Solving the tax evasion problem by co-opting the public: the Korean cash receipts system^*

* Accepted by Suresh Radhakrishnan

Abstract

In 2005 the Korean government instituted a mandatory cash receipts system to curb tax evasion by cash-based companies in the retail sector. We estimate that the system significantly decreased business tax evasion, and was cost-effective. Because it was a significant intervention, the system also had unintended consequences, including increased prices in the retail industry, firms exiting the market, and asymmetric wealth transfers across classes of individual taxpayers. The results have important policy implications for countries and/or subnational governments which consider adopting similar systems.

Keywords:

• tax evasion
• tax shifting
• income tax

Acknowledgements

The authors acknowledge the helpful comments of Eric Allen, Ayse Imrohoroglu, and participants at the 32nd Annual International Business Research Conference in Melbourne, Australia.

Notes

* Accepted by Suresh Radhakrishnan

1. See literature survey by Fuest and Riedel (2009).

2. The cash receipt lottery was designed to encourage non-wage and salary earners who did not receive income deduction benefits (e.g. students) to request cash receipt issuance more frequently. The lottery was drawn once a month on a national TV with prize money ranging from 50 thousand won (5th place) to 100 million won (1st place). It was discontinued after a few years.

3. Cash receipt cards are provided by the NTS for free of charge to address privacy issues and entry errors when providing personal ID numbers. Different types of cash receipt cards are provided for consumers and business owners. Cash receipt cards can be applied for at the District Tax Office, cash receipt website and the NTS call center.

4. See Annual Report of the Korean NTS, 2014 and later years.

5. See Annual Report of the Korean NTS, various years.

6. Ibid.

7. Ibid.

8. Ibid.

9. It was well known that firms offered such discounts to consumers for cash purchases.

10. The tax benefit under Korean law is an amount spent on credit cards exceeding 25% of total salary, where the deduction rate is 15% for credit card purchases, and 30% for cash purchases. The deduction limit is 3 M won or 20% of salary income, whichever is lesser.

11. Realistically, consumers would use an approximation for the above math (especially as to whether they expect any expenditure to be eligible for the deduction, i.e. the 15% of income threshold has been exceeded, or will be exceeded), so the above is just an assertion subject to empirical testing. For example, Chetty, Looney, and Kroft (2009) used experiments in retail stores to see if customers calculated sales tax effects. Customers who had sales tax effects posted had their decisions affected, whereas those in the ‘normal’ setting (where sales tax is determined at the cash register) did not. As in the Chetty et al. setting, here it is arguable that there are either cognitive limitations or people are unwilling to expend the energy doing the math when the amounts at stake are modest.

12. cf. Allingham and Sandmo (1972); Yitzhaki (1973).

13. See Annual Reports, various years, Korea NTS.

14. The firm would receive a VAT credit for purchases, thus reducing the net tax to below 10%.

15. Based on authors’ calculations, using NTS data.

16. As mentioned previously, there are small countervailing positive effects for firms to issue cash receipts, including a 1.3–2.6% VAT credit of the corresponding transaction, and a 20 won tax credit for transactions at less than 5 thousand won.

17. If the business operates in a non-competitive market, prices can be raised to recoup some of the tax; here, the price charged for a ‘with receipt’ cash transaction could potentially increase by anywhere from 10% (if the vendor does not pass on any of the income tax) to 30% (assuming vendor passes on all of the income tax).The stated price to the consumer, P*, is P (1 + Ф τ _υ + (φτ _c)), where Ф and φ range from 0 to 1 depending (if markets are perfectly competitive they are equal to 0), and τ _υ and τ _c are Vat and company tax rates, respectively. If the consumer’s marginal income tax rate is τ _i, then the real price paid by the consumer is P″ = P ((1 + Ф τυ + (φτ _c))(1 − 0.3 τ _i )). The after tax-deduction price to the consumer, P′, thus ranges from (1 − (0.3) (0.18))*(1.1) = 0.902 to (1 − (0.3) (0.18)) (1.30) = 1.08. The consumer would accept the first ask, but reject the latter. The maximum acceptable (to the consumer) tax passed on would be 1.22 or the 10% VAT plus 12% income tax (or slightly more than half). If the consumer’s tax rate is below the median or 18%, the vendor would have to charge an even lower price for no receipt; if the consumer’s tax rate is higher, less of a discount would have to be given. Similarly, if the vendor’s income tax rate is lower than the median (likely since the vendor would be able to charge costs of goods sold), less of a discount would be offered.

18. Except for 1997, differences between the two sources were typically less than 5%. Consumption expenditures (in billion won) by year, with NTS data in parentheses, are: 1997: 255 (273.3 ) 1998: 250.3 ( 254.9); 1999: 289.9 (292.7); 2000: 330.4 (333.6); 2001: 364.3 (367.9); 2002: 408.7(413.1); 2003: 420.1 ( 423.7); 2004: 435.1 ( 437.8); 2005: 465.4 (466.7); 2006: 494.9 (495.2); 2007: 530.3( 529.8); 2008: 561.6 ( 560.9); 2009: 575.9 (574.8); 2010: 616.9 (615.2); 2011: 655.4 (655.1); and 2012: 680.8 (678.1).

19. Data from Bank of Korea data, as reported in Statistics Korea.

20. Conversations with Korean bankers indicated no major credit card policy, rate, etc. changes during the post 1999 period which might account for such increases. We also examines usage growth rates reported for other countries as a benchmark, as reported by (World Payments Report, 2008). Growth rates over 2001–2006 for Korea were 13%, compared to 5% for the US and 7% for the Eurozone.

21. A portion of Korean small businesses are run as corporations. The average corporate effective rate (using detailed NTS data) for corporations was 22.8%. The average individual rate (again using detailed NTS data) was 18%. A simple average of the individual and corporate rates is thus 20.4%.

22. The lottery was phased out after 2005. In later years, there were equivalent costs in ‘informant’ rewards related to non-complying firms. NTS gave us the following such costs: 133 million won for 2010, 187 million won for 2011, 186 million won for 2012, 271 million won for 2013, and 3.3 billion won for 2014.

23. There is also an additional VAT burden. While such firms must pay a VAT on purchases made to vendors, some of this is passed on to consumers. The net effect increase in VAT is the firm’s profit margin times the VAT rate, which acts like an additional income tax. Accordingly, we lump this tax together with income tax effects, discussed above. We also ignore any penalties and interest which firms may incur as a result of being audited due to increased sales reported. We simplify by here lumping these into the income tax rate on the assumption that they are proportional to income taxes and VAT incurred.

24. Refer to any public economics text for similar discussion/derivations of the basic Harberger result.

25. KOSIS only collects data for these industries so we cannot use all industries as our control groups.

26. Subindustries include the followings: Catering, Hospitality, Hotels and restaurants, Lodging operating, Drinking Places and Non-Alcoholic Beverages Places, Restaurants and pubs, Retail Sale of Fuel, Retail Sale of Foods, Beverages and Tobacco, Retail Sale of Other Household Equipment, Retail Sale of Motor Vehicles and Related Parts and Accessories, Retail Sales of Textile Clothing Footwear and Leather Goods Retail, and other Retail sale in Non-Specialized Stores, in Other Specialized Stores, and not in Stores, Wholesale and Commodity Brokers, Wholesale and Retail Trade, Wholesale of Agricultural Raw Materials and Live Animals, Wholesale of Construction Materials, Hardware and Heating and Air Conditioning Equipment, Wholesale of Food, Beverages and Tobaccos, Wholesale of Household Goods, Wholesale of Machinery Equipment and Supplies, Wholesale of Non-Specialized Goods, Wholesale on a Fee or Contract Basis, Other Specialized Wholesale.