Abstract: After Latvia achieved independence from the Soviet Union in 1991 its government faced the monumental task of overhauling not only an antiquated political system
but an obsolete economic system as well. Part of reforming the economic
system meant instituting a tax policy that was friendly to and
compatible with private enterprise. This task was accomplished based
primarily on Western European standards and values. A social welfare
system was put in place and taxes were set to reflect expenditures of
the government keeping in mind the balanced budget demands of the
European Union and International Monetary Fund. Despite the adoption of
Western European practices, tax evasion and the so-called shadow
economy remained far more prevalent than in the West due to the use of
so-called envelope payments. This situation in Latvia and other
developing economies stifled growth and government services and made a
balanced budget extremely difficult and somewhat painful.
When tax rates are too high companies understand that they cannot
afford to do business if they are forced to pay all taxes associated
with their activities. This leads them to use the system of envelope
payments and other means to avoid taxes on certain transactions in
order to bring their tax burdens under control. This creates a
sub-optimal equilibrium as firms cannot abandon the practice of evasion
as long as their competitors do not, even if they can economically
afford to do so.
Lower tax rates, whether in the form of VAT, income, or other taxes
could serve as an economic incentive for companies to forgo offering or
accepting envelope payments by making the costs of evasion higher than
the costs of paying taxes. This would serve to increase the percentage
of transactions that are taxed and would allow time for both economic
and social factors to take hold and make tax-paying an accepted part of
life.
In this paper I argue that tax evasion in transition economies can be
reduced by instituting lower tax rates initially and scheduling
increases based on the rate of decrease in the country’s shadow economy
as measured by the International Monetary Fund. I accomplish this by
developing a formula for calculating a tax level at which an economic
incentive can be created to establish a tax-paying equilibrium. My
formula makes use of economic indicators combined with tax levels,
levels of government spending and IMF data on shadow
economics.
