In a new paper, three economists estimate “true income” using observed loan amounts approved by a large commercial bank in Greece. The key innovation of their paper is the use a bank's loan to income ratio – which should not be exceeded if the bank were to manage default risk. But what if banks are approving loans at an income to debt ratio way beyond their acceptable risk tolerance? Well, this may mean the bank actually believes the applicant has a higher income than reported in tax returns. The authors exploit this wedge – the difference between reported income and the income implied by the size of loans issued – to infer the “true” income and consequently the level of tax evasion. The key assumption is that wage workers report their true income while the self-employed underreport. But in economies where tax evasion is pervasive, banks take this information into consideration and adjust their estimate of actual income to reflect tax evasion.

Unsurprisingly, the authors find that for a self-employed individual loan applicant, the approved loan size implies on average a true income that is 1.75 times the reported income. For the average self-employed individual in Greece, true income is 19,478€ out of which 14,608€ is not reported! This estimate implies a tax evasion rate of approximately 43%. Through the years 2006 to 2009, tax evasion ranges from 22.8 to 28.2 billion €. In the year 2006, foregone tax revenues would have accounted for over 100% of the primary deficit, assuming a 40% tax rate.

However, evasion ability varies by industry. Lawyers, doctors, teachers and engineers form the first tier of tax evaders. Across these industries, the average self-employed individual underreports their income by 24,000-29,000€. These industries are also most characterised by the persistent use of cash transactions.

It may seem obvious that the tax authorities would be ‘aware' of the problem of tax evasion and the industries most likely to underreport income. As it turns out, the Greek parliament has attempted to address this issue by passing a law requiring tax audits targeting particular industries. More's the pity, this initiative failed! A politico-economy story may be at work here: the authors further find that up to 60% of parliamentarians have a professional background from the four most tax evading industries. While the association of Greek parliamentarians with tax evading industries is only propositional, it suggests one possible reason for the inability to enact tax reform.

Source: LAFFER