This article accompanies our April 2019 edition of Policy Perspectives: The Ease of Doing Hidden Business in Canada and B.C.
British Columbia replaced its provincial sales tax (PST) with a harmonized sales tax (HST) in 2010, but then reverted to the PST in 2013. B.C.’s shadow economy – consisting of hidden and unreported economic activities, both legal and illegal – has surged since then. Shadow economic activities range from unreported business income or rent, off-the-books employment and undeclared tips, to illegal activities such as drug trafficking, unlicensed gambling and money laundering. Since by its design the PST encourages rather than discourages hidden transactions, its return may have contributed to B.C.’s shadow economy boom.
How big is B.C.’s shadow economy?
Statistics Canada’s measure of the shadow economy is incomplete because it misses most illegal activities (in principle, they should be included). Even so, the agency’s most recent data shows that B.C.’s shadow economy is 2.9% of official GDP (Figure 1). It is the third largest in the country. In 2016, it grew by 8.1% (before inflation), faster than any other province and nearly twice as fast as B.C.’s official economy. If all illegal activities were included, the estimates would be considerably higher.
B.C.'s shadow economy has surged since the reintroduction of PST
B.C. shadow economy GDP (excl. most illegal activities) as a proportion of official GDP, 2007-2016
Note: HST replaced PST in British Columbia from 1 July 2010 to 1 April 2013.
PST is a boon for hidden transactions
The PST is a retail sales tax on a fairly narrow range of goods and only a few services. The customer pays the PST on the full value of the sale. The seller does not receive credit for PST paid on inputs. The PST cascades and compounds along the supply chain, as each firm (producing an intermediate good) charges PST on the full value of the sale to the next firm in the chain. The final customer can end up paying PST many times over. The more links in the supply chain, or the more sophisticated the product, the higher the PST penalty.
Firms – especially small ones – can avoid PST by not registering with the tax office or not declaring all sales. The onus is on the tax authorities to catch them.
In contrast, the HST and the federal goods and services tax (GST) are value-added taxes. Tax is only paid on the value added by the firm at each stage of the supply chain. Firms receive a credit for taxes paid on inputs. The customer pays tax on the cost of the good or service, less the cost of materials used in production that have already been taxed. The HST did and the GST does apply to a wider range of goods and services than the PST. Compliance costs are also much lower.
Value-added taxes tend to discourage hidden activities. Firms engaging in hidden activities (legal or illegal) are penalized by not being able to receive input tax credits. This makes them less competitive relative to tax-compliant firms. As a result:
- Firms are more likely to register for tax purposes.
- Firms are more likely to fully declare final sales transactions and income in order to claim the related input tax credits (i.e. reduced “skimming” or non-reporting of business receipts).
A thriving shadow economy is bad news for British Columbians
B.C.’s shadow economy has significantly expanded in recent years. The reversion to the PST is almost certainly one contributing factor (but not the only one). The data suggests that the PST may have facilitated hidden activities, reduced tax compliance and weakened the resiliency of B.C.’s tax system.
Other contributing factors include B.C.’s extraordinary number of tiny businesses, its heavy reliance on activities tied to real estate such as residential construction (the sector saw an unprecedented boom until 2018), and Vancouver’s role as a globally-recognized regional hub for illicit drug trafficking and money laundering. We discuss these issues in an upcoming publication (see Williams 2019).
The shadow economy is bad news for British Columbians. The missing tax revenue means that law-abiding households and businesses must shoulder a greater tax burden to pay for public services used by all. The shadow economy distorts market competition, since non-compliant firms face lower costs than competitors who play by the rules. It undermines public trust in the tax system, eroding social norms that promote voluntary compliance. Networks of non-compliant businesses can also hide and enable illegal activities that cause insidious social harm.
The tax system should be simple, resilient and encourage tax compliance. The PST fails these tests. British Columbians may be paying the price through a booming shadow economy.