Underground Economy Averages 37% of GDP

EghtesadOnline: The underground economy and tax evasion in Iran have been estimated to average 37.7% and 3.5% of gross domestic product respectively in the fiscal 2017-8, an analytical research published by the Iranian National Tax Administration shows.

News ID: ۷۵۰۶۲۱

05 August 2020

Using Vito Tanzi’s Currency Demand Approach and Vector Error Correction Model, the research put the size of the underground economy at an estimated 5,584 trillion rials ($24 billion) and tax evasion at 515 trillion rials ($2.2 billion).

Iran’s total tax revenues stood at 1,366 trillion rials ($5.86 billion) and the country’s GDP, using current prices, amounted to 14,807 trillion rials ($63.5 billion) in the year under review.

The rial values have been converted using current dollar exchange rates.

Tanzi broadly defines underground economy as economic activities hidden from public authorities to avoid taxation. His definition of underground economy is a bit narrow in the sense that it assumes tax evasion to be the only motivation for the existence of the underground economy.

The underground economy’s activities can be categorized into legal, illegal and nonmarket economic activities.

Currency Demand Approach

The Currency Demand Approach, also known as “the monetary method, is commonly used to measure the size of the shadow economy. It is based on the econometric estimates of demand for currency. These estimates are used to get the currency held by economic agents in excess of the amount needed to finance registered transactions.

The monetary method to measure the size of the shadow economy is based on the assumption that cash is used to make transactions off the official records.

Transactions made using cash are difficult to trace, as they leave no tracks. Other assets are registered in financial institutions and their uses are recorded in such a way that transactions made with them can be easily inspected.

If the amount of currency used to make hidden transactions can be estimated, then this amount could be multiplied by the income-velocity of money—the number of times one unit of currency is spent over a given period of time. It is indicative of how much economic activity occurs or is possible at a certain level of money supply—to get a measure of the size of the shadow economy.

Experimental findings in most developed countries show tax income is one of the main resources of income for governments; tax plays a key role in how economic policies of a country is implemented.

In some developed countries, 90-95% of the government’s public expenses are paid by tax revenues. Conversely, it is their inefficient taxation systems that hold back the governments of developing countries from achieving their financial objectives.

Iran’s taxation system, like those of other developing countries, has failed to play its role as a powerful economic tool due to the absence of an efficient database to provide financial information of economic players, lack of transparency in economic activities, widespread tax exemptions, weakness of measures to ensure enforcement of the law, lack of trust in government’s financial system, Iran’s non-mechanized taxation system and inefficiency in estimating people’s precise income.

Tax revenues are so meager that they make the cost-benefit equation of taxation unfavorable and the tax gap—the difference between actual taxes collected and those which would be collected under full compliance—even larger.

Iranian Measures to Reduce Tax Evasion

In recent years, the Iranian National Tax Administration has implemented a variety of plans to reduce tax evasion, some of which are as follows:

* Direct Tax Code Revision of 2015-16, which criminalizes tax evasion and improves the effectiveness of tax administration and tax compliance.

* Proposing the bill on permanent legislation of value added tax to the parliament. The VAT Law took effect in the Iranian year ending March 2009 and is being extended annually to help improve transparency at each stage of production or distribution, and prevent corruption.

* Requiring businesses affiliated to Iran Chamber of Guilds to use mechanized sales systems. Article 121 of the Fifth Five-Year Development Plan (2011–16) requires the Ministry of Industries, Mining and Trade to annually equip a number of taxpayers with mechanized sales systems and oblige them to use the system.

* Completing the database to provide detailed financial information of taxpayers (their contracts, assets, credit report, etc.) and their performance as per Direct Tax Code Revision of 2015-16.  So far, this database contains a total of 1.4 billion records.

* Drafting and implementing the guidelines on how to investigate suspicious banking transactions.

* Setting up a taskforce for designing the guidelines on how to tax dealers of foreign currencies, gold coins, cars and homes.

* Investigating taxes of 4,000 shell companies.

* Drafting the comprehensive plan to prevent tax evasion of those holding business cards in cooperation with Iran’s Judiciary, intelligence agencies, the police and other agencies.

However, these measures do not go far enough in the fight against tax evasion. Other effective reforms and policies needed include:

* Compilation of financial details of taxpayers and their compliance.

* Enforcement of Personal Income Tax—a direct tax levied on personal income, including wages and salaries, director’s fees, dividends, royalties and rental income.

* Implementation of laws regarding the criminalization of tax evasion.

* Identification and registration of taxpayers.

* Facilitation of automatic exchange of information with different organizations.

* Completion of the tax mechanization process.

* Reformation of the structure of tax statements and integration of the system of drafting tax paper and electronic statements.

* Augmentation of people’s trust in the country’s taxation system to improve their compliance.

31% Rise in Last Fiscal Year's Tax Revenues

Tax revenues increased by 31% in the last fiscal year (March 2019-20) compared with the year before to reach 1,430 trillion rials ($6.13 billion), according to the head of Iran's National Tax Administration, Omid Ali Parsa.

He said tax revenues share in budget increased from 37% in the fiscal 2018-19 to 54% last year, Mehr News Agency reported.

“The average growth in tax revenues over the past five years was 21%,” he added.

The INTA chief said tax rates will increase by 28% on average in the current fiscal year (March 2019-20).

"In underprivileged provinces, the rate will be lower. For instance, Lorestan and Ilam will see 15% growth. However, taxes in Tehran will rise by 32%," he was quoted as saying by IRNA on Thursday in a meeting with business owners in the southern Kerman Province.

"The taxation system is moving toward imposing heaviest rates on higher income deciles while minimizing levels for those with modest means," he added.

Noting that 95% of the budget go to fund civil development projects, the INTA chief said Tehran will account for 55% of the country's overall tax income in the current fiscal year.

In comparison, Kerman will account for 3.2%, he added.

Parsa said currently INTA earns 120 trillion rials ($515 million) in tax revenues (direct and indirect) on a monthly basis.

“This is while the government's general spending is at $280 trillion ($1.2 billion) per month,” he said.

"About 8% of Iranians' income are put at the disposal of the government [in the form of tax]. The global average is at 30%. At a time when oil revenues have declined, the government has no choice but to count on tax revenues."

The Sixth Five-Year Development Plan (2017-22) targets an 8% share of tax revenues from GDP by March 2022, which currently stands at 6%.

At present, revenues gained from tax are at least 1 quadrillion rials ($5.65 billion) behind the goals of the development plan, Fars News Agency reported.

Iran’s development plans outline government strategies in its budget planning for the next five years.

Experts say the reason for this disproportionate share of tax revenues in the country’s GDP is that a large segment of the Iranian economy enjoys tax exemption. The situation is exacerbated by rampant tax evasion and faulty taxing methods.

According to Parsa, 40% of Iran’s economic players are exempt from paying taxes.

Amid financial constraint, the government is counting on tax as a major source of revenue. Consequently, new forms of taxes have been introduced to curb the widening deficit the government budget has long been suffering from.