Why tax evasion threatens to become endemic due to how Cyprus was bailed out

Agora Contributor: Alexander Apostolides
Photo by Myrto Papadopoulos [www.myrtopapadopoulos.com]
Photo by Myrto Papadopoulos [www.myrtopapadopoulos.com]

One of the most difficult economic concepts for politicians to understand is the idea of dynamic equilibrium. Political economy is based on the idea that it is next to impossible to return to a past condition once expectations are altered.

In "Freakonomics," Steven Levitt and Stephen Dubner used the example of a daycare centre to explain the concept clearly: Exasperated owners decided to place a financial penalty on parents who were late in picking up their child; when they imposed it they saw that cases of tardiness rose as parents factored in the cost of their fine when calculating the optimal time to pick up their child. As the plan backfired, the owners decided to drop the fine, only for tardy cases to keep rising: the parents’ expectations of what was acceptable behavior had changed for good and tardiness remained an issue.

The Cypriot bail-in and the very severe economic downturn that followed are creating similar problems with tax evasion. What is acceptable in a society is as malleable as the parents’ expectations in that daycare centre. This is a real worry for Cyprus. The bail-in has changed expectations on the fact that deposits are not always safe; it is threatening to make tax evasion more socially acceptable as well.   

Cyprus was not known to have particularly severe tax evasion problems, at least for households. The same might not be said for companies, since Cyprus did also function as a centre for company (many of which are “brassplate”) registration. Although issues existed, the general consensus is that the high zero percent income tax threshold for Cyprus (one is taxed after making 19,500 euros) combined with a relatively professional tax service, has allowed Cyprus to avoid the severe tax evasion issues of Italy or Greece.

And yet the way the bail-in was handled in Cyprus creates future risks in this respect. Unless they are addressed, the Troika-led effort to increase efficiency in tax collection will fail. Firstly, the fact that deposits were used to cover bank losses while those two banks were under central bank control has created additional incentives for professionals to miss-record their incomes. Anecdotal evidence suggests a severe drop in declared incomes of the self-employed.

As a medical professional stated to this researcher, people who were bailed-in have changed their attitude towards tax evasion.  Many feel justified to risk the possibility of being captured for tax evasion until they recover the amount that was bailed in. They blame the government system that led to their deposits being affected and resent being taxed (as they see it) twice: once for having an account in Laiki or Bank of Cyprus and for their earned income. Thus worryingly tax evasion now seems more acceptable that in the past, at least for Cypriots who were bailed in.

The effect of the bail-in and crisis does not only affect individuals, but also companies. The Value Added Tax (VAT), raised to 18 percent for most items, is a very tempting cushion for a restaurant or a cafe that is struggling to pay its running expenses. The resurrection of the walled part of Nicosia as a place to go out (recently reviewed by the New York Times) has led to a phenomenon that was not commonplace in Cyprus: a lack of provision of receipts.  As the crisis will intensify the incentive of the owners and the hard pressed consumer align: the consumer can help the owner not to pay tax by not requesting a receipt, hoping that the owner will pass part of the 18 percent discount in cost to him. If this continues without measures to stop it, tax evasion in retail will become the new norm, with damaging consequences for the government finances.

The government has a role in preventing this condition becoming the new equilibrium by pro-actively tackling the issue. Cypriot tax authorities are running a pilot project where luxury car registration is matched to personal income statements; yet this needs to be stepped up and integrated with in situ raids, following the example set in Italy. Tax authorities need to have an action force that can monitor traffic in the multitude of bars and restaurants in downtown Nicosia.

Yet the easiest answer is perhaps the one that is often missed by politicians. Lowering the tax burden of a population who finds its income stretched is an eminently good idea.  Transparency is also important. A lagged disclosure of who is investigated and convicted will help restore the public perception of tax evasion. Yet ultimately in Cyprus, as in all other bailout countries, structural reforms are focused in proximate and not the ultimate causes that created such social distortions in the first place. 

*Alexander Apostolides is an economic historian at the European University Cyprus. For his analysis of economics and politics in Cyprus and Malta visit: www.econcyma.blogspot.com

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