Published in the Financial Post, February 27, 2002, p. 15
Taxes and the Underground Economy, a new study from the Canadian Tax Foundation, documents the growth of the underground economy, now perhaps 16% of official gross domestic product. By definition, the underground economy escapes the taxman. Indeed, as half of the evaded taxes come from otherwise legal activities, the sole objective of underground transactions is often to escape taxes. The study's co-author, David E.A. Giles, declares that the underground economy "is costing [its participants] and everybody else when the tax base is eroded."
For a long time, indeed, economic orthodoxy condemned tax evasion. The state, it was argued, needs a certain amount of revenues in order to finance necessary expenditures that are in the interest of everybody. The smaller the number of individuals over whom the required tax burden is spread, the more each one will have to pay. Consequently, anyone who evades his share forces other taxpayers to shoulder a higher burden.
This approach raises insuperable problems. Why did public expenditures in Canada increase from less than 15% to more than 45% of GDP in less than a century? Have public needs increased to such an extent that Canadians are willing to transfer to government a constantly growing proportion of what they produce and earn, even in peacetime? Do Canadians really want 93% of the $430-billion of annual public expenditures by all levels of government to be spent on something else than protection of person and property? And why would they want one-fourth of public expenditures to go back to the same persons, basically the middle-class, who financed them with their taxes (a phenomenon called "fiscal churning") after the state has taken its cut? Do we want nearly one employed person -- and one voter -- out of five to be working in the public sector? The required amount of public expenditure appears to be quite elastic - and mainly elastic upwards.
To explain these developments, we need something other than the orthodox theory, which naively assumes that the state is manned by disinterested angels who know what the people want, and impose taxes in proportion to the benefits everybody gets from public services. Over the past half-century, government decisions have been analyzed in a more realistic way by what is called the Public Choice school, of which one of the main founders is James Buchanan, the 1986 Nobel Laureate in economics.
In Public Choice analysis, the state is manned by ordinary, imperfect, self-interested individuals. Like everybody else, these individuals -- politicians and bureaucrats -- use their positions to further their own interests. Public policy is, in large part, the outcome of their interactions, and is strongly influenced by special interest groups -- even if citizens vote periodically for abstruse, non-binding programs whose consequences are unknown and unpredictable. Since bureaucrats and politicians get more perks and more recognition when their domain of intervention is larger, they want to maximize the state's revenues, and they charge to taxpayers as much as the market will bear.
In this perspective, revenues drive expenditures, not the inverse. The more income the state gets, the more priorities it will find to justify its spending, regardless of what is really economical. It follows that tax evasion and the underground economy, by drying up the source of funds, constitute a built-in restraint to state growth. Harold Demsetz, another well-known economist, writes: "As the relative sizes of government sectors grow, so do the unrecorded sizes of the hidden private sectors that operate beyond the reach of tax authorities … making the size of [the government sector] difficult to push much beyond 45 percent of real GNP in a democracy."
As state revenues and, thus, expenditures increase, more programs become objectionable to larger parts of the population. Each program serves concentrated interests who lobby for them, but its cost is spread over all taxpayers, and none of them will find it worthwhile to go and demonstrate in Ottawa. Take, for example, the announcement by Allan Rock, the Industry Minister, of a $125-million grant to the Pierre Elliot Trudeau Foundation. This subsidy costs less than $10 per taxpayer but will provide substantial revenues to scholarship recipients and the bureaucracy administering the program. Meanwhile, politicians like Mr. Rock use taxpayers' money to purchase support from political clienteles.
Consequently, tax evasion represents a net benefit to everybody, tax evader or not. Confiscatory taxes corner taxpayers into the sort of peaceful self-defence called tax evasion. Tax evasion, and its twin sister, the underground economy, are a second-best to what would otherwise be an even more interventionist state. Without the threat of the underground economy, all taxpayers would be milked, and regulated, more. A statue should be erected to the unknown tax evader.
Now, it is true that lying on tax forms, signed and filed under coercion, easily spills into cheating in free, voluntary relations, and that private cheating destroys our social capital of trust and honesty. Naturally near-sighted politicians are thus furthering the East-Europeanization of our society. This is the only serious problem with tax evasion, and it won't be solved by more authoritarian political solutions.
