OVERVIEW
The underground economy is defined by one
encyclopedia as all commerce that is not taxed. The
market consists of and includes not only legally
prohibited commerce such as drugs, prostitution, and
gambling, but trade in legal goods and services when
income is not reported and consequently taxes are
evaded through money laundering payment in cash or
kind. Underground economy transactions are typically
cash transactions to avoid tracing or complex
financial operations involving the use of multiple
subsidiaries and tax havens.
How does the underground economy manifest itself?
Invariably it will show itself in the form of cash.
What type of cash? It will be cash pending a
purchase transfer or deposit, often in huge
quantities. But for the most part cash only forms
part of the mundane issue of doing business from day
to day.
The size of the underground economy is estimated,
by various think tanks and scholars, to be in the
trillions of dollars. Somewhere in there our small
nation states have a fraction of the total. This
poses a huge problem for government both on
principle and quantitatively. On principle millions
of dollars in tax revenues are forgone due to
non-compliance and under reporting when it should
not be so. Quantitatively many governments fall
short when they have to address the problem due to
lock of capacity.
Most governments around the world now operate
under deficit spending. Collecting its fair share of
revenues from the non-compliant economy should help
reduce the deficit. It is not being suggested that
revenues earned from this sector will erase a
deficit, as it is known for some governments there
is a greater propensity to spend than to collect
taxes.
In any event, sooner or later, reality dawns and
governments have to increase taxes to meet
ever-increasing expenditures. When this happens the
increase falls on those who are already compliant
and paying. The increase does not fall on those
outside of the tax net. These persons have to be
processed and made to be compliant.
The underground economy is anything but stagnant,
it grows, it assimilates. It represents in many
respects the hallmark of entrepreneurial activity
and ingenuity.
Therefore the responsibilities and burdens placed
on tax administrations to address non-compliance are
heavy and serious. Often times administrations are
not provided with sufficient resources to address
the various issues that fall squarely at their feet.
However like true professionals they must respond
and find solutions.
THE LEGAL FRAMEWORK
In almost all tax regimes the Income Tax Law does
not define income. This is both wise and practical.
There are many types and streams of income and to
define it in the tax statute would have placed
limitations on the administration as to what income
can be assessed. The way the statute qualifies
income is by listing exemptions on certain types of
income, which cannot be taxed. This list will vary
from administration to administration. Each must cut
its cloth according to its fit.
The other important distinction about the tax
statute is that it doesn’t discriminate between
legal and illegal income. The tax is on income
period. This is a simple characteristic of the law
but extraordinarily effective. This feature in the
law alone gives the tax assessor the ability to
reach out and assess income, particularly in the
underground economy, which would normally be beyond
his grasp.
How many persons who are engaged in illegal
activity will come to the Tax Office and say, “Mr.
Commissioner I have been involved in an unusual
business and I want to make a declaration so I can
pay my taxes, taxes to the society from which I make
a living.” How many? They will not be forthcoming so
it is incumbent on the tax administrator to seek
them out and assess them.
The other consideration in assessing income is
that it should be of a revenue nature as income from
the sale of an asset is normally not taxable as it
is capital in nature.
Several cases have been decided in the U.K
jurisdiction that makes clear the reasoning for
assessing certain types of income. Reference will be
made to a few examples.
In Mann v Nash (16 TC 523) the Appellant
Mann operated certain automatic machines for public
use and which in due course was illegal. The profits
from the operation of the machines were assessed to
tax. Mann appealed the assessments on the grounds
that the operations of the machines were illegal. It
was held that the profits from the illegal
activities were subjected to tax. In this same case
it is necessary to quote the learned judge Justice
Rowlatt, “The revenue representing the state is
merely looking at an accomplished fact. It is not
considering it; it has not taken part in it; it
merely finds profits made from what appears to be a
trade, and the revenue laws happen to say that the
profits made from trades have to be taxed and they
say, “Give us the tax”. It is not to the purpose in
my judgment to say: “But the same state that you
represent has said they are unlawful; that is
immaterial altogether and I do not see that there is
any contact between the two propositions.”
In Southern v AB and Southern v AB Ltd.
both AB and AB Ltd carried on the business of street
betting. No part of the business done by the two
persons was lawful betting and their activities
involved offences for which penalties could be
imposed by the civil authority. The assessment
raised by the Inspector of Taxes was initially
discharged by the special commissioners. But
Southern the Inspector appealed and the Court held
that although the businesses carried on by the
Respondents were unlawful they nevertheless
continued a trade and the profits there from were
properly assessable to tax.
In Cooke v Haddock (39 TC 64) the
Appellant purchased a farm and 72 acres of land. He
submitted development pleas to the local authority
for approval and sold 23 plots of the land he had
bought. It was held that he was trading in land and
the profits from the sales were assessable for tax.
Even isolated transactions can be classified as a
trade or adventure in the nature of trade for the
purpose of the tax law. In Rutledge v C.I.R
(14 TC 490) the Appellant had purchased a large
quantity of paper, which he later sold at a handsome
profit. It was focused by the Court that the profits
were subject to tax as it was an adventure in the
nature of trade.
In Attorney General v Johnstone (10 TC
758) Justice Rowlatt had this to say, “This is a
very bad case. Here is a man who says he put down
£300 bone fide when he was making ₤1,500 and had
been making it for years.”
“Do you tell me that a man who can conduct a
successful business – he says he does it all by
himself – making £1,500 a year does not know at the
end of the year what his books show? His banking
account will tell him; his household expenses will
tell him; what he has in his pocket will tell him.
He would know if he made £300 or £1500. It is no use
putting up this argument to me or to anybody else
who knows anything of human affairs.”
There are many decided cases that distinguish
what income is taxable and what is not. These are
only a few to show that the necessary legal guidance
is available for taxing various sources of income.
COMMON AREAS FOR UNDERGROUND ACTIVITY
The following is a list of activities that are
common players in the underground economy. The list
is not exhaustive but gives a clear view of areas of
economic activity that have a strong tendency to
under report and neglect to report its income.
• Alcohol
• Tobacco
• Real estate
• Construction industry
• Gambling
• Drug dealing
• Lotteries
• Jewelry
• Cell phones
• CDs and DVDs
• Car dealers
• Tourism industry
• Smuggled goods
• Professionals
• Any cash basis related activity
• Electronic commerce
Some brief notes on various types of activity:
Alcohol and Tobacco These are popular
items, high in demand in most countries. When custom
duties or excise duties are high, there is strong
tendency to acquire these goods for people without
paying the required duties. Once that is achieved it
becomes convenient not to report sales for tax
purposes too.
Real Estate Beach front and good
residential properties are in high demand. Many real
estate transactions done by individuals not
registered or licensed as realtors. Many conveyances
not recorded on a timely basis. Many sales done in
each. Level of sophistication in transactions
increasing. Need to be monitored closely.
Construction Industry Traditionally
difficult to police from tax administration angle.
Voluntary compliance very poor. Many operators with
plenty cash basis transactions. Contractors,
sub-contractors, electricians, carpenters, plumbers,
masons, etc. Many freelance operators.
Gambling and Lotteries Huge cash basis
activity – strong tendency to under report if proper
controls and organization not in place. Needs to be
monitored closely. Potential for money laundering
where large cash operations occur monthly.
Drug Trafficking Illegal activity with
huge cash value. Least compliant among those in
underground activity. Assessments have to be made
where there is possession of visible assets e.g.
houses, cars, boats, real estate etc. and when there
are seizures of significant amounts of drugs or
cash.
Jewelry, Cell phones, CDs and DVDs Easily
concealed items, high in demand by public. Easy to
slip past customs. Easy to let retail sales go
unrecorded and unreported especially by small
retailers.
Car Dealers Many second hand car dealers
with no established place of business. Difficult to
track, as they are constantly on the move.
Tourism Industry Whereas it is easy to
have the hotels registered, all the tour operators
and guides may not be. Plenty of cash circulates in
this industry, is it all accounted for? Tourists
generally give tips, individually these are small
but aggregated for the day, week, or month could be
substantial. Tips should be included on returns for
tax.
Smuggled Goods Any manner of goods could
be smuggled across open borders. If a smuggler can
get past customs, the propensity for him to report
his sales to the taxman is about zero.
Professionals These are well trained and
highly skilled individuals who are mostly registered
on the tax roll but have a problem accounting for
all the cash taken in. There may be exemptions but
I’ll wager these are in the minority.
Any cash basis activity There are many
small businesses that provide goods for sale and
services to those willing to pay. Invariably these
operate on a cash basis, with record keeping
incomplete or questionable. Some small businesses
keep excellent records and file properly. Again
there are in the minority.
Electronic Commerce This is an increasing
phenomenon with the use of the Internet. A sale by
electronic means is still a sale. How easy is it to
include or exclude an electronic sale from the total
days’ sale? The U.S. based auction house, eBay has
over 40 million regular users. Items are sold over
the Internet for handsome profits. There are no
known statistics to say how many users report their
profits and pay taxes.
OPTIONS FOR TAX ADMINISTRATIONS
The underground economy is a reality. It is alive
and well in every country whether it is officially
recognized or not. It appears, for more than one, to
be an unstoppable and irreversible fact of life.
Huge sums of money are earned and go unreported
every year. What better good can tax administrators
do but to get some taxes out of this unreported
economy.
Administrators can opt to do a field survey,
which is comprehensive, and register all the visible
business in their jurisdiction. This survey should
be repeated every 4 to 5 years as the economy grows.
After registration assessments and collection should
follow closely behind. Level of yield can be up to
10 to 15 percent or more depending on level of
non-compliance converted to compliance.
Tax administrators need to decentralize their
offices as far as is practical. Economic activity
occurs in the field and administrations must have
its offices as close to the hub of activity as is
practical. This tends to increase compliance from
taxpayers and improves intelligence for the
administration.
The strongest option for the tax administration
is for a comprehensive field audit programme
sustained year in and year out. This programme if
administered effectively should yield considerable
results when most administrations have the power to
assess up to 6 years of activity in the past.
However the question will be asked ‘how can you
audit a person who does not keep records?’ Several
options are available:
1) Assess arbitrarily – persons can be
assessed arbitrarily within reason
2) Compute his cost of living expenses for
himself and family and dependents and convert to
income after deducting capital cash inputs like
loans.
3) Net Worth method – a person’s net worth for a
year is determined by computing his net worth
for a year which will then be equivalent to his
income for the year.
4) Capital Worth method – similar to Net Worth
method except that calculations are done on the
gross capital acquired.
All of the above methods are very effective, but
administrators need to exercise great care in
determining the accuracy or reasonableness of the
figures arrived at. Another effective tool is the
application of withholding provisions on a broad
stream of income that have a strong tendency to go
unreported. These include but are not limited to:
a) Contracts
b) Dividends
c) Commissions
d) Royalties
e) Payments to non residents for
(i) technical services
(ii) management fees
(iii) rental of plant and equipment
The other consideration in assessing income is
that it should be of a revenue nature, as income
from the sale of an asset is not normally taxed, as
it is capital in nature.
Administrations should note, and as they are well
aware, even persons on the tax roll who file and pay
taxes regularly also are prone to under report their
taxable income. For this reason field audits must be
a constant and permanent feature in any tax
administration’s menu of remedies to address the
issue of under reporting.
CONCLUSION
The underground economy is a worldwide
phenomenon. Some governments recognize this fact and
tries to address the issues that arise from it. Some
governments don’t. The reasons for the underground
economy are many: unemployment, the need to make a
living, neglect, and greed to name a few. The
purpose of the paper is not to identify the social
and economic reasons why the underground economy
exists but to identify areas for tax administrators
to address it. Whatever the root cause of their
behavior, operators choose to be casual rather than
formal in paying their taxes.
Governments and tax administrators must display
the will and the capacity to deal with the
phenomenon. Large jurisdictions may prefer to apply
heavy or even draconian penalties to address the
problem. They must be careful not to kill the goose
that lays the eggs. Other administrations prefer a
more moderate approach.
Whatever the mix of the remedies to fix the
problem each administration must develop its own tax
regime to address local conditions as they are. This
will mean strengthening tax laws and enforcement
capacity. Emphasis must be made on the need for a
continuous presence out in the field, by way of
audits, registration, collection, and compliance.
The field is where the economic activity occurs.
Any administration that spends almost all the time
in its offices will not only have the day past them
by, but also, the underground economy will pass by,
unnoticed.
Prepared by Eric D. Eusey
Commissioner of Income Tax
BELIZE
SOURCES
1. The Frasier Institute, Canada
2. Wikipedia, the free encyclopedia
3. U.K Tax Cases
4. The University of Chicago
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