World
Tax evasion: It’s all Greek to me

The best solution to the problem of tax evasion is to simplify both the tax and the regulatory environment
 

Periodically for the past two years we have been bombarded with stories about the Greek financial mess. The Greeks and several other countries in the Eurozone have very large deficits. The bond vigilantes have been attacking these countries’ sovereign bonds, driving the level of interest to unsustainable levels. Since many of the local banks and often other Eurozone banks hold sovereign bonds as part of their mandatory reserves, a local fiscal crisis has metamorphosed into a European wide banking crisis. The Germans could help out. They could agree to shoulder part of the debt by allowing the Eurozone countries to issue Euro bonds backed by the credit of all of the countries. But they won’t. The simple reason is that they don’t feel responsible for a country where everyone evades taxes.

 

Certainly tax evasion is rampant in Greece. The Greek government’s tax revenue is about 52 billion euros a year. It is estimated that they lose up to 45 billion euros a year due to tax evasion. This is certainly an alarming number, but determining the size of tax evasion is perhaps nothing more than an educated guess. If you believe the number above, the tax evasion in Greece was 46% of potential revenue. According to the Greek Central Bank, it is one third, still a very large number.

 

Greece definitely collects less than the other members of the Eurozone. The average tax revenue for Eurozone members is about 40% of the gross domestic product (GDP). Greece collects only 33.2%. But it is just below the Czech Republic at 33.8% and Poland at 34.8% and well ahead of Switzerland at 29.4%. None of those countries seem to have a financial crisis. The reason Greece has troubles is that it spends more than it takes in. The gap is 13%. Interestingly the US is in a similar position. Its tax take is only 27% while it spends 40% of its GDP, the same amount as Greece.

 

Why can’t Greece collect taxes? Social scientists love to ascribe cultural aspects as reasons for poor tax collection. The Greeks have low “tax morale”. The Greeks view their society and government as corrupt. So they do not feel any moral obligation to support it with taxes. The act of breaking the law by not paying taxes is simply doing what everyone else in their society is doing. With a score of 80, Greece does not rank that high on Transparency International’s Corruption Index. But it is collects about a third of its GDP in taxes. China has a better score (75), but only collects 17% of its GDP. Malaysia’s score is 60, but only manages to collect 15% of the GDP.

 

Still I find the idea that the Greeks are somehow culturally doomed to be tax evaders rather simplistic. Law and economics studies have consistently shown that the probability of a criminal act is a function of the severity punishment and the risk of getting caught. Tax evasion is defined as using illegal means to avoid taxes. This usually involves some sort of misrepresentation or outright fraud. But a complex tax code with high marginal rates and a myriad of exemptions is one of the best ways to provide the legal means and the economic incentive to avoid the tax. In Japan tax rates are rather low and only 1% of wealth is held offshore. In Europe with high marginal rates the number is over 10%.

 

Ideally good tax laws have three goals: Equity, competitiveness and the generation of sufficient public revenue. They rarely achieve any of these goals because they are designed by politicians often to satisfy special interests. These provisions once enacted are almost impossible to get rid of no matter how foolish. In China small-to-medium sized companies have a gross profit margin near 10%, but the VAT (value-added tax) was 17%. If the companies actually complied, 90% would go out of business, so instead they all avoid the tax.

 

The size of tax evasion is directly correlated to the size of the underground economy. In Greece the underground economy is estimated to be about 27%, which means a lot of the commerce goes untaxed. The problems in Greece pale compared to Russia where the shadow economy is over 43%.

 

The best solution to the problem of tax evasion is to simplify both the tax and the regulatory environment. A system free of special deductions, credits, and exemptions is easier to use and enforce. Simplified regulations encourage firms to do business in the regular economy. But the complexity benefits a plethora of specific special interests which will fight tooth and nail to protect it. Politicians will only act when there is no alternative. To stop a crisis would take a simple rewriting of the law, but the law probably will not be rewritten until there is almost total collapse.

 

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at william@emergingmarketstrategies.com or w.gamble@alrroya.com.)

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COMMENTS

Vaidya Dattatraya Vasudeo

5 years ago

Plus make the penalties extremely, with no options to give any concessions, for any reason whatsoever. This is the point where the penalties become teethless.

Secon stop generating Abhay Yojanas. Not only in I.Tax but every where. Plus make an act that any elected person who is in arrears would lose his seat and no person who is in arrears to the govt. can contest any elected post.

Economy & Nation Exclusive
China’s slow rot or dramatic crash?

In a country where information is tightly controlled, the size and extent of the underground economy can only be guessed. When this part of the economy goes bust, the landing will be very hard indeed

The Chinese economy, like the economies of the rest of the BRICs, is slowing. Despite some neutral official numbers, other numbers like industrial production and electricity consumption indicate that China’s growth rate may have fallen below the target of 7.5%. In May real estate values have fallen in a record 54 of 70 cities. In the first five months of 2012, real estate sales volume slowed by 9% compared to a year earlier. The central bank cut interest rates for the first time since late 2008, suggesting a weaker economy than forecast.
 
With all this bad news, China is still growing at a rate that any other country would envy. Business cycles have been part of every market in history. Have the Chinese found a way to prevent them?
 
Some people certainly think so. The famous Goldman Sachs’ economist, Jim O’Neill, and the creator of the term ‘BRIC’, still sees China as a “beacon of light”. O’Neill no longer believes that indicators like electricity consumption and industrial production, which have been so accurate in the past, still reflect the true level of China’s economic activity. Instead he has switched to indicators of consumption, including monthly retail sales, which seem to support his forecast that China’s economy is in for a ‘softer’ landing. This thesis is quite common among economists and has probably been priced in to global equity markets.
 
Other economists also do not see a “hard landing” but for other reasons. The excellent economist Andy Xie points out that economic collapses occur only when creditors fear for their loans and try to collect from defaulting debtors. There is a major difference in different economies depending on their legal infrastructures. In countries like the US, when a debt is not paid, the courts will happily enforce the contract. The creditor can satisfy the debt in cash, collect the collateral, foreclose on the real estate or force the debtor into bankruptcy. In other countries like Japan, debts are not collected. The difference is between a sharp crash and protracted slowdown.
 
Although a crash or hard landing may sound worse than a slowdown or a soft landing, in fact the soft landing is worse. Unless creditors can clear the loans and reallocate capital to more efficient enterprises, the economy cannot restart. The country’s economy becomes littered with zombie banks and mispriced assets. Growth comes to a halt, since the market is not allowed to function. The stagnation can last for over a decade.
 
This is what is occurring in China. Their 2008 bankruptcy law is unused. Defaulting debtors just leave town. Foreclosures are rare. Banks don’t force developers to repay loans on time, so developers see no need to liquidate inventories at lower prices. Prices do not crash, but sales do.
 
Most of the loans did not go to developers or private businesses. Instead they went to local governments and SOEs. With slowing real estate sales, the main source of income for local governments is drying up. Rather than trying to collect from another branch of the government, the state-owned banks simply roll the loans over.
 
Professor Michael Pettis has pointed out these problems for years. He understands the sclerosis inherent in the system, but believes that Beijing will prevent a slowdown by forcing banks to lend more to local governments for infrastructure projects. While this might be sufficient to stimulate the economy for a few months, eventually the loans for these projects or the bonds issued to finance them will end up in default as well.
 
Despite these predictions, there will in fact be a crash in China. As central banks in the US and Europe are discovering, there are limits to the ability of government to manipulate a market. The Chinese government controls the banking system, but there is a shadow banking system. This system is not only unregulated, its size and extent are unknown.
 
The concrete business is an excellent example. Families will buy a concrete mixer with vendor financing. Then the owners will double up on their debt by using the equipment as collateral for new loans. Finally mixing companies sell their ready-mixed concrete on credit to developers. This overleveraged pyramid could easily collapse like a house of cards.
 
Financial reform could make the problem worse. By controlling interest rates for loans and deposits, the government guarantees profits for its banking monopoly and creates a hidden tax on depositors to help clear bad loans. But the monopoly is breaking down. Banks have to offer higher rates to attract depositors.
 
In a country where information is tightly controlled, the size and extent of the underground economy can only be guessed. In most emerging markets it is over 50% of the regular economy. When this part of the economy goes bust, the landing will be very hard indeed.  

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at william@emergingmarketstrategies.com or w.gamble@alrroya.com.)

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European banking crisis can choke trade, finance says India

A crisis in European banking system can choke trade, finance and economic growth not just in the Euro Zone but in the world at large

 

Bangalore: India on Friday said a crisis in the European banking system can choke trade and finance and in the process global economic growth, and called for substantially expanding the resource base of multilateral development banks, reports PTI.

"The sovereign debt crisis and the banking crisis, now on the horizon, has grave implications not only for the European economy, but also global economy," External Affairs Minister SM Krishna said.

He was addressing a joint press conference with German Foreign Minister Guido Westerwelle.

"A crisis in European banking system can choke trade, finance and economic growth not just in the Euro Zone but in the world at large," Krishna said.

Europe is of particular concern as it accounts for a significant share of the global economy and is also India's major trade and investment partner, he said.

Krishna said there is a need to substantially expand the resource base of multilateral development banks so that they have the fire-power to help developing countries pursue their developmental goals.

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