(c) The Chartered Professional Accountants of Canada. Contact CPA Canada for permission to reproduce this article., Public Interest

Risky business

By Lisa van de Geyn

Operating in the underground economy might seem smart in the short term, but it creates a host of negative consequences for the economy, businesses and consumers.

Few – if any – countries fared worse than Greece in the aftermath of the financial crisis of 2008. Fast-forward nearly nine years and the economic outlook in the country is anything but sunny. “Last year was tumultuous, punctuated by two elections, a referendum, the imposition of capital controls, negotiations to reach a bailout deal, cliffhanger parliamentary votes and Athens’ closest brush yet with bankruptcy and euro exit,” says a story that ran in The Guardian last January. During this debt crisis, the Organization for Economic Cooperation and Development reported that nearly one-fifth of the country’s population didn’t have enough money for daily food expenses. Widespread unemployment led to a significant number of people losing their homes. Food and medicine were in short supply. In the run-up to a recent referendum on creditor-proposed reforms, banks temporarily closed their doors and ATMs ran out of cash. All of this was because the government didn’t have the funds to make payments on its national debt.

While there isn’t one simple reason why Greece’s economy continues to deteriorate, it’s hard to discount the role its underground economy (UE) has played in the crisis. A 2014 article in The Economist reported that two out of three Greek workers understate their pay or fail to disclose earnings altogether (this from an adviser to the Bank of Greece). It also stated that in 2013, 24% of “all economic activity in Greece went undeclared to evade tax and regulation, well above the European average of 19%.” When two-thirds of a country’s citizens fail to report or underreport income, they starve the government of tax revenues and, eventually, everyone suffers.

Underreporting income might seem like a good idea to individuals in the short term, but the long-term effects are devastating. If left to operate unchecked, the shadow economy can lead to higher taxes for everyone, a lack of funding for social programs and can even contribute to the whole system collapsing, as it did in Greece.

While the shadow economy is obviously rampant in parts of Europe (Bulgaria, Romania and Turkey are notorious for their underground economies), Canada isn’t off the hook when it comes to the illegal sector — we aren’t immune to tax evaders, fraudsters and the like. Statistics Canada estimates underground economic activity in 2013 totalled $45.6 billion in Canada, or 2.4% of our total gross domestic product (GDP). It says this has been stable since 2002 (the highest was 2.7% of the GDP in 1994 and the lowest was 2.2% in 2000). The Canada Revenue Agency (CRA) uses Statistics Canada data to point to four industry sectors that account for about two-thirds of the total UE: residential construction (28%); finance, insurance, real estate, rental, leasing and holding companies (13%); retail trade (13%); and accommodation and food services (12%). We might be small potatoes when compared to Greece, Bulgaria and other countries in the EU, but the CRA says this doesn’t mean that the nature of the UE will be changing any time soon. These fraudsters are here to stay. “Despite the stability in the size of the underground economy, participation in the UE is not acceptable and can erode the integrity of Canada’s tax system if left unchallenged,” says the CRA.

James Guy, professor emeritus at Cape Breton University in Sydney, NS, defines the UE as “people who are working for employers ‘off the books’; unreported rental income, tips, child-care earnings, bartering, income from the sale of homegrown products, music and entertainment, and merchandise sold at local markets; illegal gambling, smuggling and some construction activities.”

What happens to a government revenue system when an expanding number of patrons avoid paying their fair share of taxes? “The operation of the government is weakened: social programs go underfunded and face cuts; employment insurance, old age pensions, provincial welfare, transfer and equalization payments are lessened; the Canada Health Transfer and the Canada Social Transfer are examples where an essential account of money gets shortchanged,” Guy says.

The unofficial economy also negatively affects the allocation of resources and labour. In a market-based economy, says Monika Çule, department head and associate professor in economics at the University of Regina in Saskatchewan, prices provide signals for how resources should be allocated. “For instance, a farmer can use his or her land in alternative productions, either to cultivate lentils or wheat. The price of these crops (or the relative price) is a good signal on how to use the land as a productive resource. If wheat prices increase because the global demand for wheat increases, more farmers will grow wheat and thus less land will be used to grow lentils.” But if prices are paid underground, these signals are missed or are inaccurate. Inaccurate signals will misdirect the allocation of resources.

Canadian-born economist John Kenneth Galbraith once called the UE the “enviable economy.” “He sarcastically called it enviable because of its impressive efficiencies. It operates with no government regulation and services, participants keep untaxed money and, like a parasite, it lives for free off the strength of another economy — mainly the legal one,” says Guy, paraphrasing Galbraith.

And that is, of course, where the trouble lies. These freeloaders don’t exist in a vacuum — their activities create a host of effects and consequences the UE has on the economy, businesses and consumers who engage in it. Here’s how the shadow economy is affecting the lives (and finances) of Canadians.

Consequences for businesses

There are a host of issues businesses that engage in the UE can face, but there are also negative consequences for by-the-book-businesses. “Businesses that participate in the underground economy are keeping their costs lower by, for example, not charging customers the relevant taxes. This means they have an unfair advantage in the marketplace,” says Chris MacDonald, associate professor of law and business at the Ted Rogers School of Management at Ryerson University in Toronto. “When you’re a completely compliant firm, and by completely compliant it’s not just on the tax side but on the labour regulations side, following all the rules, you are going to be more costly than a firm that isn’t,” adds Lindsay Tedds, associate professor in the School of Public Administration at the University of Victoria in BC. “Construction associations, for example, are very supportive of cracking down on the UE because it’s a competition issue and we want to make sure that we do everything we can to allow firms to be competing with the same costs and info.”

Competition obviously plays a big part here. Jonathan Farrar, associate professor at the School of Accounting and Finance at the Ted Rogers School of Management, says if there’s a business trying to abide by the rules and another business that’s based on cash under the table, “it’s obvious that the cash-based business has an advantage — it can undercut the competition. They have more incentive to engage in UE activities because they can get a leg up on their competition.” This, he says, can potentially turn an honest business into becoming dishonest. “If they can’t compete, they could feel they have no other recourse than to engage in the UE.”

With under-the-table behaviour come other forms of UE activities. “If I had a business and I knew I could bring in undocumented workers, for example, instead of going down to an employment agency and hiring someone there, I’m going to be saving quite a bit of cost in terms of not paying payroll taxes such as CPP premiums, as well as less administrative time spent,” says Farrar. “So there could be more incentives for businesses to hire undocumented workers just because they don’t have to pay taxes.”

The thing is, if UE businesses aren’t paying payroll taxes, the pool of businesses that do pay is smaller, and in order to make up the shortfall, governments may have to generate tax revenues from other sources, such as raising corporate taxes or increasing payroll taxes. The end result? Legitimate businesses have to pay more than they would have paid if everyone had contributed their fair share in the first place.

Of course, it should be noted that businesses that engage in the UE could find themselves in a hotbed of tax and legal trouble. If discovered, “they’re reassessed based on what the auditor determines to be the income they should’ve reported and they have to pay all income taxes they should’ve paid as well as interest and penalties and interest on the penalties. It’s a fairly expensive thing to have to deal with if in fact a business is busted or caught by the CRA,” says Farrar.

Consequences for individuals

Last year, Ontarians Dawn and Mark (not their real names) decided it was time to renovate their 30-year-old kitchen. When they hired contractor X, it was made blatantly clear that if they paid for the very expensive job in cash, they wouldn’t be charged HST. At one point Dawn heard contractor X speaking with partner Y and it sounded to her as though their particular renovation would be an under-the-table job for the company. “In hindsight, I wish I’d asked them to confirm whether they were following the law, paying taxes on the job and whether I’d get a warranty for their work, but I didn’t at the time. It’s a mistake I’ll never make again,” says Dawn, who ended up with a problem with her flooring installation. (Luckily the crew fixed the work after the job was all said and done, but she knows now that she could have been up a creek without a paddle if the company had taken off. It happens all the time.)

Here’s the kicker — both Dawn and Mark have jobs, pay their taxes, contribute to CPP, etc. While they might have saved several thousand in HST on their kitchen job, they (like the rest of Canadians) will eventually pay more tax if the government loses too much revenue to the UE cheats and has to increase income tax rates or implement new taxes to make up for the shortfall. “Tax evasion leads to fewer or lower quality of goods and services delivered by the public sector and those who pay taxes bear the higher burden of paying taxes for what is delivered,” says Tedds.

The CRA says that if you pay cash and don’t get a written contract or receipt when you purchase goods or services, you may be helping someone cheat on his or her taxes. “You may also be putting yourself at risk, particularly when it comes to home renovations,” says the CRA. “For example, getting a cash deal from a contractor for renos without a written contract is risky. You have no protection against poor or incomplete work; being sued if a worker gets injured; cost overruns; the use of sub standard materials; responsibility for damages to your or a neighbour’s property; or fraud, when you pay for work that’s never done.”

“As consumers, it’s important for us to know when we make decisions to go with a cheaper supplier or a cheaper good that we fully understand why it’s cheaper and what that consequence is,” says Tedds. “So you have consumers who will do everything to save a buck and in the end they can end up with a reno that hasn’t been permitted, with shoddy construction, and they end up in court.”

Farrar says, as a consumer, when he’s dealing in areas where he knows there’s an element of tax noncompliance, he does his due diligence before he deals with a particular vendor. “Don’t go for the cash-only deal. Make sure they have a GST number if they’re a business that is large enough. These are things that also protect you in terms of the quality of the service that you’re getting, and you have more vehicles open to you if the quality of the service is poor than if you go through an underground supplier,” he says.

Besides the legal ramifications (you truly don’t have any recourse if you deal with a business that doesn’t offer a tax number or warranty, etc.), there’s a psychological component of dealing in the UE as a consumer. “People have to live with themselves and if you know you’re aiding and abetting some kind of illegal activity, that’s something you have to be able to come to terms with. There’s a psychological risk here of personal discomfort. ‘If I can get a better deal with contractor X than Y, I’ll pay X whether or not he has above-board practices’ is not a situation you want to find yourself in.” (Of course, adds Farrar, there is a snitch line — you can always make an anonymous tip to the CRA if you suspect someone is engaging in illegal activities.)

When it comes down to it, you give up all recourse if things go sideways. “People who decide to engage or transact with firms or entrepreneurs in the illegal sector also give up the ability to use the court system in case of litigation that could happen,” says Steeve Mongrain, professor of economics at Simon Fraser University in Burnaby, BC. “Let’s say you hire roofers from the shadow economy without records to redo your roof. You’re now prevented from falling back on a warranty or pursuing a legal suit in case of negligence. The threat of a lawsuit is there to keep people in check, engaging in workers’ compensation and not using negligent products and techniques. There is no such threat for workers in the shadow economy.”

Are their positives to the UE

It may not be popular opinion, but many experts agree there is a place for the underground economy. “One of the areas I think we have to pay attention to is that a certain degree of informality is a necessary part of growing a business,” says Tedds.

“You don’t necessarily want to crack down on all of this level of informality because you can never have complete compliance — that’s completely unrealistic and it can have negative economic consequences.” Tedds says women in particular who start their own businesses from home need a certain amount of knowledge about our tax system to be compliant. She points to this example: maybe you start baking cakes for your friends and soon your friends start recommending you to their friends and you’re taking orders from them. “The next thing you know you have a business you didn’t mean to and suddenly you realize you’re a business and now you’re trying to be tax compliant.” With the information that’s out there, you likely don’t understand the next steps and become an ostrich, burying your head in the sand. “I don’t blame these people,” says Tedds. “Everything we put out there is in government speak and isn’t meant to allow individuals to quickly and easily acquire the information they need. You shouldn’t have to go to an accountant or a lawyer to be tax compliant.”

Can we curb the UE?

Yes, says Farrar, who says he believes the UE is likely to shrink. He points to three main reasons. The first is that there’s a lot less cash being used these days. “We’re using credit, debit, mobile payment apps. If you have an economy where there are lots of cash transactions, you definitely have the potential for illegal activities. But once cash becomes less common, the UE should shrink the opportunity to engage in non-reporting of transactions,” he says. Second, there’s a lot more availability of third-party sources of information out there. “It’s less and less common for only one or two people to have access to information. There’s more of a universal use of computers to store and access information, so it’s increasingly more difficult for people to hide transactions,” he says. And lastly, Farrar predicts there will be fewer and fewer traditional mom-and-pop shops with globalization. “It’s more likely people will be employed with very large organizations that of course don’t deal in cash. If you change the form of the structure of the business and there are fewer smaller ones and more larger ones, then the opportunity for participation in the UE would shrink.”

The CRA agrees — it believes that finding unreported or under-reported income through data analytics, legislative tools and other sources of information will allow the agency to look at industry trends and be able to identify and address those who refuse to meet their obligations. They’ll also keep up on the UE and work to reduce the social acceptability of participating in it. For example, to reduce the UE in the construction and home renovation sector, the CRA works with the Canadian Home Builders’ Association, which runs the “Get it in Writing!” campaign. “The campaign focuses on the importance of getting a written contract for renovation projects,” says the CRA. Concludes Farrar, “Yes, the UE is a problem, but maybe it’s not quite as severe as we think it is.”