Detecting envelope wages with e-billing information

International Tax and Public Finance (2024) 31:26–65 https://doi.org/10.1007/s10797-023-09811-y Detecting envelope wages with e‑billing information Andrea Lopez‑Luzuriaga1 · Monica Calijuri2 · Carola Pessino2 · Simeon Schächtele2 · Ubaldo Gonzalez2 · Carla Chamorro3 Accepted: 22 October 2023 / Published online: 22 December 2023 © The Author(s) 2023 Abstract We use information from the electronic billing system to estimate the underreporting of income of private sector employees. We follow an expenditure-based methodology using the consumption of public and private sector employees for similar levels of reported income. We find that private sector employees underreport between 7 and 9% of their income in Ecuador. The size of the underreporting gap is negatively correlated with the number of employees at the firm, consistent with different risks and administrative costs of ‘envelope wages’ in small versus large firms. Keywords Income tax · Evasion · Electronic billing JEL Classification H24 · H26 · D83 * Andrea Lopez‑Luzuriaga Monica Calijuri Carola Pessino Simeon Schächtele Ubaldo Gonzalez Carla Chamorro 1 Universidad del Rosario, Bogotá, Colombia 2 Inter-American Development Bank, New York, USA 3 Servicio de Rentas Internas Ecuador, Quito, Ecuador 1Vol:.(1234567890) 3 Detecting envelope wages with e‑billing information 27 1 Introduction Informality is a key feature of emerging markets and developing economies (Ohnsorge & Yu, 2021). It constitutes an extraordinary challenge for their development as the shadow economy eschews taxation and social security contributions while hindering the state’s ability to deliver benefits and enforce regulations. An understudied form of quasi-informality is the payment of envelope wages. Envelope wages refers to the practice of firms paying formal workers part of their remuneration off the books. Taxpayers thus avoid payroll and income tax but also lose out on entitlements. A great deal of hope for curbing evasion and increasing formality is put into technology. First, the withholding of income and payroll taxes by the employer is believed to make the underreporting of wages nearly impossible under the right circumstances (Kleven et al., 2011; Jensen, 2022; Slemrod, 2019), leaving selfemployment as the main source of unreported labor income. Second, by increasing traceability and reducing transaction costs, digital payments could make tax evasion and informality a memory of the past. However, withholding may not work equally well in all countries; hence, it may not be correct that for employees, “tax authority income records can be regarded as the ‘gold standard”’ (Cabral et al., 2021). Moreover, the extent of envelope wage payments is not known in all countries, and to estimate their size, researchers have resorted to survey data, which have been shown to yield biased results (Cabral et al., 2021; Paulus, 2015). This paper seeks to answer the question, “To what extent do employees underreport income?” using a novel approach that matches electronic billing data (a thirdparty reported measure of consumption) with income tax records. Our study sheds light on how well firms comply with the withholding of income and payroll taxes. In addition, we provide empirical results on the theoretical prediction that collusive tax evasion is easier and more likely in small firms. We use an expenditure-based methodology to estimate the gap in reported income between public and private sector employees in Ecuador. Briefly, we estimate the consumption and income relationship, controlling for individuals’ demographic characteristics for public and private sector employees. We assume that the relationship between consumption and real income is independent of the employment sector, and any differences observed are due to a difference between real and reported income. Ecuador has a comprehensive electronic billing system. We match this detailed data on consumption to employees’ income tax records. Our study focuses on wage earners, so we exclude all individuals that have self-employed income. There are two reasons for making this empirical choice. First, the main focus of this study is to understand the extent to which envelope wages exist in a context where a third-party reporting system comprehensively covers the relationship between employers and employees. The second reason is practical; including these individuals would add noise to the estimation, given the characteristics of the tax system in Ecuador. In the Ecuadorian tax system, self-employed individuals only have to report their gross income and expenses. The expenses are deductible from their taxable income. As a result, self-employed individuals have an 13 28 A. Lopez‑Luzuriaga et al. extra margin to evade that, in the Ecuadorian case, is easily used to decrease taxable income when gross income is third-party reported as shown by Carrillo et al. (2017). At the core of our estimation is the assumption that individuals with similar demographic characteristics and real income will have similar consumption patterns, particularly of food, independently of the source of their income. If we find differences in the relationship between consumption and reported income, those differences are consistent with income misreporting. Crucially, public employers have no incentive or opportunity to misreport their employees’ wages, so we can use employees in the public sector as the benchmark. Using survey data, we find evidence that if there is a systematic difference in public and private sector employees, the public sector employees report higher consumption; therefore, any bias would be against our estimation, and the difference in reported income between otherwise similar employees in the public and private sectors is a lower bound estimate for underreporting of employee income in the private sector. Overall, we find that for a given consumption level, the reported income from private sector employees is smaller than that reported by public sector employees. Specifically, estimates center at around 8% of underreporting. However, once we look at heterogeneity by firm size, the underreported income is between 25% for small firms and 12% for middle-size firms using food consumption and between 40% and 13% using total consumption, and the gap is statistically significant in all cases. We calculate the size of the underreported amount using our estimate for the whole sample to be conservative and find that the amount of wages not reported amounts to 3% of Ecuador’s GDP. The income tax loss is relatively small due to the tax’s progressive nature, around 1% of total tax revenue. However, the unpaid social security contributions are sizable and equivalent to 9% of the total contributions. The heterogeneity by firm size is striking: the reporting gap is largest–up to 40% of income–for small firms with 3 employees. It decreases with firm size until it vanishes for larger firms with more than 5 (...truncated)