1.0 Introduction
When you visit a busy market, street vendors often conduct their sales exclusively in cash, without issuing receipts or maintaining formal sales records. Consequently, a significant portion of their income goes unreported. Meanwhile, in the same town, several homeowners rent out rooms or properties without declaring this rental income to tax authorities, thereby avoiding taxation. This is the so-called "Shadow Economy", also known as the informal economy or black market, which plays a crucial role in shaping national and global economic landscapes.1
The shadow economy comprises economic activities that operate outside official government oversight or record-keeping, intentionally hidden from regulatory bodies. These activities range widely in nature. Some are outright illegal, like trafficking in contraband or engaging in activities such as extortion and bribery. Others include everyday actions like paying employees in unreported cash or informal bartering of goods and services. These transactions typically exist in a legal gray zone, beyond the scope of established laws and not subject to government regulations, taxes, or monitoring.2
In most societies, some form of shadow economy is an inevitable presence. Often, it serves as a crucial source of employment and income for marginalized communities and small enterprises. The formal economy frequently engages with it as well. Economic research, including studies by the IMF (International Monetary Fund) over the past two decades, indicates that approximately two-thirds of the money flowing through the shadow economy quickly re-enters mainstream channels, such as retail spending, thereby indirectly stimulating the formal economy.3
Governments are increasingly aware of the importance of curbing the shadow economy, especially given its ties to issues like tax revenue loss, diminished productivity, and national security risks. However, the challenge lies in the shadow economy's inherent secrecy, making it difficult to detect, quantify, and effectively manage these hidden economic activities. Effective management of the shadow economy is vital for governments aiming to maintain transparency, accountability, and public trust, as well as to foster societal well-being within the broader economic framework.
2.0 The Elusive Nature of the Shadow Economy
Defined as a network of economic activities that circumvent official oversight and taxation, the shadow economy includes unrecorded labour, illicit transactions, tax evasion, and other forms of concealed economic activities. Due to its clandestine nature, accurately measuring the shadow economy's scope presents significant challenges.
The American shadow/informal economy was estimated to have reached $1 trillion in 2009, representing approximately 8% of U.S. gross domestic product (GDP); however, by 2013, largely due to the long-term effects of the 2008 financial crisis and the resulting contraction of the formal economy, underground economic expenditures reached an estimated $2 trillion. Estimates vary, but studies show that the U.S. underground economy is 11% to 12% of GDP, making the underground economy approximately $2.5 trillion in 2021.4
Key questions arise: What drives the emergence of the shadow economy? How do factors like overregulation, high taxation, unemployment, and corruption contribute to its development?
Over-regulation and High Taxation
These are often cited as primary catalysts for the shadow economy's growth. The burdensome nature of excessive bureaucratic processes and tax obligations incentivises individuals and businesses to seek alternatives. This often leads to operations within informal frameworks to avoid state scrutiny, effectively operating 'under the radar'. High tax rates further motivate tax evasion and undeclared labour, diminishing the attractiveness of formal economic participation. This creates a direct link between stringent regulation, high taxation, and the expansion of the shadow economy.
Unemployment and Social Insecurity
These factors also significantly contribute to the shadow economy's allure. Individuals excluded from formal employment often turn to the informal sector as a means of survival. The absence of legal protections in the shadow economy results in precarious working conditions, further highlighting the appeal of informal employment in the face of unemployment and inadequate social security.
Corruption and Inadequate Law Enforcement
State-level corruption and weak law enforcement also facilitate the shadow economy. For example, bribery enables entities to circumvent regulations without facing serious repercussions.
2.1 Impact and Harmful Effects
The shadow economy not only undermines state finances through tax revenue losses but also distorts competition and affects the working conditions and social security of employees in formal sectors.
Loss of Tax Revenues
This shortfall significantly impairs the state's capacity to fund essential public services such as education, healthcare, and infrastructure, adversely affecting societal welfare.
Distortion of Competition
By evading legal obligations, businesses operating within the shadow economy gain an unfair advantage over their law-abiding counterparts, leading to market distortions.
Decreased Efficiency in Economic Activities
Activities within the shadow economy often lack formal legal recognition or registration, depriving them of benefits available to the formal sector, such as access to financing and government support. This limitation hinders the enhancement of productivity through skill and technological development.
Vulnerability of Informal Sector Workers
Employees in the shadow economy are usually not covered by legal safeguards like minimum wage laws, safety regulations, and social security. This lack of protection makes them susceptible to exploitation and unjust treatment.
Lack of Trust in Institutions
The prevalence of a large shadow economy can indicate a lack of fairness, transparency, and effective governance, diminishing public confidence in the government's ability to manage economic and social affairs.
Threats to National Security and Law Enforcement
The shadow economy often facilitates illicit activities, including money laundering, tax evasion, and terrorist financing. These activities pose serious threats to national security and challenge law enforcement efforts.
By offering services that ensure compliance, anti-money laundering (AML), and Know Your Customer (KYC) practices, organizations empower businesses to make informed decisions and aid law enforcement agencies in identifying and mitigating risks associated with illicit activities, thereby strengthening institutional trust and national security.
3.0 Presumptive Taxation
Presumptive taxation involves the use of indirect means to ascertain the tax liability of a Taxpayer which differs from the extant practice of using the Tax payer's annual returns via self-assessment based on the taxpayer's audited accounts.
Presumptive Tax can be referred to as the use of predefined criteria for the assessment of a Taxpayer to Tax. It is the process by which governments estimate or presume the appropriate income of the taxable person on which taxes should be levied.
The Taxpayer majorly designed to be captured under this regime are the class of taxpayers that are hard to assess either because they earn low incomes, sell their goods and offer their services majorly for cash thus making it impossible to apply extant Taxes. These class of Taxpayers are compelled by reasons other than for Taxation to keep books of accounts. Basically, the informal or shadow economy.
The number of these class of Taxpayers is huge which makes it impossible to monitor a reasonable percentage of them and thus, their classification as the informal sector. The above makes it easy for such Taxpayers to conceal their incomes.
Forms of Presumptive Taxes
In line with the provisions embedded in CITA 2007 as amended, there are provisions legitimating presumptive Taxes already. Highlights are as below:-
- In accordance with the provisions of Section 30 CITA 2007, a company can be assessed to Tax on the basis of a reasonable percentage of the company's Turnover. This is regarded as the deemed profit on which Taxes are paid. This is a form of presumptive Tax. The only limitation on this is that the law did not state the rate to be used thus leaving this to the discretion of the Tax authority.
- Section 33 of the same Act provides for the use of minimum Tax as a criteria for assessing a company to Tax. The criteria are predetermined and have no addition or subtraction. They are clearly stated. The only limitation is just that Taxpayers see it as a way of paying Taxes out of the company's capital where the company operates at loss.
- Section 40(2) of the same act talks about excess profit which is the difference between Standard profit and the total profit as computed by the company.
- Section 65(1-3) of the same act provides guidance on the
accessibility of companies to Tax where:-
- The Taxpayer fails to file audited accounts
- Where the company has filed its returns but the Service is of the opinion that the company ought to pay more than what has been filed, the service may reject the returns and to the best of its judgment determine a taxable profit for the Taxpayer
Other Forms of Presumptive Taxes
- Standardized Assessment: This is a way of assigning lump-sum taxes to taxpayers on the basis of occupation or level of business activity. Standardized assessments are capable of broadening the tax base with limited disincentives. This method is, to many scholars viewed more equitable than estimated assessments, and also not as open to corruption as the latter.
- Estimated Assessment: This is a method used with specific indicators. The indicators in use might be income which will be a function of wealth creation specific to a particular profession or a given level of economic activity. The indicators might also range from property location to industrial parameters which might be in terms of the number of skilled staff in the company's employment or the company's net Asset etc.
- Net Asset: The Company's net asset might be a way to estimate the Taxes payable by the Taxpayer whereby the net asset at the beginning of the year might be compared with same at the end of the year.
The National Tax Policy
The NTP, an initiative of the Federal Government driven by the Federal Ministry of Finance sought to set the direction for Nigeria's tax system as well as provide the basis for tax legislation and administration in Nigeria. The NTP in recognizing the different stakeholders in the Nigerian tax system, identifies the taxpayers as the single most important group while reiterating the need to ensure strict compliance with the tax laws at all times. In this wise, it envisages frequent interactions and engagements between the various stakeholders to ensure seamless administration of tax regimes.
The NTP encourages through innovative policy directions i.e a shift from direct taxation to indirect taxation, reduced direct tax rates (Personal Income Taxes and Companies Income Taxes alike) & increased indirect tax rates. This is all in a bid to stimulate economic growth and create an enabling environment for more investment. Regardless of the form of taxation i.e direct or indirect, a good tax system is founded on equality, certainty, convenience and economy; these are still largely relevant in today's economy.
PITA
By the provisions of Section 6 of the Personal Income Tax Act (Amendment) 2011 (hereinafter referred to as "PITA") provides for a new sub-section (6) to Section 36 of the Principal Act which states:
"(6) notwithstanding any of the provisions of this Act, where for all practically purposes the income of the taxpayer cannot be ascertained or records are not kept in such a manner as would enable proper assessment or income, then such a tax payer shall be assessed on such terms and conditions as would be prescribed by the Minister in regulations by order of gazette under it prescriptive tax regime".
However, the provision of the above provision seems not to be in line with an age long principle of taxation which posits that only statutes can create tax obligations. This principle was laid down in Attorney-General v. Railway Passenger Assurance Co.,5 it was held thus:
"The subjects of this country are not to be taxed unless the words of the statute clearly impose the obligation."
The above principle was also followed in Cape Brandy Syndicate v. Inland Revenue Commissioners,6 where the principle of strict interpretation of tax statutes was also established that all tax statutes must be interpreted strictly, in this case, Rowlatt J famously stated:
"In a taxing Act one has to look merely at what is clearly said. There is no room for any intendment. There is no equity about a tax. There is no presumption as to a tax. Nothing is to be read in, nothing is to be implied. One can only look fairly at the language used."
One of the essence of the above principle is the position that taxes seeks to derogate from certain rights of citizens particularly property rights. Therefore, before certain rights of any individual can be legally derogated from, there must be a direct backing of statutory authority. This position was expressed in A.G., Federation v. Abubakar,7 where the Apex court held thus:
"A statute must not be construed so as to take away a right, which already existed before the statute was passed unless there are plain words in the statute which indicate that such was the intention of the legislature. [Ekeocha v. Civil Service Commission, Imo State (1981) 1 NCLR 154 referred to.] (P.92, paras. E-G)"
In F.B.I.R. V. I.D.S. Ltd.,8 the Court of Appeal also following the same principle held thus:
"A law which imposes pecuniary burden is under the rules of interpretation subject to the rule of strict construction. All charges upon the subject must be imposed by clear and unambiguous language because in some degrees they operate as penalties. Therefore, the subject is not to be taxed unless the language of the statute clearly imposes the obligation. The language must not be strained in order to tax a transaction which, had the legislature thought of it, would have been covered by the appropriate words.[Ahmadu v. Governor, Kogi State (2002) 3 NWLR(Pt. 755) 502 referred to.] (Pp. 637-638 paras H-C)...
...In construing a taxing legislation, one has to look merely at what is clearly said. There is no room for any intendment. There is no equity about a tax. Nothing is to be read in and nothing is to be implied .One can look only fairly at the language used. But the strictness of the language interpretation may not always endure to the subject's benefit, for if the person sought to be taxed comes within the letter of the law, he must be taxed, however great the hardship may appear to the judicial mind. [Ahmadu v. Governor, Kogi State (2002) 3 NWLR (Pt. 755) 502 referred to.](Pp. 637 para H; 638 paras. C-E)"
The armada of case law above seems to raise two questions with respect to presumptive taxes namely-- whether presumptive taxes clearly provide for the tax liability of the tax payer and whether section 36(6) of PITA is legal if the tax statute does not create a tax liability but requests the minister to make a regulation?
It is also worthy of note that, there are certain principles by which a government applies when it seeks to achieve a successful tax system. The first four were laid down by Adam Smith in his book Wealth of Nations, where he set out certain "canons of taxation ". A few others have been added by various economist to elaborate the initial four though. These principles are:
- Equity: This principle posits that a tax system must be fair and equitable. It is divided into the horizontal and vertical equity. The horizontal equity posits that those in equal circumstances should pay the same amount of taxes. In the case of the vertical equity it proposes that those in unequal circumstances should pay different amount of tax.
- Neutrality: A tax system is supposed to be neutral in the sense that it is not affected by the fluctuations of the internal market structure. This also means that taxes should not favour any particular individual or group. Neutrality also entails that the tax system should not be designed to influence individual decision making.
- Certainty: This simply implies that the extent of the tax should be clear and unambiguous. The tax payable by every person ought to be certain and not arbitrary.
- Efficiency : This principle simply connotes a profit making tax system in the sense that the cost of administration and collecting of taxes should not be higher than the revenue to be raised.
- Simplicity: This means that the tax system should be understood by an average taxpayer. A taxpayer should understand the system of assessment and determination of tax payable by him at a particular point in time. However, this simplicity principle might sound it is not a basis for the application of flat taxes.
- Transparency: This principle posits that the tax system should be clear and there should be honesty between the taxpayers and the revenue authority. It also posits that the government needs to be truthful of the benefits which citizens would derive from the tax system. It seeks to establish a relationship of trust in the tax system.9
The above principles of taxation must be applied by every government to achieve the goals of every good tax system which are: raising funds for the government; as a means of wealth distribution; to manage the economy and as a means of regulation. Therefore, in the application of presumptive tax systems, the government ought to concern itself with the principle that underpin every good tax system in achieving whatever goal they seek to achieve by the extant tax system.
Conclusion and Recommendations
Corporate entities and entities in the formal sector are burdened with the obligations to pay various taxes like companies' income tax, capital gains tax, stamp duties tax, withholding tax, industrial training fund contributions, tertiary education tax to mention but a few. To add salt to the injury of these companies, the Finance Act of 2023 took away some of the incentives they enjoy – such as the road investment tax credit scheme, investment allowance on plants and machinery, etc., thereby stifling these companies.
However, with respect to the informal sector – we have doubts that they even assess themselves for personal income tax. The Nigerian informal sector and the Nigerian people in general ask for more while they are not giving at all. Some may be of the school of thought that the people pay indirect taxes – whether as market levies or other indirect taxes like VAT. Some studies have stated that the nation is losing a whopping sum of N35 trillion from neglecting the informal sector.
What then are the effects of overburdening the formal sector? We see the rise in inflation numbers. Obviously, inflation responds to the rise in the cost of production, the retrenchment of some staff (which contributes to the unemployment rate), some companies are either forced out of business or made to relocate their businesses to fair taxing economies. And guess who the losers are – the people. The way forward is to tax the informal sector.
There is deep distrust on the part of the citizenry towards the government. The Government at all tiers must come to understand that there exists a social contract between the people and themselves – which consideration is the payment of Tax on the part of the People and the provision of basic amenities and protection on the government's part.
There is the need to leverage technology in taxing the informal sector, trust must be built by the Government to convince the citizens that they can account for the taxes paid, the need to consolidate the indirect taxes levied on the people must be considered. We should also make adequate legal provision for the taxes accruing to each tier of Government to avoid the multiple tax regimes in the Country; so as to promote certainty – which is a pivotal pillar of taxation and this seems to have been addressed by the Tax Reform Bills. Moreover, the Government of Nigeria must strive not to be wasteful so as to stop the mixed signal sent out to the People.
Footnotes
1. Cedar Rose, 'The Shadow Economy: Causes and Countermeasures' (2024) available at https://www.cedar-rose.com/blog/exploring-the-shadow-economy-a-dive-into-its-causes-andcountermeasures
2. Ibid
3. IMF, 'Shadows Economies Around the World: Size, Cause and Consequences' (2000) available at https://www.imf.org/external/pubs/ft/wp/2000/wp0026.pdf
4. Dickinson, 'Understanding the Shadow Economy' available at https://www.dickinson.edu/news/article/3136/understanding_the_shadow_economy
5. (1856) 5 E & B 828; 119 ER 730
6. [1921] 1 KB 64
7. (2007) 10 NWLR (Pt. 1041) 1
8. (2009) 8 NWLR (Pt. 1144) 615
9. R. Murphy, Joy of Tax,(Bantam Press London 2015) P. 253
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