Are there better ways to surface undeclared work?

Earlier this month, it was reported that HMRC were setting in place a voluntary disclosure scheme to encourage regular eBay traders to declare their tax liabilities. In a sign that the tax authorities are treating undeclared income from online trading more seriously, sellers who fail to come forward by the 6 week disclosure deadline will be subject to a penalty of between 40 and 100 per cent of their tax obligations. The figure is between 10 and 20 per cent for those who choose to cooperate with the authorities and declare their earnings.

For a country that is at the forefront of online trading, this appears to be a sensible and timely move. According to analysis by The Economist, by 2016 the ‘internet economy’ will contribute up to 12 per cent of the UK’s GDP, the highest figure among leading industrialised nations by a large margin. Alongside other structural trends such as the continuous rise in the number of self-employed workers (now over 1 in 10 of the workforce), this is creating a number of challenges for tax authorities since it opens up more opportunities for non-compliance.

In a country where some estimate that the ‘hidden economy’ already represents as much as 10% of GDP, it is clear that we will need to find better ways of channelling these informal activities into the formal, tax-paying sphere. One approach witnessed in initiatives like that mentioned above is to deploy greater deterrence measures; ratcheting up penalties for non-compliance and expanding the number of inspections. The reasoning behind this is simple: people will weigh up the cost and benefits of their actions and, assuming a sizable penalty and a strong likelihood of being caught, cease their activities.

This sounds like a reasonable strategy until we consider that the decisions people make are seldom based solely on such a cool and calculated cost-benefit analysis. For some, working informally is the only option available. For instance, those living in poverty and acting as family carers may have to engage in undeclared work to top up low level benefits that would diminish or cease entirely should they work in the formal sphere (this is a central message in the ‘Need not Greed’ campaign established by Community Links). For others like micro-entrepreneurs, the costs of registration, the complexities of book-keeping and the burden of tax on operations prohibit them from running their business in the formal sphere. Applying sanctions for non-compliance in this context could just be the straw that breaks the camel’s back.

This is not to say that deterrence doesn’t work. In many cases it can be the most effective means of drawing out people from informal working patterns, particularly those who have resisted all previous calls and who could still live comfortably while declaring their income. But therein lies the problem of deterrence approaches. They are like using a sledgehammer when a scalpel is needed. Because deterrence is often not tailored to different groups and different needs, everybody is on the receiving end. Whether that’s the persistent non-compliers, the micro-entrepreneurs who are struggling to get by or the vast majority of the population who are fully compliant.

As a number of experts in the field have pointed out, the effect of this blanket approach can often be to alienate taxpayers and non-taxpayers alike, creating an “us and them” culture between citizens and the state. Those who are just about making ends meet are unlikely to respond well to a distant authority which is demanding they pay thousands in taxes for government services which they perhaps rarely feel the benefit of. Studies have shown that deterrence approaches can even embolden taxpayers to engage in more undeclared work in future years.

Arguably what is needed instead is a two-fold approach to addressing the hidden economy. First, we need to cultivate greater tax morality, recognised by many as one of the biggest predictors of informal activity. By this I mean that the state should make people feel that they are getting enough out of the system relative to what they are putting in, and that it should be fair in the way it treats every individual, rich or poor. In practice, efforts to boost tax morality might include introducing more of a contributory principle in welfare services, or establishing the ‘life-cycle’ welfare accounts that the 2020PSH once suggested. It would certainly involve addressing tax dodging from high earners.

Second, we need a more tailored approach to addressing informal activity which combines deterrence with encouragement. Community Links, the organisation that has done most in the UK to look into this issue, recognise that many informal entrepreneurs aspire to formalise their operations and that it just a matter of time before they can grow their business to a size that makes this feasible. Government services could do better to help informal entrepreneurs reach this stage by providing more appropriate advice (the current offer from JCP and Business Link is often not relevant) and decent sources of financial credit. In practice, tailored support could be delivered by segmenting groups and individuals by their risk or otherwise of non-compliance, as has been done by the Australian government.

For anyone keen to know more about effective approaches to addressing undeclared work and supporting hidden entrepreneurs, look out for an upcoming report from the Enterprise team.