CONTRIBUTION EVASION AND SOCIAL SECURITY: CAUSES AND REMEDIES. Clive Bailey 1 International Labour Office. John Turner International Labour Office

Transcription

1 CONTRIBUTION EVASION AND SOCIAL SECURITY: CAUSES AND REMEDIES Clive Bailey 1 International Labour Office John Turner International Labour Office October 31, 1997

2 SUMMARY Contribution evasion is a problem in both defined benefit and defined contribution plans. It typically involves the participation of both employers and employees, with governmental acquiescence or ineffective enforcement. A number of factors cause it, and there are a number of policies that can be enacted to reduce it. Contribution evasion occurs when employees and employers do not pay required social security contributions. It is a critical problem for social security programs in much of Central and Eastern Europe, Latin America, Africa and Asia. In some countries in Latin America and Central Asia, it has caused the social security system to collapse, with revenue falling far short of that needed to pay benefits. Even OECD countries often receive substantial underpayments of contributions due to evasion. To conceal evasion, firms and employees exhibit great inventiveness. Evasion occurs by firms failing to register some or all of their employees, by firms hiring workers informally rather than as part of the official payroll, by claiming workers are contractors rather than employees, or by failing to pay for their registered employees. Contribution evasion may occur by underpayment, or by delinquent payment. It occurs due to the failure of workers to make required contributions. It occurs by government in some countries, with the government failing to make required social security contributions for its employees. In some countries, public enterprises are the worst offenders because they are in the worst financial condition. Contribution avoidance is a closely related phenomenon. It occurs when workers take jobs not covered by social security to avoid making social security contributions. It occurs due to employers structuring work and payment so that the people who work for them will not be classified as employees. It also occurs due to workers leaving the workforce to avoid making contributions. Evasion causes inequities in effective contribution and tax rates between contributors and noncontributors, with resulting effects on income distribution. It causes contribution rates to be higher than they would need to be, although the increase in the mandatory contribution rate may occur with a long time lag causing an intervening period of revenue shortfall. Contribution avoidance and contribution evasion may distort labour market activity, which has attendant welfare costs. The shift of workers to the underground economy or the informal sector may reduce economic growth. Because evasion is by definition illegal, firms and employees attempt to conceal it, which makes it difficult to obtain accurate data on evasion. In some countries, however, estimates suggest that as much as 50 to 60 percent of the legally required contributions to social security go unpaid. Contribution evasion plus delinquency was an estimated 60 percent in the defined benefit social security system in Brazil in the 1980s (Mesa-Lago 1991), and was about 50 percent in the early 1990s (Dyer 1996). Contribution evasion was estimated to be 49 percent in Argentina in the early 1990s (Cottani and Demarco 1996) and to be 33 percent in Peru (Nitsch and Scwarzer

3 1995). Some analysts have considered contribution evasion to be primarily a problem of defined benefit schemes with the replacement of those schemes by defined contribution schemes solving the problem (World Bank 1994). In Chile s defined contribution system, however, funds that catered to lower paid employees averaged contribution evasion of 45 to 55 percent in 1990 (Gillion and Bonilla 1992). In Chile, nearly 40 percent of members do not contribute to their account in a typical month (Queisser 1995). This figure overstates evasion because members currently not working are not required to contribute. A study done in Chile reporting compliance of 95 percent (Chamorro 1992) is certainly, however, considerably overstates compliance. In any case, the percentage of workers in Chile not participating in the defined contribution system is roughly equal to those not participating in the defined benefit system it replaced. Experience in Uruguay, Colombia and Peru also indicates that switching to a defined contribution system from a defined benefit system does not solve the problem of contribution evasion. In all these countries, roughly half of the workforce participates in the mandatory defined contribution system. Contribution evasion in Chile has also been a problem of employer wrong doing. As of February 1996, the pension fund Superintendent agency in Chile had 150,000 cases pending against employers who had failed to remit employee contributions to the pension fund management companies (Economic Intelligence Unit 1996). This is the worst form of contribution evasion since it amounts to employers defrauding employees of their own contributions. Mandatory payments by employees and firms to finance social security benefits are called taxes by some social security analysts and contributions by others. We use contributions to indicate that the benefits employees receive are related to payments by or on behalf of the employees. That occurs when both benefits and contributions are based on the employee s earnings. Contributions imply a right to a future benefit. A tax, by contrast, finances the general functioning of government, but the government-provided benefits the individual receives do not depend on the amount of taxes the individual pays. Tax evasion has been analyzed by Cowell (1990), Tanzi and Shome (1993), and others and the literature has been surveyed by Alm (1996). Manchester (1997) discusses economic effects of social security contribution evasion. The analysis of tax evasion compares the expected utilities from evasion versus compliance. This involves on the one hand an assessment of the probability of being caught, the expected financial loss if caught, and the risk aversion of the employer or worker. On the other hand, it involves the financial loss due to paying the tax. The analysis of contribution evasion is more complex because it also involves the worker s assessment of the gain in expected future benefit payments by contributing to the social security system. Understanding the causes of evasion is important for structuring social security reform. A partial understanding could lead to an overstatement of the reduction in evasion due to reform and thus an overstatement in the increased revenues caused by a change in social security systems. We show that most reasons why evasion occurs apply equally to defined contribution as well as defined benefit systems. One system does not have a clear advantage over the other in managing evasion.. 2

4 WHY DOES CONTRIBUTION EVASION OCCUR? Contribution evasion involves firms, employees, and the government. Its prevalence depends on the attitudes of each and on the cost and reward structure they face. While both employers and employees have incentives to contribute or to evade, and the incentives for each group can be examined separately, the actual prevalence of contribution evasion depends on the interactions between the incentives of employers and those of employees, on the one hand and the interaction of both with the enforcement activities of the government. In most social security schemes, employers are legally obligated to pay social security contributions on behalf of employees, also withholding employee contributions from pay. The legal burden of contributions is placed on employers. Thus, opportunities to evade for workers wishing to do so are limited to collusion with employers and to changing their employment to become self-employed, casual, or contract workers, where contributions may not be required, or where required contributions are more easily evaded. In some countries social security contributions are collected with income taxes and it is not possible to pay one and not the other. In that circumstance, the evasion of social security contributions must be considered with the evasion of income tax payments. In other countries for all workers, and in yet other countries for some workers, the payment of the two is separated. Contribution evasion must generally involve some form of collusion between employers and employees. Exceptions to there being collusion occur for self-employed workers and in the case of employer embezzlement of contributions, when the employee would not consent to and may not be aware of the evasion. Because employers are legally obligated either to make payments on behalf of their employees or to collect contributions from their employees, or both, when evasion occurs and employees are aware of it, the employees could report this to the social security institution enforcement office. When workers also wish to avoid contributing, collusion is easily established. In that situation, employers evading contributions will have an advantage in labour markets because the compensation package they offer, which does not involve social security contributions, is more desirable than the compensation package offered by nonevading employers. Thus, in some instances the motivations of employees may be a key factor in determining evasion. However, if employees wish to contribute in a system where employer contributions are required, then the employer must offer them higher wages to offset the disadvantage of working for an evading employer. Presumably, to some extent sorting occurs in the labour market, so that employees that most wish to evade contributions work for employers that also most wish to evade contributions. The reasons for contribution evasion can be divided into those affecting employees willingness to pay or reluctance to report nonpayment to authorities and those affecting employers motivations. A further factor is the government s attitude towards evasion. For contribution evasion to occur, three conditions are required involving employees, employers, and the government: 1) employees must either prefer nonpayment of contributions or be reluctant to report nonpayment to authorities, 2) employers must wish to evade or place a low priority on making social security contributions relative to other expenses, and 3) government enforcement must tolerate evasion or be inadequate to prevent it. 3

5 Reasons Why Workers Wish to Evade Paying Social Security Contributions or Are Reluctant to Report Nonpayment by Employers A weak relationship between social security contributions by workers and the benefits they ultimately receive was stressed by the World Bank (1994) as a cause of evasion. Issues relating to the effect of a worker s contributions on his or her future benefits were analyzed earlier by Burkhauser and Turner (1985) among others. The relationship between contributions and benefits, however, is only one aspect of evasion, and we argue that it is probably a relatively minor one, in part because of the role of other mandatory contributions and taxes. The marginal gain from social security contribution evasion, treating social security contribution evasion separately from income tax evasion, is measured by the true economic social security tax rate on earnings. The true economic tax rate facing workers for social security is the difference between the social security contribution rate and the marginal accrual in actuarial present value of future benefits with a marginal increase in earnings. The higher is the true economic tax rate for social security, the greater is the marginal gain from contribution evasion. In a defined benefit scheme, the marginal accrual in actuarial present value of future benefits with a marginal increase in earnings is determined by the effect of current earnings on future benefits, as specified by the benefit formula. If benefits are not tied to the worker s earnings (or earnings-based contributions) in the period, the tax rate equals the contribution rate. The true economic tax rate varies across workers if the social security system provides more generous benefits relative to earnings or contributions for some workers than for others. The amount of evasion is also affected by the opportunities to evade, which depend in part on actions taken by employers and the government. Individuals have a three-part decision when considering the effect of mandatory social security contributions on work: 1) do not work, 2) work for an evading employer, 3) work for a contributing employer. In addition, there may be varying degrees of evasion that are offered by different work situations. Workers wanting to evade may be unable to do so because no attractive employment opportunities are available where evasion is possible. This could occur because of strict enforcement or because of the structure of the economy, with few good jobs in the casual or informal sector. The marginal cost of evasion is affected by the difference between wages in jobs where evasion is possible and wages in covered jobs, and by the expected value of the cost of governmental penalties for evading. In most countries, the penalties for evasion are levied solely on employers. If the marginal cost of evading is less than the marginal benefit of doing so, taking into account the accrual of future benefits, workers will seek employment where evasion is possible. Firms have their own decision problem as to whether to evade. The legal burden of not evading is placed on them. They will weigh the labour market benefits of providing contributions for their employees against various costs--the direct costs of providing them, the cost in terms of higher wages workers may require to work for an employer that does not contribute, the costs incurred to conceal evasion, and the expected present value of paying a penalty if caught evading. National legislative bodies, government social security agencies and tax collection agencies in dealing with evasion presumably weigh the costs of enforcing mandatory contributions against the perceived costs and benefits in terms of social objectives of doing so. 4

6 5 FACTORS AFFECTING EVASION IN DEFINED BENEFIT AND DEFINED CONTRIBUTION SYSTEMS The following list describes reasons for contribution evasion. The elements in the list are not mutually exclusive but contain areas of overlap. Unless otherwise noted, the reasons for evasion generally are expected to affect both defined contribution and defined benefit schemes equally. The list is divided into factors affecting workers demand or motivation for evasion, reasons workers have for not reporting evading employers, and factors affecting the supply or the ease with which the worker can find employment that makes evasion possible. Within each category, we loosely rank the causes of evasion according to our hypothesis as to their relative importance in most countries in determining the overall level of evasion, recognizing, however, that the relative importance of factors differs in some countries. Workers Demand for Evasion For self-employed workers, the worker s motivations for evasion are key. For employees, the worker s demand for evasion is a factor that employers must consider in deciding whether to evade. The worker s demand for evasion may also affect the worker s job choice (contribution avoidance), if the demand for evasion causes them to seek jobs where contributions are not required. 1. Myopia. A fundamental aspect of social security is that social security contributions around the world are mandatory because some workers would not adequately save for retirement on their own. Some workers have difficulty planning for distant needs such as for retirement. They have a high discount rate concerning future consumption, meaning that they place a low value on it. For this reason, the utility value of future benefits is low and workers attempt to evade contributions. 2. High Income Tax Rates and Contribution Rates for Other Social Programs. When social security contributions are collected with income taxes, contribution evasion may be an aspect of tax evasion. When the overall tax rate is high, contribution evasion may occur even if the contribution rate for social security is moderate. Even if income taxes are collected separately from social security contributions, the payment of social security contributions provides public information concerning a worker s income tax liability. It is generally difficult for a worker to evade high income taxes and other mandatory contributions and at the same time contribute to social security. This argument applies in developed countries and in middle income countries. In most developing countries few workers pay income taxes and similarly, few are covered or pay social security contributions. In the Caribbean, there is no income tax in the Bahamas and a couple of other tax havens, but most countries levy an income tax. 3. Poverty. Poor workers may feel they cannot save because their immediate needs are so pressing. Because the contributions are mandatory savings, poor workers may seek to evade contributing. 4. Temporary Financial Hardship. The life cycle model of consumption predicts that workers experiencing temporary financial hardship will attempt to maintain their consumption level by reducing saving, and thus may prefer not to contribute for a temporary period. Thus, evasion is

7 generally higher during periods of severe economic problems. 5. Low Discounted Value. Young workers may wish to evade because benefits would not be received for many years and their discounted value is low. That assessment could arise from myopia (having a high discount rate) or it could be the rational assessment of a nonmyopic worker. For some workers, it could arise because the worker did not expect to live until retirement. 6. Low Rate of Return. When workers receive a lower rate of return on their defined contribution account than on other investments, they are motivated to evade because of the better rate of return elsewhere. A low rate of return on a defined contribution scheme in comparison to what the worker could have earned acts as a hidden tax that workers seek to evade. Defined contribution schemes may have unattractive rates of return for a number of reasons. This could occur for a low wage worker due to the fixed expenses charged against individual accounts, or for workers generally because high expenses of the scheme manager cause the rate of return to be low, or because tight regulation of the allowable investments keep the rate of return low. Evasion may also occur if the mandatory contribution rate is high and the worker did not want to save that much for retirement. Workers may lack confidence that their defined contribution system will provide adequate benefits. A survey conducted in all Chilean cities with at least 40,000 inhabitants by Market Opinion Research International, found that 59 percent of respondents expressed little or no confidence in the Chilean individual accounts pension system (IBIS 1996). Defined benefit schemes do not have an account earning an explicit rate of return, but when benefits are linked to contributions the worker s contributions earn an implicit rate of return in terms of accrued future benefits. If the social security system provides a low implicit rate of return, evasion may occur. Defined benefit social security systems typically provide a high rate of return at the start of the system but the rate of return declines over time. In many defined benefit social security systems, benefits are based on the highest few years of earnings and for full career workers earnings in a substantial number of years have no effect on contributions. When that type of benefit formula is combined with high contribution rates, workers have a substantial incentive to evade contributing in years that are not counted in computing benefits. 7. Inflation. High inflation makes it financially advantageous to postpone contributions because their real value quickly falls. For workers disinclined to contribute, high inflation increases the value of postponing contributions. 8. Gaming. Gaming the system refers to workers rationally calculating the pattern of contributions that maximizes their gain. Some pension systems are structured so that workers can avoid contributing in some years with little or no effect on their future pension benefits. Workers will determine how much in benefits is lost by not contributing and decide on that basis whether to contribute. Gaming occurs in both defined benefit and defined contribution systems for low income workers when they become eligible for alternative benefits by reducing their contributions to social security. 9. Compliance Cost. All workers and employers bear a compliance cost in terms of time, expense, inconvenience, and frustration in obtaining necessary forms, completing them, and otherwise complying with contribution requirements. These costs may be particularly great for 6

8 self-employed workers and workers in the informal sector. Workers in rural areas may need to travel long distances to reach a government office that can assist them with compliance. The compliance cost increases with the complexity of the contribution and tax laws and the frequency with which they are changed (U.S. General Accounting Office 1996b). It is less costly for employed workers to comply because the administrative burden of compliance is borne by the employer, who generally can bear it more efficiently. 10. Lax Administration of Benefit Qualification Regulations. Evasion can occur because workers realize that they need not make required contributions in order to receive benefits. 11. Legitimacy. Workers are more likely to evade contributions if they feel that the system is unfair or that the government lacks legitimacy. Evasion may be a form of economic protest. 12. Attitude toward Evasion. Some workers will not evade solely because that is unethical. However, in some countries evasion is viewed as an acceptable practice 13. Illegal Activities. Workers engaged in illegal occupations generally attempt to conceal the income derived from them and do not pay social security contributions. Factors Causing Workers to be Reluctant to Report Evading Employers Workers may wish to participate in the social security scheme but be reluctant to report their employer who is not making required contributions on their behalf. 14. In many developing countries, there is an excess supply of labour relative to jobs in the formal sector, and employees may fear that if they report their employer they would lose their job and become unemployed. 15. Employees may not report evasion because they feel powerless or intimidated in dealing with large employers and the government. Factors Affecting the Supply or the Ease with which Workers Can Evade 16. Inadequate Penalties or Enforcement. Evasion could occur because the penalties are low or the low probability of their being levied causes them to have a low expected value. Contributions may be routinely paid in arrears when the interest penalty for late payment is low. Whatever the reasons for evasion, ineffective enforcement makes evasion more likely. 17. Easy Access to the Informal Sector. Evasion is greater when a large informal sector makes it is easy for workers to find employment comparable to that in the formal sector. The U.S. Internal Revenue Service has estimated that self-employed individuals who informally supply goods and services (such as street vendors) report less than 20 percent of their business income. Other selfemployed individuals who operate more formally, such as gas station owners, reported less than 70 percent (U.S. General Accounting Office 1996a). 18. Self-employment. In some social security systems, such as in Chile, self-employed workers are not required to contribute but may voluntarily contribute. For part-time or temporary workers, it may be difficult to determine whether they are self-employed and this provides an opportunity for evasion. In systems where self-employed workers are required to contribute, they frequently have high evasion rates because of difficulties of enforcing contributions. It is generally difficult for government to determine the taxable earnings of self-employed workers because they receive income on a cash basis, they have legitimate costs that reduce their taxable income, and their record keeping is often less developed than for large enterprises. The U.S. Internal Revenue 7

9 Service has found that independent contractors have much lower income tax compliance than employees and that misclassification combined with lower tax compliance cost the U.S. Treasury $3.3 billion in social security and unemployment insurance contributions in the early 1990s (U.S. General Accounting Office 1996a). Self-employed workers may prefer to invest in their own business. In some countries, self-employed persons form self-help associations that develop social protection mechanisms more attuned to their needs than the national social security scheme. 19. Minimum Income for Social Security Contributions. Often social security systems have a minimum level of income below which it is not necessary to contribute. This is the case, for example, in the United Kingdom and the Bahamas. Workers earning above the minimum in total earnings but working two or more jobs where they earn below the minimum may evade contributions. Even though their total earnings exceed the minimum, because their earnings on each job is less than the minimum none of their employers withholds contributions or contributes for them. 20. No Income Tax. While high income tax rates may encourage evasion, lack of an income tax makes it more difficult for the government to obtain information about the earnings of workers. Thus, lack of an income tax facilitates social security contribution evasion. Reasons Why Firms Wish to Evade or Place a Low Priority on Social Security Contributions Relative to Other Expenses When workers wish to evade social security contributions, firms have little incentive to contribute, and workers and firms may collude in evasion. In that situation, evasion by firms makes the employment they offer more attractive to workers. Firms, however, also may evade even if their workers value the future benefits gained by contributions. In this situation, evasion by employers makes their offer of employment less attractive to workers. Firms may still determine that evasion is their optimal policy, but they would pay a cost in the labour market in terms of needing to offer higher wages to attract workers. The factors of lax enforcement and low penalties, compliance costs, inflation, and financial distress discussed for workers also apply to firms and will not be repeated. 1. Cost Savings. Financially weak firms may evade contributions because they place a low priority on those expenditures. Paying salaries would be a higher priority than paying social security contributions. Among benefits, providing health benefits may be a higher priority expenditure than providing retirement benefits. Financially healthy firms may evade contributing to reduce their expenses. Doing so may give a firm a cost advantage over its competitors. Cost savings are incurred due to the nonpayment of contributions and due to the avoidance of compliance costs. Compliance may require additional record keeping and calculations. Imprecise and ambiguous language in laws can add to compliance cost by creating uncertainty as to what is required. 2. Fraud. Evasion may occur due to firms collecting social security contributions from their employees but keeping the contributions. This is the worst form of evasion since it involves defrauding workers of their own contributions. Fraud occurs in a more subtle form when 8

10 employers delay transmitting employee contributions to the appropriate authorities. Such a practice benefits firms due to the interest gained while holding the employees contributions. 3. Corruption. Firms may not comply because it is cheaper to bribe the labor inspector. 4. Low Reputational Cost. Evasion may occur because the cost in terms of the firm s reputation may be low. If evasion is widespread, tolerated by the government, considered an acceptable business practice, widely accepted because the government is unpopular, or if government agencies and enterprises do it, then individual firms are more likely to do it 5. Alternative Arrangements. Employers may have developed their own retirement arrangements for their workers, and see no advantage in participating in the social security scheme. 6. Small Scale Production. Evasion is more easily accomplished when production is mainly done by small firms and by firms with no fixed location of production. It is easier for the government to control evasion when production occurs primarily in large firms. The more employees a firm has the more employees it must induce or force to collude with evasion. Thus, in many circumstances it is more difficult for a large employer to evade contributions. However, if evasion is due to macroeconomic causes such as high inflation and declining national output, large firms as well as small ones may be contribution evaders. In sum, a number of factors cause workers and firms to evade contributions, or facilitate them doing so, most of which apply equally to defined contribution and defined benefit social security systems. However, a list of reasons does not indicate that defined contribution and defined benefit schemes are affected equally. In particular, how important is the effect of incentives through restructuring social security so that benefits are more closely tied to contributions? When contribution payments are associated with income tax collection, or when the information on contribution collection is used to enforce income taxes, incentives in the social security program may have little effect on social security contributions. Similarly, when contributions for pensions are only a small part of social security contributions, then increasing incentives for paying pension contributions only is likely to have a small effect. Because of the numerous factors that affect evasion in both defined benefit and defined contribution schemes, there is no reason to expect that a defined contribution system would have less evasion than a defined benefit system. Indonesia, which has low contribution rates and a defined contribution system has high evasion. The United States with moderate contribution rates and a defined benefit system has low evasion. A more relevant comparison, however, is whether contribution evasion within a country would be affected by switching from one system to the other. The evidence sited earlier for Chile indicates that switching to a defined contribution system has little effect on the percentage of the working population participating in social security. In both defined contribution and defined benefit systems, noncontributors tend to have the following characteristics: self-employed, young, domestic employees, short-term or part-time workers, work in the informal sector or underground economy, low paid, work for small firms, or work for firms in financial distress. Evasion tends to be higher in poor countries that attempt to provide broad coverage, and by doing so include workers in categories where evasion tends to be high. In some countries, evasion occurs in large firms, in government enterprises and in the government. Evasion is also associated with macroeconomic distress--high inflation, high unemployment, and declining gross national product. 9

11 Reasons Why Governments Tolerate Evasion or Have Enforcement Inadequate to Prevent It The government also has a role in contribution evasion. Some countries do not enforce compliance, levying no penalties but perhaps trying to encourage compliance. The reasons why governments do not to enforce compliance can be divided into attitudes and resources. Attitudes 1. Mandatory Contributions Are Really Voluntary. Some social security administrations do not take evasion seriously. They perceive their objective as helping people who are their clients rather than being law enforcers. They prefer to act through education, persuasion and incentives, rather than through enforcement, inspectors and penalties. The government has the attitude that contributions are for the benefit of the worker and his family, and if the worker feels that he cannot or does not want to contribute, the government will not force him to do so. The government treats contributions as being voluntary. In some countries failure to pay social security contributions is not illegal. This is the case in Nicaragua and Guatemala. 2. Reluctance to Levy Penalties. Because workers and firms who do not comply tend to have lower income, some social security administrations are reluctant to levy penalties against these groups that are already in a poor financial situation. Levying penalties or forcing compliance might force a poor enterprise into bankruptcy, and it is generally considered that it is better for a poor firm to provide employment without social security contributions than to not provide employment. Reluctance to levy penalties may also arise when evasion is widespread because it is felt that it is unfair to penalize a few while most evaders go unapprehended and unpenalized. The higher are the minimum penalties above a threshold level, the more likely is it that they are not levied. 3. Bribery. In some countries, bribery and corruption is widespread. In this situation, the social security institution may tolerate bribery of enforcement agents and corruption of firms. 4. Division of responsibility. In individual account defined contribution systems, such as in Chile, enforcement of contribution evasion may be more difficult because of the division of responsibility between the government regulatory agencia, which is called the Superintendencia, and the pension fund management firms. It is the responsibility of the pension fund management firms to collect contributions. The responsibility for monitoring nonpayment could be assigned to the Superintendencia, which would then need to work with the pension fund management firms to determine if contribution evasion occurred. It, however, could be assigned to the pension fund management firms. Enforcement of compliance is not normally a function of financial management firms, and thus they may be poorly designed to carry out this function. In addition, they have little or no incentive to enforce compliance among low income workers because the expense of managing small accounts may exceed their fees from such accounts. Resources 5. The government may have inadequate resources to enforce compliance. It may have too few enforcement officers or inspectors, and they may be inadequately trained and paid. POLICIES TO REDUCE CONTRIBUTION EVASION 10

12 Contribution evasion can be reduced by changes in: 1) attitudes towards compliance, 2) administrative procedures that improve the efficiency of the contribution collection process, 3) the design of social security systems, and 4) macroeconomic policies. Changes in Attitude Payment of contributions should be encouraged through public relations and educational campaigns as to the benefits of paying and the penalties for not paying. In Chile, for example, a pilot program is teaching secondary school students about the social security system. Sometimes payments are not made due to ignorance as to how and why to do so. The public perception needs to be established that noncompliance is unacceptable. The authorities should publicize their enforcement efforts in order to encourage more voluntary compliance. For example, they could print in the newspapers the names of persons or firms who were contribution evaders and publicize penalties levied. This would increase the reputational cost of evasion. Administrative Changes The contribution process can be analyzed chronologically as the enactment of contribution law, the identification of contributors, the assessment of the contribution, the control and verification of the assessments, litigation if necessary, and collection of contributions (World Bank 1991). Contribution evasion can result from weaknesses at any of these stages. An important reason why workers and employers evade social security contributions in both defined benefit and defined contribution schemes is that there is no effective administrative mechanism to identify nonpayment and to enforce payments. Some schemes lack the powers or the resources to enforce compliance. Evasion may result from an inefficient administrative arrangement for collecting social security contributions. Countries may need to improve their administrative capacity, for example, by providing further training for staff. Methods of Contribution Collection. In some countries, such as Kazakhstan, the administration of the collection of contributions is done locally. Contribution enforcement at the local level may be inefficient. Economies of scale may be achieved by organizing contribution collection on a national basis. Strengthening administration may be an important aspect of reducing contribution evasion in both defined benefit and defined contribution systems. Combining collection of social security contributions and tax collection may in some countries result in better contribution compliance due to more efficient use of resources involved in collecting revenues. Combining the collection of social security contributions with other contributions allows for improved efficiency through specialization in administrative function, with a single collection and enforcement agency. It also facilitates compliance, because firms and workers need make payments only to a single agency rather than to multiple agencies. In some countries, the social security institutions are more efficient in collecting contributions than are the tax collecting authorities and combining the two would worsen the collection of contributions. In some countries, it is best to keep the collection of social security contributions and income taxes separate because government cannot be trusted to remit to the social security institution all funds collected. The joint collection of taxes and contributions may have serious adverse implications for the administration of social security institutions as autonomous agencies. While this situation indicates serious problems in government 11

13 administration, it is best to recognize the constraints facing government administration. It suggests that among countries with well developed systems of government administration, combining the collection of social security contributions and taxes would be most efficient. Among countries lacking well developed systems of government administration, it sometimes may be most efficient to separate the two functions. In the Chilean individual account pension system, the pension fund management companies are responsible for dealing with nonpayment of contributions. However, they have little incentive to pursue workers not making required contributions. The costs of such action exceed the benefits to the company. Competition for clients makes it unlikely that the Chilean pension fund management companies will take actions against clients that are not in full compliance. Contributors who wish to not fully comply would seek out management firms that were known to not enforce compliance. In Argentina, which also has an individual accounts system, the collection is done centrally by the government, and the management of contribution evasion may be more efficient, although there is insufficient experience in Argentina thus far to judge empirically the superiority of its approach. Record Keeping. The administrative authorities need to keep records on taxpayers. Contributions are generally payable monthly. It is necessary to have a mechanism for followingup on those employers who do not pay. An additional administrative check is with the authority that collects the income tax, if that authority is different. Collection authorities could investigate firms or workers who pay the corporate or personal income tax but paid no social security contribution. Better record keeping by government, including computerization of contribution records, may reduce evasion. The assignment of a taxpayer or social insurance identification number facilitates record keeping and cross checking of taxpayer information from different sources. It facilitates the use of computers. In most countries, businesses must register with local authority. This provides information for enforcement. The issue of public works contracts, licences, and permits could be dependent on social security compliance. In Italy, for example, the increased use of electricity by a firm is used to trigger an investigation of whether a growing company is complying with social security contribution requirements. Governmental Example. In some countries, such as Tajikistan during the mid 1990s, the government does not regularly pay social security contributions for its employees. Social security finances and the credibility of compliance efforts would improve if the government paid required social security contributions for its employees. Enforcement. Because of limited resources, enforcement efforts may need to target larger firms. For some types of noncompliance, it may be too expensive for the government to try to enforce compliance. Enforcement could be improved by a program of audits to determine compliance. Another enforcement tool is for the enforcement agency to have the power to take court action against the officers of enterprises. Corruption. In some countries, corrupt firms bribe tax inspectors to not report evasion. The tax inspectors have low salaries and it is cheaper for a firm to bribe a tax inspector than it is to pay social security contributions for its employees. Because tax inspectors generally work alone in the field, it may be difficult to supervise them. A supervisory agency or authority is 12

14 needed that is responsible for the honesty of the tax inspectorate. Although compliance rather than punishment is generally the goal, ultimately, enforcement may require legal action through the court system, both against corrupt firms and against corrupt enforcement officials. An improvement in the salaries of tax inspectors may need to be part of a campaign to eradicate corruption among the tax inspectorate. It also may be desirable to periodically rotate the geographic area of responsibility of tax inspectors as a way of cross checking on the accuracy of the enforcement effort. Penalties. Failure to make mandatory social security contributions should be illegal and should be punishable through penalties. Adequate penalties that are actually levied need to be part of an enforcement effort. Penalties, however, should not be so high as to discourage voluntary reporting of noncompliance. Very high penalties would force firms and workers who initially were noncomplying to continue noncompliance in order to avoid the penalties. Penalties need to be indexed to inflation or to a market interest rate. Because market interest rates can be readily observed, indexing to an interest rate may be administratively simpler than indexing to inflation. Fixed monetary penalties become meaningless in periods of high inflation. To strengthen the ability to collect payments, the collection authority can be given power to require firms to provide wage payment records, to recover from bank accounts, to secure payment from third parties who have debts to an enterprise with arrears, and to establish liens on property. Amnesty. Contribution amnesties, during which penalties and contribution arrears are forgiven, are sometimes granted to encourage voluntary compliance by noncompliers. A one time only contribution amnesty may be useful when it signals the change between a regime where noncompliance was tolerated and a new regime where noncompliance would be punished. A one time amnesty was granted in Bolivia when it switched from a defined benefit system to a defined contribution system. The amnesty was designed to encourage participation in the new system. A pattern of periodic contribution amnesties, however, may encourage evasion because the expectation of future periods of amnesty reduces the expected cost of noncompliance. Simplify Laws. Laws concerning social security contributions should be written to the extent possible so that they are simple to understand. Definitions of key concepts such as wages, employees, and tax years should be standardized across different governmental functions. Forms and publications should be designed to be as clear and as simple as possible. Governmental communication with employees and employers should be simple and clear. Knowledge of Governmental Officials Concerning Requirements. Government officials should be knowledgeable about the legal requirements so that they provide accurate, reliable advice to employers and employees. Timeliness. Improving the timeliness of enforcement actions tends to improve their effectiveness. In the United States it has been found that the faster the Internal Revenue Service (IRS) acts to obtain delinquent taxes, the more likely the action will succeed (U.S. General Accounting Office 1996c). Changes in the Structure of Social Security Reducing Security Contribution Rates. In countries with poor compliance with social 13

15 security contribution payments, the mandatory social security contribution rate is often high. The high mandatory contribution rate is both a cause and a result of poor compliance. A high mandatory contribution rate is an inducement to avoid paying contributions. It creates a high hurdle for low income workers or for workers with limited desire to participate. Contribution compliance may increase if high payroll contribution rates are reduced. This effect will be limited, however, if pension contributions are only a small part of social security contributions and taxes. As part of an effort to improve compliance by reducing the mandatory contribution rate, the government may decide that fewer benefits and less generous benefits should be provided. Countries may, however, have constitutional problems in reducing the current generosity of social security programs as the benefits are viewed as entitlements. Tying Benefits to Contributions. Social security payroll contribution evasion may be reduced by adjusting the benefit formula used to compute social security retirement benefits. The effective net payroll contribution facing workers can be reduced by tieing benefit payments to the individual's contributions. This can be done through a defined contribution system, where the payroll payments become contributions to the worker's retirement account. Tieing benefits to contributions can also be done through a traditional defined benefit system by tieing the benefits to earnings on which contributions have been paid. It is not sufficient to base benefits on earnings. It is important to require that contributions have been made on those earnings. Doing so provides an incentive to make required contributions. Frequently, social security benefits are based on a worker s earnings over a few years, such as over the three years preceding retirement. This method of calculating benefits provides no incentive for the accurate payment of contributions on worker earnings in earlier years. Firms and employees may collude in under reporting employee earnings for purposes of social security contributions for younger employees and over reporting for older employees. Thus, it is desirable when adequate records can be maintained that benefits be based on earnings over a ten year period, and if accurate record keeping can be maintained a longer period of 30 or more years would be better. The incentive to evade social security contributions depends on what other contributions are required and workers motivation to avoid those contributions. Because workers may have a greater demand for health care than pensions, linking the payments for the two may reduce social security contribution evasion. In Mexico, all workers who contribute to the defined contribution system receive a contribution made by the government. The government contribution is designed in part to encourage low income workers to participate in the system. Integration of Programs. For low income workers, poverty program benefits may be only slightly less than their benefits based on their contributions. For this reason, low wage workers may avoid paying social security payroll contributions and instead rely on poverty benefits and minimum benefits. Thus, it may be necessary to reduce poverty benefits or improve minimum social security benefits in order to encourage social security contributions by low wage workers. Coverage. High evasion may reflect that for some groups, such as workers in the informal sector, it is unreasonable to expect high participation rates in social security. It may be better to make coverage voluntary for such workers. Given that there will be high evasion in developing countries that attempt to have high coverage rates, the question arises as to how to design 14

16 systems where evasion will due the least harm. Widespread evasion fosters disrespect for law. Coverage should only be extended on a mandatory basis if it can be enforced. Otherwise, the credibility of the scheme suffers. Recognizing administrative difficulties for small firms in complying with social security contribution requirements, some countries, for example Indonesia, set a minimum firm size for mandatory social security participation. Other restrictions could involve excluding workers who work less than a minimum number of hours or receive less than minimum annual earnings. A further option would be to have a category of workers and firms for whom participation was voluntary. A problem with voluntary participation and excluded categories of participation, however, is that it opens the system to gaming by workers, with them participating in such a pattern as to maximize the value of their participation. This could occur by workers for whom participation is voluntary participating only for the minimum number of years. The contribution law should clearly delineate who is required to register under the scheme. In some cases, nonpayment of contributions may occur because firms and workers do not believe they are required by law to contribute. The Macroeconomic Environment High inflation and financial distress of firms can motivate contribution evasion. In these situations, a temporary reduction of mandatory contribution rates and benefits may be required as an emergency measure to keep the social security system operating at a low level. The ultimate solution, however, is to fix the macroeconomic problems. CONCLUSIONS For contribution evasion to occur, three conditions are required: 1) employees must either prefer nonpayment of contributions or be reluctant to report nonpayment to authorities, 2) employers must wish to evade or place a low priority on making social security contributions relative to other expenses, and 3) government enforcement must tolerate evasion or be inadequate to prevent evasion. Evasion of social security contributions is a common problem in both defined benefit and defined contribution social systems. Depending on the causes, administrative and design changes in social security can improve compliance. These fall into four categories: 1) attitudinal changes, 2) administrative changes, 3) changes in social security, and 4) solving macroeconomic problems. Attitudinal changes involve the social security administration adopting a clear policy that evasion will not be tolerated. This also involves changing the attitudes of workers and firms so that evasion is not viewed as an acceptable practice. Administrative changes involve changes in the monitoring of contribution payments and the effective enforcement of the law. Restructuring social security involves changes that increase the incentives for workers and firms to contribute. For some categories of workers, however, such as the self-employed or workers in small firms, it may be too costly to achieve high rates of compliance, and for these groups it may be best to make coverage voluntary. Macroeconomic changes involve controlling inflation and establishing a stable macroeconomy. It is important that the problem of contribution evasion be addressed. It should be addressed to assure adequate financing for social security so that retirees receive adequate benefits. Equally important, reducing evasion helps build a society based on respect for law. 15