Information sharing, bank penetration and tax evasion in the developing countries

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS INFORMATION SHARING, BANK PENETRATION & TAX EVASION IN THE DEVELO

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

INFORMATION SHARING, BANK PENETRATION & TAX EVASION IN THE DEVELOPING COUNTRIES

BY

VO MANH TAN

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, NOVEMBER 2016

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

INFORMATION SHARING, BANK PENETRATION & TAX EVASION IN THE DEVELOPING COUNTRIES

A thesis submitted in partial fulfillment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

DECLARATION

I hereby declare, that the thesis report entitled, “Information sharing, Bank

penetration & Tax evasion in the developing countries” written and submitted by me

in fulfillment of the requirements for the degree of Master of Art in Development Economics to the Vietnam – Netherlands Programme This is my original work and conclusions drawn are based on the material collected by me

I further declare that this work has not been submitted to this or any other university for the award of any other degree, diploma or equivalent course

HCMC, November 2016

Vo Manh Tan

ACKNOWLEDMENTS

Immeasurable appreciation and deepest gratitude for the help and support are extended to the following persons who in one way or another have contributed in making this study possible

Above all, I would like to express my special appreciation to my supervisor - Dr

Võ Hồng Đức, for his supports, advices, guidance, valuable comments and suggestions It

is an honor to work with him

I would like to acknowledge all the lecturers and staffs at the Vietnam – Netherlands Programme for their useful knowledge and support during the time I studied

at the program In specific, I am grateful to Prof Nguyễn Trọng Hoài, Dr Phạm Khánh Nam and Dr Trương Đăng Thụy, who guided me the first steps in the courses as well as

in the thesis writing process

I would like to thank my friends at Class 21 for their helps

Last, but not least, I would like to thank family, my parents and my sister, who always love, take care of and support me unconditionally on the way I have chosen

HCMC, November 2016

Vo Manh Tan

ABBREVIATIONS

TEI: Tax evasion index

IRS: The U.S Internal Revenue Services

GNP: Gross National Products

GDP: Gross Domestic Products

OECD: Organization for Economic Co-operation and Development

DYMIMIC: Dynamic Multiple Indicators – Multiple Causes approach

ABSTRACT

In April 2016, a huge leak of confidential documents regarding tax affairs, known

as “Panama papers”, occurred This leak has revealed information in relation to the way

in which the rich has hidden their assets to evade tax with the assistance of a Panamanian law firm, known as Mossack Fonseca The consequences have spread around the world for months, and possible for years, which has been considered as one of the biggest global scandals in relation to tax evasion at all times A question has been put forward in relation to the approach in which the governments of many countries, regardless of the economic development of the nation, have adopted to really manage tax evasion being consistently occurred in the economy This study is conducted in response to this important and hotly debated issue regarding tax evasion

Shadow economy refers to taxable business activities but failed to be reported by financial/ tax authority As a result of shadow economy, tax evasion defines illegal activities which aim to conceal taxable income from tax authorities or to include expenses which are not allowed in order to reduce tax liabilities to be paid to the coffers

of the governments Tax evasion and shadow economy are critical problems and barriers

to growth, regardless of the level of economic development of a nation However, it is argued that the issue of tax evasion is more serious and difficult to be handled in developing countries in comparison with the developed nations

An extensive literature review in this study presents that (i) tax and social security contribution burdens, (ii) regulations, (iii) public sector services, (iv) quality of institutions and (v) tax compliance play an important role in the decision of whether or not firms would evade tax Three contributions of this study can be summarized as below

First, on the ground of this literature review and other empirical studies, the so-called tax

evasion index (TEI) is developed to measure tax evasion in the developing countries

Second, potential influences of information sharing and bank penetration from financial

intermediate developments on tax evasion is examined using the newly developed TEI

Third, potential contributions of firms’ characteristics including firm size and location to

the relationship between information sharing, bank penetration and tax evasion is discussed and quantified

The sample consists of 112 developing countries during the period of 2006 to 2014 using data from standardized World Bank Enterprises survey 2006 – 2014 The new TEI

is constructed by calculating equally weighted average of five indicators which represent the main five sources of influence This new index falls within the range of 0 to 1 As such, Tobit regression is utilized to examine the relationship between information sharing, bank penetration and tax evasion

Findings from this study indicate that there is a substance variance in relation to tax evasion, which is proxied by the new TEI in this study, among 112 countries adopted in the research sample The difference of the TEI across countries is mostly explained by the difference in public sector services Corruption contributes the largest part to the estimate of the TEI with the average of 2.76 over the maximum of 4 The average TEI for developing countries in the sample stays at 0.62 with the lowest estimate of 0.25 (for Etritrea) and the highest estimate of 0.7539 (for Brazil) In addition, empirical analyses indicate a consistent and negative relationship between information sharing, bank penetration and tax evasion in developing countries Finally, large firms are generally considered to have adopted good tax compliance practices while firms located in remote areas are more likely to evade tax

Key words: Tax evasion, Shadow economy, Information sharing, Bank penetration,

Developing countries.

TABLE OF CONTENTS

DECLARATION i

ACKNOWLEDMENTS ii

ABBREVIATIONS iii

ABSTRACT iv

TABLE OF CONTENTS vi

LIST OF FIGURES viii

LIST OF TABLES viii

Chapter 1: INTRODUCTION 1

1.1 Problem statement 1

1.2 Research objectives 4

1.3 Research questions 4

1.4 Contribution of the thesis 5

1.5 Structure of the thesis 6

Chapter 2: LITERATURE REVIEW 7

2.1 Explaining tax evasion 7

2.1.1 Tax evasion approach 7

2.1.2 Tax evasion framework 8

2.1.3 Empirical evidence 12

2.1.4 Determinants of tax evasion 15

2.2 Connection with information sharing and bank penetration 18

2.2.1 Information sharing and bank penetration in financial system 18

2.2.2 Information sharing and Bank penetration role to tax evasion 19

Chapter 3: DATA AND METHODOLOGY 22

3.1 Methodology 22

3.1.1 New tax evasion index 22

3.1.2 Conceptual framework 23

3.1.3 Financial developments versus tax evasion 24

3.2 Data 26

Chapter 4: RESULTS AND DISCUSSIONS 32

4.1 The first hypothesis: Information sharing, bank penetration and tax evasion 32

4.2 The second hypothesis: Firm size and location influences 35

Chapter 5: CONCLUSIONS 39

5.1 Conclusions 39

5.2 Policy implications 41

5.3 Limitations 42

REFERENCES 43

Appendix A Definitions and sources of variables 48

Appendix B Data summary and list of industries 50

Appendix C Tax evasion index in the developing countries 51

LIST OF FIGURES

FIGURE 1. Conceptual framework of the thesis 24

FIGURE 2. Tax evasion index in the developing countries, mean value from 2006 to

2014 51

LIST OF TABLES

TABLE 1. Tax evasion index by country in 2006 – 2014 28

TABLE 2. Tobit regressions about effects of information sharing and bank penetration

to tax evasion status 33

TABLE 3. Tobit regressions about effects of firm size on the relationship between financial development variables and tax evasion status 36

TABLE 4. Tobit regressions about effects of location on the relationship between

financial development variables and tax evasion status 37

TABLE 5 Data summary 50 TABLE 6. List of industries 50

Chapter 1 INTRODUCTION 1.1 Problem statement

Existing studies significantly focused on the link between financial development and formal economic activities Levine (2005) grouped factors into five categories through which financial development might have effects on real sectors of the economy: (a) producing information and enhancing capital allocation efficiency; (b) monitoring firms and conducting corporate governance; (c) reducing risk; (d) creating pools of saving and (e) promoting exchange Given these groups, understanding the potential channels through which financial sector can influence real economic activities is important for any economy regardless of its economic development level

Growth nexus has attracted great attention from the literature on financial development However, limited researches on the effects of financial intermediary developments to unofficial economic activity or shadow economy have been conducted Examining this relationship is necessary, as shadow economy is a substantial problem in developing countries Johnson, Kaufmann and Zoido-Lobaton (1998) and Friedman et al (2000) estimated that total contribution of shadow economic activities in the GDP ranges from 10 to 15 per cent in developed countries and 19 to 46 per cent in developing countries respectively Moreover, shadow economy can negatively affect growth in two

main mechanisms First, it constrains investment opportunities as illegal firms may only

operate in underground environment, which does not provide necessary market-support

Second, shadow economy leads to tax evasion, then reduces tax revenues Governments

facing fiscal deficits in tax revenues may not be able to be disciplined with their budget

or have to do external funding; both of which are risky and complicated in various ways

As a result of shadow economy, tax evasion refers to illegal activities which aim

to conceal taxable income from tax authorities or include expense which are not allowed

to reduce tax amount By reporting a smaller income, higher expense, or in extreme case,

no income, enterprises could evade tax and save the money The enterprises then face with the potential of being caught cheating and not only the amount of evaded tax but also a fine is applied Main reason for tax evasion comes from information asymmetry, or tax authorities do not have enough information to reveal illegal activities aiming to reduce tax amount This is also why improvement in financial sector, especially factors which accelerate information and promote transparent market, could help to control tax evasion

Better information sharing and bank penetration are among the targets of financial intermediary development Together with other financial factors as well as macroeconomic factors, their role is to help (a) formal banks to increase their loan security by avoiding information asymmetry between loan owners and loan takers and (b) firms which operate legally in the economy to get benefits The factors were previously discussed and confirmed in many studies including Love and Mylenko (2003), Beck et al (2011) and Beck et al (2014)

Financial developments like information sharing and bank penetration could assist tax evasion relief from various aspects First, Straub (2005) and Beck et al (2007) suggested that better access to formal credit services help increase formal operating firms’ benefits, which would reduce tax evasion Moreover, information sharing leads to lower transaction costs and improves credit efficiency by enhancing credit availability (Brown et al., 2009) and reduces bank corruption in lending (Barth et al., 2009) These evidences boost benefits of formal firms, thus, lower motivations to evade tax of the informal group

Second, tax evasion could as well appear under the shape of “cooking the book”

In financial systems where information sharing and bank penetration are well improved, firms that misreport their revenues would have more obstacles in borrowing Formal banks and other financial intermediary institutions prefer appropriate functioning firms because of lower risk due to lower information asymmetry, and then less likely to allocate resources to misreported firms As such, the opportunity costs of evade tax is

higher in countries which have enhanced information sharing and high level of bank penetration (Beck et al., 2014)

In addition, an extensive literature review indicates that the standardized dataset

2006 – 2014 of World Bank Enterprise Surveys have not been significantly used in this area of studies Instead, previous studies on tax evasion appear to use national-level data estimated from international database like World Bank Development Indicators (Cobham, 2005) or firm-level data from World Bank Enterprise Surveys 2002 – 2005 database (Beck et al., 2014) The World Bank Enterprise Surveys is a firm-level dataset which covers many aspects of firms’ operations and is conducted by World Bank – a reliable partner In 2002 – 2005, the dataset is collected and grouped into one dataset The dataset is grouped again in 2006 – 2014 and standardized for comparability of results The necessity of using this updated data from 2006 - 2014 for the research issue is one of the key objectives of this empirical study Moreover, the contents and structures of the survey change through time, which in fact creates missing main variables to determine tax evasion and raises the demand to discover another measurement method

Developing countries including Vietnam do not have an advanced tax system with high tax revenue and high extent of coverage Lack of tax revenue is a major problem as government could be deep in debt while finding the way to finance national expenditures

at all government levels The need of an independent research to provide the governments with an additional empirical evidence in relation to the approach in which tax evasion in

a country can be reduced is an urgent question at this point in time Developing countries including Vietnam also have to acknowledge the differences in organizational issues, tax law and other aspects between developing and developed economies so that changes can

be made accordingly in the process of economic transformation and development

Recently in April of 2016, a huge leak of confidential documents about tax, known

as “Panama papers”, happens and reveals a lot of information about how the rich hide their assets to evade tax under one Panamanian law firm Mossack Fonseca The

consequences spread around the world in months, which created a global scandal This event also put a question mark on how governments really manage tax evasion This study is conducted in response to this recent event and it is expected that findings from this empirical study will encourage more research in relation to tax evasion in the near future, in particular for Vietnam

1.2 Research objectives

This study aims to evaluate the potential contribution of information sharing and bank penetration in solving tax evasion problem in developing countries On the ground

of empirical findings, policy implications are drawn Using updated dataset – 2006-2014

in World Bank Enterprise Surveys and other additional data source, the following three specific objectives are expected to be achieved in this study:

 First, establishing a new tax evasion index using model approach, by which

influential factors are combined into a single index which is considered as a representative for tax evasion

 Second, estimating the effect of higher information sharing level and wider

bank penetration to tax evasion in developing countries using new tax evasion index

 Third, investigating the effect of typical characteristics of firms such as their

size, together with their location on the relationship between information sharing - bank penetration and tax evasion

1.3 Research questions

To achieve the above objectives, this study attempts to answer the following research questions:

 First, what is the current level of tax evasion of typical developing countries in

the research period?

 Second, do higher information sharing level and wider bank penetration help to

reduce tax evasion in developing countries?

 Third, how do typical characteristics of firms such as their size, together with

their location, affect the relationship between information sharing - bank penetration and tax evasion?

1.4 Contribution of the thesis

The study contributes to knowledge on the financial development and growth nexus on the following grounds:

 First, a new index to measure tax evasion is to be constructed in this study

using data from World Bank Enterprises Survey As in many previous papers relating to tax evasion (including Beck et al., 2014), tax evasion is dealt by using answer coded c2411 in World Bank Enterprise Survey from 2002 – 2005 dataset An alternative measure is to calculate tax evasion ratio using the difference between 1, the maximum value and the answered figure reported in question c241 Unfortunately, this question is not available in standardized surveys from 2006, except for existing as country specific variable in questionnaire of some countries like Yemen This raises the demand of a new measurement of tax evasion from 2006 onwards

 Second, a comprehensive relationship between proxy of financial intermediary

development and shadow economy/ tax evasion variables using standardized data of World Bank Enterprise Survey from 2006-2014 which is considered as the most generalized and updated survey at this time, is developed

 Third, the effects of firm size and location to the relationship between financial

developments which are information sharing and bank penetration, and tax evasion is examined and quantified in this empirical study

1 Answer coded c241 is for question 41 in Business-Government relations part of World Bank Enterprise survey in 2002-2005 dataset: “Recognizing the difficulties many enterprises face in fully complying with taxes and regulations, what percentage of total sales would you estimate the typical establishment in your area of activity reports for tax purposes?” The answer is presented in percentage format

1.5 Structure of the thesis

The thesis concludes five main chapters Following the Introduction, the rest of the thesis is structured as follows

- Chapter 2 reviews relevant literature including theoretical backgrounds and previous empirical studies First, the study focuses on explaining tax evasion based on academic and measurable approaches Second, information sharing and bank penetration is defined, investigated to demonstrate their roles to tax evasion issue

- Chapter 3 presents the methodology and data to be adopted in this study This section presents how new TEI is developed and used in revealing the relationship between financial developments, with information sharing and bank penetration as representatives, and tax evasion Then, source of data is defined and explained about the suitability Finally, initial analytics of data and results of tax evasion index calculation are also presented

- Chapter 4 presents and discusses the result of empirical analysis Two regressions are conducted with the main findings used to answer two research questions Additional discussion and comparison with previous empirical studies are then presented

- Chapter 5 provides a summary of conclusions, which are drawn from empirical findings from this study Limitation of this study and suggestion for future research are mentioned at the end of the thesis

Chapter 2 LITERATURE REVIEW 2.1 Explaining tax evasion

2.1.1 Tax evasion approach

There are three main approaches to measure tax evasion in a country (Schneider &

Enste, 2000) First, direct approaches include voluntary surveys, tax auditing and other

compliance methods For example, the U.S Internal Revenue Services (IRS) implements

a detail audit program from 1965 to 1988 on a stratified random sample of nearly 50.000 individual tax returns every 3 years to detect the tax gap The result of the audit is first used to generating the actual income of an individual Then by comparing with reported income from that person, we yield the tax gap It could be considered as a proxy for tax evasion

The advantage of direct approach is detailed information it can get from replies However, dishonest answers are mainly considered its disadvantage The data can be distorted or biased based on attitudes and willingness to answer of respondents, as most

of them hesitate to reveal the sensitive information Quality of this method also depends

on how the questionnaire are constructed and implemented

Second, indirect approaches, known as indicator approaches, mostly use

macroeconomic and other indicators to estimate the growth of tax evasion issue over time They look into traces of tax evasion in measurable indicators, give a try to measure the issue via other things That is the reason why this method is called “indirect” Some indicators used in this approach to measure unofficial sectors include difference of measurement between expenditure and income approach of gross national products (GNP); discrepancy between official and actual labor force; difference over time between volume of transactions and official GNP

Another way to investigate tax evasion indirectly is to look into transactions which use money, with an assumption that a true level of economic activity could be fully described by Fisherian relationship between money and its velocity By comparing estimated level of economic activity and official national accounts, we can get “shadow economy” Shadow economy could be used as a proxy to measure tax evasion

Although all indirect methods could be used to measure tax evasion and the data is available in many sources, even in long period, each method has its own limitations2 and may not be able to apply to every case One of the most important reason is that all of indirect method only use one indicator to represent for effect of shadow economy and/ or tax evasion; and some monetary approaches consider only tax burden as cause of the issues However, shadow economy and tax evasion are created by many causes and result

in many effects in various aspects: production, labor and money markets

Third, model approach was first introduced by Frey and Weck (1983a, b), Frey

and Weck-Hannemann (1984) when they combined twenty-four countries of OECD in a panel dataset to determine the size of the shadow economy Based on statistic theory, shadow economy or tax evasion is considered as unobserved variables, and could be estimated via its causes and effects, which are measurable The DYMIMIC (or Dynamic Multiple Indicators – Multiple Causes) appears to fully cover the meaning of model approach and soon proves its advantage by flexibility and precision

Nevertheless, there are also disadvantages of mistakes in measurement, wrong choice of variables, all of which can lead to the biasness of the results This paper adopts the model approach to give suitable measurement for tax evasion, and to examine the relationship between tax evasion and information sharing as well as bank penetration

2.1.2 Tax evasion framework

It’s useful to start with the early theoretical tax evasion framework by Allingham and Sandmo (1972) whose research inspires and puts a foundation for a number of later

2 For detail review, see Schneider & Enste (2000)

researches in discovering tax evasion issue In general, the analytical framework shows that a tax compliance decision is made by maximizing a utility function They viewed tax evasion as a gamble by which a person weighs the financial benefit by successfully evading the tax against the consequences of being detected and punished to decide whether he or she will play The individual would choose to pay tax due to the fear of being caught guilty and punished As their fear depends on the probability of being checked, which is audit rate and the amount they would have to pay per dollar they hide, which is fine rate, model appear to be the useful to investigate the issue

To clearly illustrate the issue, we could consider the analytic idea of Allingham

and Sandmo (1972) For example, an individual has a fixed amount of income I He could

decide by himself to report all of his income to tax authorities or hide some parts of it

We then assume he would choose to hide X dollars (0 ≤ X ≤ I) With tax rate of t and fine rate of f, in case he gets caught hiding his income, he has to pay full tax and additional

fine due to his tax noncompliance behavior His income becomes 𝐼𝑐 and is calculated as below:

𝐼𝑐 = 𝐼(1 − 𝑡) − 𝑓𝑋

In case he successfully wins this “gamble”, he would save an amount of tax due to his underreported income His income is 𝐼𝑠 and is calculated as below:

𝐼𝑠 = 𝐼(1 − 𝑡) + 𝑋𝑡 Whether he would receive 𝐼𝑐 or 𝐼𝑠 all depends on a fixed probability of being

checked – audit rate p Now we assume the individual utility function is an increasing

function of net income This means that if his net income is high, he gets more benefits

and vice versa His utility income in tax compliance case would be:

𝐸[𝑈] = 𝑝𝑈(𝐼𝑠) + (1 − 𝑝)𝑈(𝐼𝑐)

Or 𝐸[𝑈] = 𝑝𝑈(𝐼(1 − 𝑡) − 𝑓𝑋) + (1 − 𝑝)𝑈(𝐼(1 − 𝑡) + 𝑋𝑡) (1)

In function (1), E is the expectation operator and U is the utility function Function (1) is solved using standard methods

Beside net income, Allingham and Sandmo also mentioned reputation as another

variable for analysis They argued that there must be more than income that tax payer would lost for their tax noncompliance, or there must be more than one variable in utility

function For a general term, they choose reputation to represent for these other factors

The utility function becomes two variables function 𝑈(𝐼, 𝑟), where r stands for reputation variable

This approach shows that tax compliance only depends on audit rate and fine rate People are more likely to comply tax regulation if audit rate and/or fine rate is high, which creates high probability of detection and heavy punishment In Allingham and Sandmo’s case, not only net income but reputation could be considered as punishment if

a person is accused for his tax noncompliance There is also a number of extensions of this “economics-of-crime” approach (Alm, 2012), but the basic idea about economic consequences is retained The idea is confirmed once again: people pay tax only because

of the fear of being detected and punished

However, it’s quite clear that not only detection and penalties relate to tax evasion story Based on many researchers’ arguments including Torgler (2011) and Alm (2012), the proportion of tax returns under tax inspection of authorities over total tax revenues is quite small in most countries, regardless of the development level The limited resources

of government also do not allow applying a high audit rate In addition, the penalty from cheating case rarely exceeds the total tax evaded amount, which refers a non-high fine rate Following this financial approach, we could suggest a high level of tax evasion in most countries And a rational citizen would choose to hide all income because of high potential benefit from this illegal behavior The governments could not base only on their audit rate and tax rate, which is relatively small, to guarantee tax compliance In fact, compliance level in different regions may not be the same, and its average is quite low,

but it rarely reaches the compliance level as predicted by tax evasion theory (Alm, 2012) The original model could not explain this issue There must be other factors which affect compliance level rather than the fear The must be answers for the fact that there is often

a different number of citizens who often pay tax fully (or most) in different countries

Another insensible issue is that the basic model of tax evasion often suggests a higher and higher tax rate because it is believed to better off the situation via increasing the punishment of tax evasion, regardless of the fine rate However, theory proves that substitution effect of high tax rate actually reduces the reported income due to increasing benefit of illegal behaviors It also has income effect which decreases the attractiveness

of cheating in case of low income Yitzhaki (1974) has pointed out from his research that government in most countries actually used fine rate to remove substitution effect of high tax rate, then income effect would raise the compliance level, not to increase as high as possible

Because of two main reasons above, the basic model of Allingham and Sandmo (1972) could not become the best model to describe real situation despite its simplicity and elegant But based on this pioneer analysis, researchers found out an instruction to investigate the complicated tax evasion issue

Although the basic model is concluded as not to be the best model to investigate the tax evasion issue, many extensions are derived from this model3 They mostly focus

on adding more variables to the original model to increase its complexity and more likely

to match real situation Some of them are expanding individual choices, adding alternative tax, rewarding honest tax payers or even setting up a model for government to choose which company to audit.4 All of extensions are necessary and contribute to the main theory However, they did not solve the problem of high tax rate – compliance relationship

3 An updated list of main theories and studies in tax evasion aspects is contributed by Schneider et al (2015)

4 For a comprehensive summary, see Alm (2012)

Slemrod (2007) introduced an enhancement of original tax evasion by Allingham and Sandmo The author made the idea go further by analyzing tax evasion choice of businesses instead of individual tax decision He argued that large public firms are expected to keep neutral tax attitudes, not risk adverse like individual or small firms In addition, in large public companies, it’s not the stock holder but the financial manager or another authorized person to define the reported income To balance the income incentives between stock holders and tax decision makers, firms have to make sure that benefits of decision makers should tie up with cooperate profit, which is source of stock holders’ income

Some other researchers chose to approach tax evasion via behavioral economics, which means they added more behavioral variables into the basic function In other word, they put the sense, the psychologic material of tax payers into the model to analyze This method seems to be innovative, as they could analyze not only individual but also group decision making process However, it could have difficulties in measuring social sciences variables For example, different persons could behave differently to an event (gain or loss in tax evasion), their risk attitudes could change over time, it depends on surveyors

to have good quality of answer, there are no standard or measurement in social sciences, and so on Theoretically, these kinds of analysis break the old tax rate – compliance relationship Therefore, in some aspects, we could expect to have a better, more realistic result with behavioral approach, provided that we have qualified data

2.1.3 Empirical evidence

Over the years, attempts have been made to verify the result of the basic model Most of researches concentrate on two main parameters: the enforcement intensity – audit rate and level of tax rate However, empirical results failed to look for a method to measure the level of tax noncompliance Because of the complexity of tax evasion, suitable method is hard to find out as well as would have to face a lot of arguments This difficulty could not prevent researchers try to find a way to measure tax evasion, use all kind of data that they have to deal with the issue

Many findings have been found through this process but some results still mixed Researches show that higher tax rate really sticks with lower level of tax compliance (Clotfelter, 1983; Crane and Nourzad, 1992); however, Feinstein (1991) found the negative relationship between tax noncompliance and marginal tax rate Witte and Woodbury (1985) as well as Dubin, Graetz, and Wilde (1990) found statistically significant and positive but diminishing influence of audit rate over reported income: An increase of 10% in audit rate is estimated to lift reported income by from 1 to 2% This result is also in doubt because the compliance function is non-linear, which means there must be a maximum level where governments reach its full potential of audit, and cannot increase any further Then governments could not base all of their effort on bettering off the taxation issue due to this limitation Literature also shows remarkable evidence that tax amnesty does not have much effect on compliance as it just creates a small number of tax revenues (Fisher, Goddeeris, and Young, 1989) Some other findings include: information sharing between countries could raise compliance; strategic audit selection could cause revenue gains and audit rates meet endogeneity issue (Feinstein, 1991; Alm, Bahl, and Murray, 1993; Johannesen, 2014)

Field experiment is another source of evidence which researchers could find While theories and analyses often seem to be so compact or so complicated, field experiment method allows occupying data in a simpler manner Data collectors get the information directly from the participants, by which they would have a micro-data with individual level The data is then ready for economic or econometric analysis However, this kind of research depends on quality of responses, which is affected by a lot of individual factors Therefore, we always have to check answer’s quality by survey design, choose suitable participants or guarantee education level of surveyors

The basic ideas of compliance experiments are nearly the same Participants have

to choose an income level, and they will get (or earn) that amount of money Then they have to decide how much income to report Only reported income is subject to tax, participants do not have to pay tax for their underreported income They are also warned

about the probability of being audited In case they successfully hide their income, they save money Otherwise, they have to pay additional fine for cheating The experiment repeats a number of rounds with different scenarios Changes in scenarios include audit rate, tax rate, fine rate and other types of institution After the process, participants would receive money according to their performances in the experiment

Field experiment has covered a lot of assumptions and conditions, allows researchers to look into tax evasion without spending too much time on waiting for an official database Results from this method also have critical findings For example, higher tax is found to lower tax compliance; higher audit rate has a small, diminishing but positive impact reported income Through experiment, participants seem to overweight the information of enforcement intensity, making it far different with the standard utility model of Allingham and Sandmo (1972) Compliance is also proved to increase to with a small attitude caused by the increase of fine rate and disclosure of noncompliance acts In case of government ready to give out group rewards or individual rewards, compliance is encouraged and actually rise Many issues relating to audit side like productivity of audit, audit selection methods, collective decision rules and so on are also in discussion For an overall review of these issues, please refer to Torgler (2007), Alm (2012)

Although experimental method seems to have advantage in research, performing this method requires many standards to meet so as to have a qualified and applicable dataset One issue may come from repeated design of experiment or neutral instructions, which mostly belongs to early researches before international standards for experimental method was established Some results lack realism due to using so many assumptions without applying parameters and values of real world Another issue is that unsuitable participants are sometimes used As finding a large number of participants to represent for a group of people or even a country is challenging and time consuming for compliance experiments, sometimes persons who have never paid tax like students are selected as alternatives, which reduces critically the quality of data and experiments Finally, success of experiment depends on attitude of participants towards the issue and

the environment they are in For example, a person would think that he is in an experimental laboratory, then just be nice, otherwise people would consider him as a cheater

2.1.4 Determinants of tax evasion

We start from academic definitions for shadow economy While there are no general and exhaustive definition about shadow economy due to its characteristics of multi-dimension and extent, researchers mainly use these four below definitions to explore the problem (Ministry of Finance of Bulgaria, 2016)

 Fiscal definition: it confines the informal sector to activities which contravene tax

regulations and fail to be reported by financial authorities It includes but not is limited to the hiding of sales by a company from the fiscal authorities, the false bookkeeping, or the sale of undervalued real estate All legal operated with false bookkeeping and illegal firms are covered in this definition As a result, this view considers tax evasion as a critical factor through which shadow economy can be measured

 Market definition: it focuses on the difference between payable and non-payable

services This scope pays attention to unregistered and undeclared labors of firms

to evade additional payments

 Legal definition: it encompasses all activities conducted in contravention of the

law This perspective concentrates on trade of stolen goods, drugs, corruption and money laundering

 Statistical definition: it discerns those activities which should be reported in

official statistics but they are not The final definition targets hidden resources of informal firms which statistical reports cannot have data of It also covers the resources of official firms which are in lack of related data

Based on the availability of data and scope of this paper, fiscal definition of shadow economy is adopted Tax evasion is considered to be representative of shadow

economy, and influential factors of shadow economy could be determinants of tax evasion Ela (2013) supports this argument by describing shadow economy and tax relationship as a “feed and strengthen” interaction Heavy tax burdens increase tendency for firms to be operating in the informal sector, and vice versa, tax non-compliance of informal part boosts tax duties of formal firms to meet government tax revenue target

Schneider and Enste (2000) pointed out five reasons why shadow economies exist and increase in size Schneider and Buehn (2013) then improved the relationship by re-categorizing the factors and adding three remarkable points Six influences are summarized below as the most important determinants of shadow economy: (i) tax and social security contribution burdens; (ii) regulations; (iii) public sector services; (iv) quality of institutions; (v) tax morale; and (vi) deterrence.5 Each of these determinants is discussed in detail in turn below

First, tax and social security contribution burdens may make distortion in labor

market by creating preference towards shadow economy The larger the overall tax burden, the higher percentage of firms who find their way to run unofficially It is reasonable because if firms join in legal part, they are exposed to tax, which they can evade if they select the inverse choice

Second, regulations, especially in labor benefits as well as trade barriers also play

an important role in the decision of being invisible Number of licenses needed to operate

a specific business is often in use to measure regulation intensity As labor costs rise together with intensity of law, firms tend to work in shadow economy to evade additional payment owned by the government

Third, a circle of influence occurs related to public sector services If participation

rate of firms in shadow economy is high in a country, tax revenues of the government decrease, then public goods and services deteriorate To catch up with government tax revenue target and to fulfill national expenditure in that case, tax rates are forced to be

5 See Schneider and Buehn (2013) for detailed references of each factor

high despite low quality of public goods and services As a result, even stronger incentives of firms to join shadow economy Smaller shadow economy thus exists in countries which have higher tax revenues but lower tax rates, fewer regulations and less bribery (Johnson, Kaufmann, and Zoido-Lobatón, 1998)

Fourth, quality of institutions is also an important factor which may determine

shadow economy even stronger than tax and social security contribution burdens Good institutions assure property rights and enforceability of laws and regulations A country characterized by well-organized institutions tends to have smaller informal part in the economy In addition, there exists a certain level of taxation in which tax policy is considered as efficient In reality, formal firms benefit from high level of productive public goods and services, and loss with tax, while unofficial ones do the opposite The appropriate level of taxation would minimize the unofficial part by enhancing the quality

of productive public goods and services and benefit legal firms

Fifth, beside economic and institution terms, tax morale appears as a

representative for indirect effect of public goods and services on the size of shadow economy Tax compliance is always expected from tax authority side, but low quality public goods and services may damage the honest of taxpayers Just like a trade, people pay taxes to receive equivalent values, the quality of public goods and services in this case No equivalent values lead to failure in exchange Moreover, appropriate social behaviors of tax authorities to taxpayers may also enhance the morale A partnership would do more help than a hierarchical relationship; then taxpayers would be more stick

to the obligations of tax code and regulations

Sixth, deterrence, which indicates fines and punishments if firms are found illegal,

is mentioned Empirical studies have “the traditional economic theory of tax compliance” to explain the mechanism, but little evidences are announced This is due to the unavailability of data, and mixed previous econometric results

non-By applying above six factors while combining tax morale and deterrence in a more general category: tax compliance, we suggest five determinant categories of tax evasion including (i) tax and social security contribution burdens; (ii) regulations; (iii) public sector services; (iv) quality of institutions and (v) tax compliance

2.2 Connection with information sharing and bank penetration

2.2.1 Information sharing and bank penetration in financial system

Information sharing in financial development indicates the exchange in data between financial organizations, mainly focuses on credit information Shared information is critical in case of dealing with firms which do businesses with many financial organizations Credit information sharing also helps in credit granting process for opaque firms and households by reducing information asymmetry via provision of credit history In general, a financial system which has high level information sharing may reduce costs and efforts to identify risk as well as better off its operational risk management thanks to transparent environment

Theoretical studies indicate three main ways that information sharing could better off financial system Firstly, information sharing reduces moral hazard and encourage borrowers to repay and pay in time Because late repayments and defaulters are considered unacceptable, borrowers decide to repay to avoid any punishment such as captured in blacklist or any doubtful list, which could reduce future external financing (Klein, 1992; Vercammen, 1995; Padilla & Pagano, 2000) In addition, information sharing keeps firms’ activities transparent If they want to pay off, they have to work hard and pay attention to the business, from which moral hazard reduces (Padilla & Pagano, 1997) Secondly, adverse selection is prevented as bank now have more and accurate information about customer to make a right decision (Pagano and Jappelli, 1993) Thirdly, with information sharing, firms cannot be over-borrowing as lenders could access indebtedness of their customer from all lenders in the market (Bennardo et al., 2015) Some more evidences state that information sharing could reduce credit risk

(Jappelli and Pagano, 2002), default rates (Powell et al 2004; Houston et al., 2010) and also likelihood of financial crisis (Houston et al., 2010; Büyükkarabacak & Valev, 2012)

Bank penetration in this paper refers to physical outreach by banks and lending institutions In an easy measurement, it is the number of branches of banks and lending institutions available in a territory Having more branches does not necessarily mean higher market shares for a bank or a financial institution but a higher level of service availability Customers of the bank could use financial service at a larger number of places, which creates better customer service for loan providers and greater convenience

in operation for customers Furthermore, high level of bank penetration specially encourages microfinance to grow Bank now has more business, more opportunity to earn money and financial system is better off

2.2.2 Information sharing and Bank penetration role to tax evasion

There are a number of cases that enterprises deny their legal corporation tax duties or evade tax Beck et al (2014) divided them into 2 main groups The first group gains little benefits for being formal in underdeveloped institutions Thus, they choose to hide their output This group achieves only no tax burden but faces non-supportive business environment as well as potential penalties from the government The second group chooses to be formal, but “cook the books” to reduce their tax duties They seem to be harder to recognize, as incorrect information in their financial statements and general ledger are not so easy to find out To the end, they are illegal Potential punishments and low credible statements are what they exchange for refusing additional tax burden Theoretical and empirical evidences have been given to examine the impact of information sharing and bank penetration to corporate tax evasion level

First, by basing on financial constraint, Allingham and Sandmo (1972) suggested

that a rational individual decides to pay or not to pay tax due to their calculation of maximizing his or her utility It means that taxpayer completes required tax duties because of their balance between the risk of being punished or getting financial fines and

additional hidden revenues Johnson et al (2000) later clarified the higher motivations of firms to hide their income in underdeveloped market-support institution because they cannot make good use of being formal Straub (2005) and Beck et al (2007) suggested that better access to formal credit services help to increase formal operating firms’ benefits Moreover, information sharing is pointed out to lower transaction costs and improve credit efficiency by enhancing credit availability (Brown et al., 2009) and reducing bank corruption in lending (Barth et al., 2009) These evidences boost benefits

of formal firms, thus, lower motivations to evade tax of the informal group

Second, hidden revenues by “cooking the book” can also be reduced when

improving information sharing and bank penetration Tax evasion by this method creates uncertainty in firms’ financial reports As a result, it raises the costs of banks to double check in order to avoid potential risk The additional costs are also transferred to borrowers as they face higher interest rate and stricter loan terms (Graham et al., 2008)

In financial systems where information sharing and bank penetration are well improved, firms that misreport their revenues would have more obstacles in borrowing Formal banks and other financial intermediary institutions prefer right functioning firms because

of lower risk thanks to lower information asymmetry, and then less likely to allocate resources to misreported firms Therefore, the opportunity costs of evade tax is higher in countries which have enhanced information sharing and high level of bank penetration (Beck et al., 2014)

Besides, there are offset effects Tax evaded firms do not list hidden resources as their assets However, as firms need collateral when borrowing, firms engaging in tax evasion have less opportunity to have collateral for their loans Thus, stricter loan terms and higher interests could be included in case banks accept to give loans In countries that are in high level of information sharing and bank penetration context, the importance of collateral is low as lenders now can monitor borrowers thanks to less information asymmetry (Beck et al., 2011) Firms may benefit while less collateral is required in a loan Again, tax evasion worsens firms’ opportunities in these countries