The shadow economy

8.2. Increased penalties.

Given the high costs involved in increasing the probability of detection, it is sometimes decided to impose higher penalties for participating in the shadow economy. The evidence is again by no means clear-cut, however, that this is an effective way of legitimising or reducing the shadow economy. While some studies find that increasing fines reduces the shadow economy (De Juan et ah, 1994; Friedland et ah, 1978; Klepper and Nagin, 1989; Schwartz and Orleans, 1967), others conclude that increasing penalties leads to a growth in such work and/or has no effect, or only a short-term effect, on compliance (Chang and Lai, 2004; Elffers et ah, 1987; Feld and Frey, 2002a; Friedland, 1982; Murphy, 2005, 2008; Spicer and Lunstedt, 1976; Varma and Doob, 1998; Webley and Halstead, 1986; Williams, 2001). This is because imposing penalties can be counterproductive and undermine the relationship between the legal authorities and those they seek to regulate (Ayres and Braithwaite, 1992; Blumenthal et ah, 1998). The use of threat and legal coercion can lead to the opposite behaviour from that sought. Increasing the penalties can result in greater non-compliance (Murphy and Harris, 2007), creative compliance (McBarnet, 2003), criminal behaviour or overt opposition (Fehr and Rokenbach, 2003; Frey, 1997a; Kagan and Scholz, 1984). In other words, it can increase resistance to compliance.

In consequence, increasing penalties has unintended impacts. One principal reason for raising penalties is to increase the amount of tax revenue to be collected. A Danish study found, however, that the purchasers of shadow work would prefer to resort to do-it-yourself activities (34 per cent) or simply not consume the services (30 per cent) rather than pay the official formal price (Mogensen, 1985). Hence, nearly two-thirds of shadow work would not be converted into declared jobs this way and, instead, the work would simply not take place.
Another potential unintended impact of increasing penalties (and detection) is that it may cause a reduction in tax morale and therefore an unintended growth in the shadow economy. For instance, an analysis of the 1987 American Taxpayer Opinion Survey (Smith, 1992) reveals that perceived procedural fairness and responsiveness in providing a service were positive incentives that increased taxpayers’ commitment to paying taxes. Meanwhile, Kinsey (1992) found that, while detection and punishments are used to attempt to force people to comply, these processes also alienate taxpayers and reduce voluntary compliance. An increase in the perceived severity of punishment and likelihood of detection may therefore amplify rather than lower tax evasion by reducing respect for the system’s fairness. This is also confirmed by the findings of Murphy (2005, 2008).
Indeed, Wenzel (2004a), in a survey of 1,406 Australian citizens, finds that increasing penalties works only where individual ethics are weak. Where social norms are strongly in favour of tax honesty, increasing severity of sanctions increases tax evasion. Harsh penalties and tax morality, therefore, are not comfortable bedfellows. This does not mean, however, that they cannot be used in a temporal sequence. For example, Davis et al. (2003) find that harsh enforcement increases compliance among previously non-compliant taxpayers and that returning to the previous more lax system does not necessarily cause them to return to their previous behaviour. This suggests that harsh penalties followed by their reduction and a shift towards more enabling measures could be an effective means of eliciting ongoing compliance since those who were previously outside would be then within the compliance system. For those already compliant, however, such a regime would perhaps have the perverse effect of increasing their non-compliance.
A final but important Ending regarding the effectiveness of deterrence is that many participants in the shadow economy are not rational economic actors swayed by the cost-benefit ratios confronting them. As the 2007 Eurobarometer survey reveals, the greater part (55 per cent) of shadow work is conducted for and by kin, neighbours, friends and acquaintances, and such work is often conducted for redistributive reasons rather than purely financial gain. This has important implications for tackling the shadow economy. It can no longer be assumed that all participants are rational economic actors seeking to make or save money and that therefore shadow work can be tackled simply by changing the cost-benefit ratio confronting them.
To summarise, the evidence that improving detection and increasing penalties improves compliance is less than conclusive. Not surprisingly, therefore, other approaches and measures are beginning to be used beyond ‘push’ factors to try to legitimise the shadow economy and help move shadow work into the official economy.