Information sharing, bank penetration and tax evasion in the developing countries

VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS INFORMATION SHARING, BANK PENETRATION & TAX EVASION IN THE DEVELOPING COUNTRIES BY VO MANH TAN MASTER OF ARTS IN DEVELOPMENT ECONOMICS HO CHI MINH CITY, NOVEMBER 2016 UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES HO CHI MINH CITY THE HAGUE VIETNAM THE NETHERLANDS VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS INFORMATION SHARING, BANK PENETRATION & TAX EVASION IN THE DEVELOPING COUNTRIES A thesis submitted in partial fulfillment of the requirements for the degree of MASTER OF ARTS IN DEVELOPMENT ECONOMICS By VO MANH TAN Academic Supervisor Dr VO HONG DUC Ho Chi Minh City, November 2016 DECLARATION I hereby declare, that the thesis report entitled, “Information sharing, Bank penetration & Tax evasion in the developing countries” written and submitted by me in fulfillment of the requirements for the degree of Master of Art in Development Economics to the Vietnam – Netherlands Programme This is my original work and conclusions drawn are based on the material collected by me I further declare that this work has not been submitted to this or any other university for the award of any other degree, diploma or equivalent course HCMC, November 2016 Vo Manh Tan i ACKNOWLEDMENTS Immeasurable appreciation and deepest gratitude for the help and support are extended to the following persons who in one way or another have contributed in making this study possible Above all, I would like to express my special appreciation to my supervisor - Dr Võ Hồng Đức, for his supports, advices, guidance, valuable comments and suggestions It is an honor to work with him I would like to acknowledge all the lecturers and staffs at the Vietnam – Netherlands Programme for their useful knowledge and support during the time I studied at the program In specific, I am grateful to Prof Nguyễn Trọng Hoài, Dr Phạm Khánh Nam and Dr Trương Đăng Thụy, who guided me the first steps in the courses as well as in the thesis writing process I would like to thank my friends at Class 21 for their helps Last, but not least, I would like to thank family, my parents and my sister, who always love, take care of and support me unconditionally on the way I have chosen HCMC, November 2016 Vo Manh Tan ii ABBREVIATIONS TEI: Tax evasion index IRS: The U.S Internal Revenue Services GNP: Gross National Products GDP: Gross Domestic Products OECD: Organization for Economic Co-operation and Development DYMIMIC: Dynamic Multiple Indicators – Multiple Causes approach iii ABSTRACT In April 2016, a huge leak of confidential documents regarding tax affairs, known as “Panama papers”, occurred This leak has revealed information in relation to the way in which the rich has hidden their assets to evade tax with the assistance of a Panamanian law firm, known as Mossack Fonseca The consequences have spread around the world for months, and possible for years, which has been considered as one of the biggest global scandals in relation to tax evasion at all times A question has been put forward in relation to the approach in which the governments of many countries, regardless of the economic development of the nation, have adopted to really manage tax evasion being consistently occurred in the economy This study is conducted in response to this important and hotly debated issue regarding tax evasion Shadow economy refers to taxable business activities but failed to be reported by financial/ tax authority As a result of shadow economy, tax evasion defines illegal activities which aim to conceal taxable income from tax authorities or to include expenses which are not allowed in order to reduce tax liabilities to be paid to the coffers of the governments Tax evasion and shadow economy are critical problems and barriers to growth, regardless of the level of economic development of a nation However, it is argued that the issue of tax evasion is more serious and difficult to be handled in developing countries in comparison with the developed nations An extensive literature review in this study presents that (i) tax and social security contribution burdens, (ii) regulations, (iii) public sector services, (iv) quality of institutions and (v) tax compliance play an important role in the decision of whether or not firms would evade tax Three contributions of this study can be summarized as below First, on the ground of this literature review and other empirical studies, the so-called tax evasion index (TEI) is developed to measure tax evasion in the developing countries Second, potential influences of information sharing and bank penetration from financial intermediate developments on tax evasion is examined using the newly developed TEI Third, potential contributions of firms’ characteristics including firm size and location to iv the relationship between information sharing, bank penetration and tax evasion is discussed and quantified The sample consists of 112 developing countries during the period of 2006 to 2014 using data from standardized World Bank Enterprises survey 2006 – 2014 The new TEI is constructed by calculating equally weighted average of five indicators which represent the main five sources of influence This new index falls within the range of to As such, Tobit regression is utilized to examine the relationship between information sharing, bank penetration and tax evasion Findings from this study indicate that there is a substance variance in relation to tax evasion, which is proxied by the new TEI in this study, among 112 countries adopted in the research sample The difference of the TEI across countries is mostly explained by the difference in public sector services Corruption contributes the largest part to the estimate of the TEI with the average of 2.76 over the maximum of The average TEI for developing countries in the sample stays at 0.62 with the lowest estimate of 0.25 (for Etritrea) and the highest estimate of 0.7539 (for Brazil) In addition, empirical analyses indicate a consistent and negative relationship between information sharing, bank penetration and tax evasion in developing countries Finally, large firms are generally considered to have adopted good tax compliance practices while firms located in remote areas are more likely to evade tax Key words: Tax evasion, Shadow economy, Information sharing, Bank penetration, Developing countries v TABLE OF CONTE DECLARATION ACKNOWLEDMENTS ABBREVIATIONS ABSTRACT TABLE OF CONTENTS LIST OF FIGURES LIST OF TABLES Chapter 1: INTRODUCTION 1.1.Problem statement 1.2.Research objectives 1.3.Research questions 1.4.Contribution of the thesis 1.5.Structure of the thesis Chapter 2: LITERATURE REVIEW 2.1.Explaining tax evasion 2.1.1.Tax evasion approach 2.1.2.Tax evasion framework 2.1.3.Empirical evidence 2.1.4 Determinants of tax evasion 2.2.Connection with information sharing and bank penetr 2.2.1 Information sharing and bank penetration in financial system 2.2.2 Information sharing and Bank penetration role to tax evasion Chapter 3: DATA AND METHODOLOGY 3.1.Methodology 3.1.1 New tax evasion index 3.1.2.Conceptual framework 3.1.3 Financial developments versus tax evasion 3.2.Data vi Chapter 4: RESULTS AND DISCUSSIONS 32 4.1 The first hypothesis: Information sharing, bank penetration and tax evasion 32 4.2 The second hypothesis: Firm size and location influences 35 Chapter 5: CONCLUSIONS 39 5.1 Conclusions 39 5.2 Policy implications 41 5.3 Limitations 42 REFERENCES 43 Appendix A Definitions and sources of variables 48 Appendix B Data summary and list of industries 50 Appendix C Tax evasion index in the developing countries 51 vii LIST OF FIGURES FIGURE Conceptu FIGURE Tax evas 2014 LIST OF TABLES TABLE Tax evasion index by country in 2006 – 2014 28 TABLE Tobit regressions about effects of information sharing and bank penetration to tax evasion status 33 TABLE Tobit regressions about effects of firm size on the relationship between financial development variables and tax evasion status 36 TABLE Tobit regressions about effects of location on the relationship between financial development variables and tax evasion status 37 TABLE Data summary 50 TABLE List of industries 50 viii Chapter CONCLUSIONS 5.1 Conclusions Shadow economy refers to taxable business activities but failed to be reported by financial/ tax authority As a result of shadow economy, tax evasion defines illegal activities which aim to conceal taxable income from tax authorities or include expense which are not allowed to reduce tax liability By report a smaller income, or in extreme case, no income, enterprises could evade tax and save the money Enterprises which have evaded tax face potentials of being caught cheating and not only the amount of evaded tax but also a fine is applied Tax evasion and shadow economy are critical problems and barriers to growth, regardless of a level of economic development However, the issue is more serious and difficult to tackle in developing countries than in the developed nations An extensive literature review presents that the following factors have generally played an important role in the decision of whether or not firms would evade tax that: (i) tax and social security contribution burdens; (ii) regulations; (iii) public sector services; (iv) quality of institutions; and (v) tax compliance This study is conducted to provide a closer look to tax evasion in the developing countries by (i) developing a new TEI using data from standardized World Bank Enterprises survey 2006 – 2014; (ii) exploring the importance of information sharing and bank penetration to tax evasion; and (iii) investigating the role of firm size, location to the information sharing, bank penetration and tax evasion relationship Key findings from this empirical study can be summarized below First, on the ground of the literature review, tax evasion in many aspects, from approach to framework and determinants, is analyzed A model approach for tax evasion is adopted to combine multi indicators and multi causes in a newly developed unique index Then, the influential factors including: (i) tax and social security contribution 39 burdens; (ii) regulations; (iii) public sector services; (iv) quality of institutions; and (v) tax compliance using the equal weight are applied to develop the so-called new tax evasion index (TEI) This new index varies within the range of 0.25 to and there is no zero-value included within the range In the research sample, Brazil has highest TEI of 0.7539 whereas Eritrea has the lowest TEI of 0.25 The variation of TEI across countries is approximately 0.17, mostly caused by difference in public sector services Corruption contributes the most part to the index with its mean of approximately 2.76 within the range of and Second, a compact model developed by Beck et al (2014) was used to develop the research methodology and to test the research hypotheses A series of tobit regressions is adopted to investigate the information sharing, bank penetration and tax evasion relationship, using the TEI as a proxy for tax evasion The empirical results present that higher level of information sharing and bank penetration might lower tax evasion for countries in the research sample This is consistent with findings from previously empirical studies including Brown et al (2009) and Beck et al (2014) Third, the interactive terms of financial developments, firm size and location are then added to the regression equation to examine the role of these factors to the relationship between information sharing, bank penetration and tax evasion Our results indicate that larger firms are less likely to evade tax in the environment with high financial developments We also note that firms located in the small regions appear to evade tax more often than in medium sized cities if there is at least a high level of information sharing or bank penetration The characteristics of locating in capital cities or small in size not significantly impact the relationship between information sharing, bank penetration and tax evasion These empirical results have provided additional empirical evidence to the literature in relation to the firm size and location effects to link between tax evasion and financial development 40 5.2 Policy implications On the ground of the above empirical findings, policy implications are then drawn for the developing governments in general including the Government of Vietnam Each of these policy implications is discussed in turn below First, the development of the new tax evasion index (TEI) is urgently needed which can provide the governments with the evidence to implement policies which include the best possible approach method to reduce tax evasion in a country The set including five fundamental factors, which is adopted in this study, is not only used in the TEI calculation but also provides an insight for tax authorities to consider each issue included within the group separately: (i) tax and social security contribution burdens; (ii) regulations; (iii) public sector services; (iv) quality of institutions; and (v) tax compliance Policies addressing the weakness in these areas may provide constrain to tax evasion occurring in the economy For example, findings from this study indicate that corruption is the most serious issue for tax evasion due to its largest contribution to the newly developed index As such, controlling corruption in developing countries including Vietnam can be considered as an effective approach to limit tax evasion Second, the relationship between financial developments such as information sharing, bank penetration and tax evasion suggest another idea for tax governance This relationship is found negative and significant, which means that higher information sharing and bank penetration reduce tax evasion This finding supports the view that a higher level of financial developments could be focused as an effective method to constrain tax evasion Third, on the ground of the analyses, it appears that even if there is a high level of information sharing and bank penetration in a country, firms locating in small city appear to evade tax more often because isolation could provide more opportunities for tax cheater As such, governments in the developing countries should enhance tax authorities in quantity and quality in small cities so as these new forces can limit tax evasion through random tax inspection Together with the enhancement, the governments may also have 41 to care about corruption to guarantee fairness and accuracy in the process of revenue collection 5.3 Limitations This study has some limitations which can suggest further researches First, the TEI should be constructed in a weighted method with unique coefficient for each area, country and industry instead of equally distributed Second, more robustness test and improvement could be made to enhance regression results Third, data is available for Vietnam to run 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Log of manager’s Question b7: How many years of experience working in this sector does the top manager have? World Bank Private Enterprise Survey experience level Source: Author’s analysis 49 Appendix B TABLE Data summary and list of industries Data summary Variable Tax rates obstacle Electricity obstacle Business license obstacle Political obstacle Corruption obstacle Tax evasion index Info sharing Depth of info sharing Demographic bank penetration Geographic bank penetration Small firm Large firm Capital city Small city Ln (GDP per capita) Ln (Firm age) Ln (Top manager's experience) Source: Author’s analysis TABLE List of industries No Industry Textiles Leather Garments Food Metals and machinery Electronics Chemicals and pharmaceuticals Wood and furniture Non-metallic and plastic materials 10 Auto and auto components 11 Other manufacturing 12 Retail and wholesale trade 13 Hotels and restaurants 14 Other services 15 Other: Construction, Transportation, etc Source: Author’s analysis 50 Appendix C Tax evasion index in the developing countries FIGURE Tax evasion index in the developing countries, mean value from 2006 to 2014 Tax evasion index (mean) 0,8 0,7 0,6 0,5 0,4 0,3 0,2 0,1 0 20 Source: Author’s analysis 51 ... exploring the importance of information sharing and bank penetration to tax evasion; and (iii) investigating the role of firm size, location to the information sharing, bank penetration and tax evasion. .. of institutions and (v) tax compliance 2.2 Connection with information sharing and bank penetration 2.2.1 Information sharing and bank penetration in financial system Information sharing in financial... tax evasion  Second, estimating the effect of higher information sharing level and wider bank penetration to tax evasion in developing countries using new tax evasion index  Third, investigating