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The Wall Street Journal Europe

February 28, 2001

International Commentary:
Why Are Your Neighbors Paying in Cash?

By James Sproule.

Mr. Sproule, an economist, is a visiting fellow
of the Institute of Management at the London School of Economics.

     There are supposedly two certainties in life: Death and taxes. While, death is still inevitable, for many Europeans, taxes are looking increasingly optional.

     Massive tax evasion is Europe's dirty little secret. Consider high-tax Sweden: The size of the underground economy there has mushroomed to 20% of gross domestic product from 7% of GDP in 1970, according to a recent International Monetary Fund study. Italy and Belgium, which were not included in the IMF report, are suspected by the IMF to have even larger underground economies. Interestingly, the lowest underground economies are in the United Kingdom and the Netherlands; the IMF estimates that each has a shadow economy equal to some 13% of GDP.

     The true size of the shadow economy, even in the relatively lightly taxed U.K., became clear to me a couple of years ago when I visited a cable-television company in the East Midlands. In my discussions with the finance director, I asked if there had been anything that surprised him. Yes, one thing, he said. When they had started operations, they arranged a number of ways for people to pay their bills: direct debit, the mail and, almost as an afterthought, cash payments through a window at their headquarters. To everyone's surprise, paying cable bills by cash was by far the most popular option. In fact, it seems people were willing to take a 10 pound taxi ride each way to pay a 20 pound bill. Why? Many of the locals, while officially unemployed, were working on building sites nearby. They get paid in cash and cannot put their earnings into bank accounts lest the authorities discover their ruse. Thus they pay in cash.

Rampant Tax Avoidance

     The number of shadow-market workers must be even higher in countries-such as Italy, Spain and Belgium-where prosperity and rampant tax avoidance happily coexist.

     While the size of the shadow economy is still debated by economists, few debate its cause-Europe's steeply climbing tax rates. Even though the amount of government spending in Sweden has fallen in recent years, the state still spent 57% of GDP in 1997, the latest estimate available. The result? High taxes needed to pay for all this government spending is clearly driving businesses and entrepreneurs underground. Other countries with high government spending and high taxes have also found their shadow economies have tripled since 1970 -- Denmark, France and Germany all have over 15% of economic activity now taking place in the shadow economy. Contrast this with relatively low-tax America, where government spending accounts for only 31% of the economy and the shadow economy is roughly 9% of GDP.

     Measuring a shadow economy may appear a bit of a hit-and-miss proposition, but it is not really that difficult. Most income-tax evasion can be measured by looking at income, spending and savings. Data consistently shows that more is spent each year than is earned or withdrawn from savings-with no prizes for guessing what makes up the difference.To measure cash-only transactions, economists look at how quickly cash circulates in an economy, which gives them a good idea of the size of cash-based economic activity.

     People are not moving into the shadow economy simply to avoid taxes-the shadow lands are also refreshingly free of many bureaucratic hassles. But bringing many small businesses into compliance is simply going to result in most of those enterprises shutting down and will deter future start ups.

     Given Europe's less than stellar entrepreneurial record, this is probably not a course of action that recommends itself.

     Perhaps, the scale of tax evasion today should be set against both the basic economic inefficiencies it creates as well as wider moral arguments. First, the more activity that is "shadow," the more the honest have to pay in taxes. That is not a message any government should want to send.

Financial Structure

     Second, as companies grow, they need financing. If a company does not have audited accounts, finding such financing will be very difficult. Is it any wonder that Italy's stock market has traditionally been so small? Smaller Italian companies have relied upon retained profits and family financing to expand. But within a European single market, this is not the sort of financial structure that is going to be able to provide for corporate expansion in future. Are family nest eggs really the best way for Europe to build a world-class new economy?

     What Europeans want, or at least some of their political elites want, is to have laws express a moral purpose. But dare we mix up morals with basic law making? Are laws to be a broad expression of moral purpose or a code of behavior that we are all expected to adhere?

     The Peruvian thinker Hernando De Soto has written that the key to a growing economy is found in a general adherence to the rule of law. It is difficult to imagine places like Russia being able to develop economically until their people see law as something to be obeyed, rather than an impediment to be overcome. Of course, European problems are a long way from Russia's. But, if we want to avoid such a situation, we would be well advised to turn from our current path.

     So what is to be done? European taxes have been too high for too long. But tax evasion is a learned behavior. Only tax cuts can restore respect for the law-and save Europe from becoming a continent of tax cheats.

-- From The Wall Street Journal Europe


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