Evidence of a Post-GST Increase in the Underground Economy

Abstract

Experience in other countries suggests that evasion of value-added taxes is a significant problem at the retail level. There is a likelihood that, at the margin, switching from the narrow-based federal manufacturers’ sales tax to the broad based goods and services tax (GST) may have increased the incentives and opportunities for tax evasion in Canada. This study analyzes the growth in cash balances held by the public, as an indicator of transaction volumes, and finds that there has been a substantial increase in the underground economy since the introduction of the GST. The underreporting of income means that not only GST revenue is lost, but also the associated income tax and provincial sales tax. The increase in the size of the underground economy in this paper was inferred in a somewhat simplistic way from the residuals in an equation estimating the demand for cash. This approach was refined in the author's subsequent paper in the Canadian Tax Journal, "Estimating the Underground Economy: A Critical Evaluation of the Monetary Approach," (1994), Vol. 42, No. 4.

Keywords: underground economy, tax evasion, value added tax, Canada, GST, cash

JEL Classification: H26, H24