Underground Economy

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CHAPTER 1

INTRODUCTION

1.1

BACKGROUND

In every economy, there exist vast variety of activities some which undergo official recording and some other activities take place outside the officials. The later is the underground economy that refers to the economic activities that generate income but are hidden from official authorities in order to evade various taxes and remain unrecorded in official statistics (Yasmin and Rauf, 2004).

The most common causes of underground economy are heavy tax burdens where economic agents evade high tax charges and resort to stay untaxed, high business regulation whereby this regulations are difficult to obey and do tempers with the welfare of the society (intensity regulation) as well as public doubts where the public may believe that the state do not use their taxes efficiently. This phenomenon requires attention of economists, policy makers, public officials and politicians because income earned in underground economy is quickly absorbed in the formal economy hence stimulate economic growth as well as tax revenue if indirect taxes are employed. On the other hand, huge shadow economy reflect a direct loss of public revenue hence depress the growth of GDP. Again, it provides greater incentive for domestic and foreign workers to move away from the official economy (Ariyo and Bekoe).

According to Schneider (2012), increase of the shadow economy can cause state revenues to decline which will ultimately reduce the quality and quantity of publicly provided goods and services. This will ultimately results in deterioration of provision of public goods by government, increase unfair competition by forcing legal businesses out of the market and great harmonious environment for criminal activities including tax evasion. Further, these

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activities alter the quality of statistics like unemployment, official labour force, income and consumption that policy makers depend on to formulate their policies. Consequently, suboptimal policies will result due to inaccurate information and governments may then respond to decline in tax revenue by raising taxes but this will increase the number of the shifts into the underground economy. Moreover, Schneider and Frey (2001), has shown that, the concept of shadow economy should not be recognized only with illegality because Most of the activities are perfectly legal but the taxes are evaded due to different reasons and due to loopholes in the economy itself.

1.2

PROBLEM STATEMENT

Lesotho’s dependence on revenue from SACU has been gradually reduced on total revenue in recent years which implies higher domestic revenue collection (International monetary fund, 2012). The domestic revenue collection can be done through value added tax (VAT), income tax and other measures. Looking at these measures, income tax has been above VAT for the period 2003-04 to 2007-08 this was partly because of VAT introduced in 2003 which is more effective than the sales tax it replaced, also is a reflection of the easing of the tax burden on individuals and companies, which has been made to expand discretionary demand, and in so doing encourage investment and employment (LRA Annual report, 2008).

According to sector study of the effective tax burden (2007) the rates of tax since first April 2006 are varying for both sole proprietors and companies. The personal income tax is approximately above 35% of annual income which is incorporated by tax credit. Consequently, higher tax burden are faced by sole proprietors than companies of similar size and this higher rates great disincentive for corporation. Having this in mind, Chuimya (2007) in view of tax burden said that the tax burdens great the incentive for individuals to remain in the second economy.

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Excessive regulations encourage individuals to operate in activities within the scope of underground economy (Alanon and Gomez-Antonio, 2005). According to World Bank’s doing business rankings, the...
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