Monday, February 13, 2012

On taxation and black economies

A few months back I tried to shed some light on the problems in Greece by citing a statistic that there are more Porsche Cayennes registered in the country than taxpayers declaring an income of 50,000 euros or more. That statistic, when combined with other anecdotal evidence, shows that one of the root causes of Greece's ongoing economic problems is its government's inability to collect taxes on the economic activity that is actually occurring in the state.

An article last week regarding Italy showed that Greece is not alone in that regard.
Police fanned out across Milan in late January halting more than 350 vehicles, mostly luxury SUVs and Porsches. 
At checkpoints, including one adjacent to the fashionable Corso Como, the police got the driver’s license and registration, which they passed on to the national tax agency. The tax authorities will use the data to check if the cars’ owners had declared enough income -- and of course paid the right amount of income taxes -- to justify their lifestyles. 
It was at least the fifth raid targeting wealthy Italians since a Dec. 30 sweep at the posh Cortina d’Ampezzo ski resort, where 251 high-end cars were stopped, including Ferrari and Lamborghini supercars, Bloomberg Businessweek reports in its Feb. 13 issue. Rome, Portofino on the Italian Riviera and Florence have also been targeted.
Italy is getting aggressive with its tax evasion crackdown, and it's a necessary step--depending on the estimate, the underground "Black Economy" (or, "System D") accounts for 20 to 30% of all economic activity in the country. However, it's unclear whether Italy's efforts will be sufficient in the long run to solve its significant debt problems.

Ultimately, the strength of a state depends entirely on its ability to collect taxes from its citizens. One could argue that the United States is relatively strong in this regard (its "Black Economy" is nowhere near the levels of Italy and Greece), but it still does not collect nearly enough tax to pay its annual bills. If it in fact tried to raise its tax rates in order to close that gap--as Italy is now trying to do, in effect--it might find that the "Black Economy" would grow significantly as a result.

Those who argue that raising tax rates would harm economic growth are therefore certainly correct, although perhaps not in the way they might imagine. Instead of actually decreasing the overall amount of economic activity, a higher tax rate might just lead to a decrease in the amount of "official" economic activity, as more and more transactions went off the record. It's quite possible (if not probable) that's what happened in Italy over the last decade, which would help explain the nation's pitiful "official" economic statistics.

If citizens (of any nation) begin to feel that their tax burden is too high--or that their government is misusing their tax dollars--they will always find ways to avoid paying their tax bill. Sometimes this will be through outright misrepresentation and fraud, but often it will be much more subtle and therefore much harder to prove. If a mechanic fixes a friend's car for free, with the understanding that his doctor friend will return the favor in the future by dispensing free medical care, the level of "economic activity" (in terms of favors exchanged) is the same whether or not cash actually changes hands. But in one case, the government can collect taxes on the transactions, and in the other case, the government cannot (at least not easily).

The choice to do these transactions "on the record" or "off the record" depends entirely on the mechanic and the doctor's respective faith in their government, and whether they feel that their leaders are operating in good faith with respect to taxation. Unfortunately, once that good faith bond has been broken, it can be incredibly difficult to restore, as Italy and Greece are now learning. As the U.S. tries to solve its own deficit and debt problems, it too will end up facing a similar dilemma--how can it extract more money from its citizens without pushing more economic activity down into the underground, beyond its reach?

The strength of the state, ultimately, is only as good as the citizens' belief in that state and its leaders. Break that bond, and the state can suffer even as many of its citizens continue to thrive--at least in the short run. But in the long run, both the state and its citizens suffer together, and that's where Italy and Greece now find themselves.


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