by Sylvain Comeau

Economics Professor Dan Otchere doesn’t trust predictions. In 1994, he decided to look into a predicted drop in the demand for cash, which was forecasted in some economics papers.

“I teach money and banking and monetary economics, and I have read some studies suggesting that increased taxes cause the demand for cash to go down. I teach that idea in my courses, so I wanted to do some research, to see if the theory can be verified by empirical evidence.”

Otchere did expect to find that demand for cash was dropping, particularly due to the rise of cash alternatives like debit cards, credit cards and Interac.

“Advances in banking technology are also supposed to make people hold less cash. But when I looked at the data, I found that the demand for cash [in Canada] continues to go up. For example, between February 1996 and January 2002, the public’s currency holdings have risen by 45.9 per cent, although its proportion of the narrow money supply has declined from 43 per cent to 29 per cent. So I wanted to find an explanation, and I noticed that over the same period, the tax burden has also grown by 21 per cent.”

That trend overturns other predictions, about a supposed cashless society of the near future.

“We are not getting very close to the cashless society that some people have predicted,” Otchere said. “My conclusion is that higher taxes drive more and more people into the underground economy, which is why the demand for cash is going up. Cash leaves no paper trail, or electronic trail. Naturally, it’s ideal for the underground economy.”

The GST, in particular, because it taxes services as well as goods, encouraged a lot more under-the-table work. “I estimate that since the early 1990s, the underground economy has increased by at least three to four per cent,” Otchere said

The news is not all bad. Otchere found a silver lining in the fact that a certain amount of wealth is hidden below the poverty line.

“The good news is that some of this unreported income is going to people with low incomes. Officially, these people live below the poverty line, but in actual fact, they are not as poor as we thought. The strength of the underground economy means that official figures on poverty in this country are exaggerated.”

Surprisingly, this is also good news for government coffers.

“Normally, these poor people would be seeking some form of government assistance, but they don’t need to, since they are receiving unreported income from the underground economy. And it also means that the poor are quiet. That’s why they are not protesting in the streets. They are able to survive.”

Not as surprisingly, Quebec, with its onerous tax burden, has the most active and flourishing underground economy in North America. Otchere says that recent ad campaigns by the federal and provincial governments which vilified the underground economy are ineffective, if not futile. He feels that tax and government spending reform is the only way to put a dent in it.

“We know that higher taxes will just drive people further underground, which makes the tax base shrink. They also discourage foreign investment in the economy. The government has to show that they are not abusing the tax system, and that they are not wasting taxpayers’ money. Until that happens, people’s attitudes toward tax compliance won’t change.”

Confidence-building important

Otchere notes that tax cuts do not have an immediate impact on the tax base; they are more of a long-term solution.

“If they reduce taxes for a long period of time, confidence will be built. People will become more tax compliant and foreign investment will come in, so that more people will enter the work force. Incomes will go up, the economy will improve. That all means the government will collect more revenues to make up for their initial losses from lower taxes. A wider tax base is better than a heavily taxed but narrower one.”

Otchere is still working on a model to estimating the size of the underground economy; however, the results of his current research are available on the Internet. To read them, use a search engine and type in the words Otchere and underground economy.