ISP Working Paper Number 07-04

Tax Morale and Tax Evasion in Latin America

James Alm and Jorge Martinez-Vazquez, March 2007

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Abstract:

It is well accepted that most people do not like to pay taxes, and, because of this fundamental reason, it is hard for tax administrations to levy and collect taxes anywhere and any time. However, taxing certain kinds of activities, sectors, or individuals – the so-called “informal sector” – is an additional challenge for tax administrations in both developing and developed countries, and the “fiscal gap” that arises from the failure to tax this sector can be quite large.

Even aside from the collection of additional tax revenues from taxing those in the informal sector, there are other important tangible effects that arise from taxing the informal sector. One benefit is an improvement in horizontal and vertical equity. Another is an increase in economic efficiency. There are also significant intangible effects, including higher overall “tax morale” – or citizens' intrinsic motivation to pay taxes – in the country. If there is a growing sense of the inability or unwillingness of tax authorities to catch tax evaders, the resulting unfairness of relative tax burdens could potentially lead over time to much lower tax yields than the lower tax yields due directly to the failure to tax this sector. This issue is especially pressing in Latin America and Caribbean (LAC) countries, where often over half of the workforce is found in the informal sector.

In this paper we examine taxation and tax compliance in LAC countries and beyond, focusing on several main questions. What is meant by the “informal sector”? What is the size of informal sector in LAC countries? What are some effects from an informal sector, including the size of the “fiscal gap”? What are the reasons for this fiscal gap? What can be done to address these various issues? We begin with an overview of the tax systems of LAC countries.