 2000. So had the shadow labour force.

The paper looked into the major driving factors. One was the rising burden in Europe of tax and social security payments. The shadow economy is larger the more reported pre-tax earnings exceed post-tax earnings. A second factor was increasingly restrictive labour market regulation. A third factor was a weak rule of law. Countries that are corrupt, lax or arbitrary in applying the law have this weakness.

So where does New Zealand lie?

The 2018 IMF paper finds that between 1991 and 2015, New Zealand’s shadow economy averaged 11.7% of GDP. Australia’s averaged 12.1%. Switzerland had the lowest average of the 158 countries, at 7.2%, Zimbabwe was highest, at 60.6 percent. Thailand had the highest average ratio amongst Asian countries, at 50.6%. China averaged 14.7%, India 23.9%.

Greece (27.1%) and Italy (25.0%) topped the European countries. The Scandinavian country averages ranged between 13 and 15% of GDP. So did those for many European countries and Ireland.

Six other countries had a lower estimated average ratio than New Zealand. They were, from lowest to highest, the USA, Austria, Japan, Luxembourg, the Netherlands and the UK.

The shadow economy widely lost share during this period. The estimated proportion for New Zealand declined from 15.0% of GDP in 1991 to 9.0% of GDP in 2015. The average for all 158 countries declined from 31.8% of GDP in 1991 to 27.8% of GDP in 2015.

These estimates imply that New Zealand’s income per head is under estimated. But it is under estimated to a lesser degree than in most other countries. The measured income gap with Australia, Scandinavia, and most of Europe likely understates the actual gap.

Readers should regard these estimates as tentative and indicative. They attempt to measure something whose presence is more inferred than observed. They use abstract, technical, statistical techniques. They also make some heroic assumptions about scaling parameters.

Even so, they have passed some statistical tests for robustness. Researchers have also assessed their reasonableness in the light of other information. There is a degree of qualitative plausibility in many of the comparisons.

So how can New Zealand have both a high tax revenue ratio to GDP and a low shadow economy ratio? There are two reasons:

  • We have a broader tax base and lower tax rates at the margin than many other countries; and
  • Other factors are operating where we score relatively well. They include institutional quality. This includes the rule of law and the absence of corruption. We also rank highly for the broader category of economic freedom.

We ranked much less well for institutional quality before 1984. The post-1984 reforms also widened the tax base while lowering top tax rates. Both changes likely reduced the extent of today’s shadow economy.

In short, Orwellian double think about tax is unnecessary. The tax system does have undesired and unintended consequences. Tax is necessary but is not benign.

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