Tax Evasion, Tax Avoidance and the Influence of Special Interest Groups: Taxation in Iceland from 1930 to the Present**

Nordic Tax J. 2015; 2:1–17 Article Open Access Johannes Karlsson and Thorolfur Matthiasson* Tax Evasion, Tax Avoidance and The Influence of Special Interest Groups: Taxation in Iceland from 1930 to the Present** DOI 10.1515/ntaxj-2015-0006 of political economy, so much as the business of taxation. The man Received Aug 05, 2015; accepted Oct 16, 2015 who understands those principles best will be least likely to resort to oppressive expedients, or sacrifice any particular class of citi- Abstract: This paper focuses on tax evasion and tax avoid- zens to the procurement of revenue. It might be demonstrated that ance in Iceland, and on how special interest groups have the most productive system of finance will always be the least bur- shaped the taxation system to serve their own ends. The densome. period covered is from 1930, when the present Icelandic Alexander Hamilton, Federalist, No. 35 1788. system of power was established, to the present. Tax evasion is sometimes an intended, and other times an unintended response to taxation. Willful tax evasion is more likely to occur if consensus regarding fairness and equality of the tax-code is lacking. Tax evasion is an inte- 1 Introduction gral part of the “underground economy”, or more formally, the Non-Observed Economy (NOE). Measuring the size and The purpose of a country’s taxation regime is to facili- scope of the NOE in general, and tax evasion in particu- tate the funding of useful projects, to redistribute rents, lar, is a difficult task. We compare results from three meth- and to fund social insurance schemes. Taxes can be col- ods for estimating the size of the Gross Domestic Prod- lected in many different ways. A particular method may be uct (GDP): the production approach, the expenditure ap- less burdensome for a given group than another method. proach, and the income approach. The results of applying However, taxes affect economic behavior and transfer re- these three methods should, in principle, be identical, but sources from the taxpayer to someone else. Hence, vested they are not. We use the difference, guided by historical interests will try to dictate the principles used for funding facts and anecdotes, to give an idea of the magnitude of and redistribution embedded in the tax-code. tax evasion during the 20th century. Taxation policy is shaped by political institutions that We suggest that the construction of the tax system to serve are, unfortunately, subject to corruption. Corruption is a special interest groups may have disrupted the social, ju- complex phenomenon that all governmental structures, dicial, political and economic balance of the Icelandic private or public, have to deal with. The objectives of bu- “project”. reaucrats and politicians are not necessarily in harmony with those of the general public. Research by OECD shows Keywords: Tax Evasion; Tax Avoidance; Icelandic Tax Sys- that corruption is harmful to economic growth; it increases tem; Governance inequality and poverty, and it affects the allocation of pub- JEL–codes: H2, H3, H5, H6, N1, N2 lic spending and publicly financed infrastructure (OECD (2012)). In developing countries, where the distinction be- There is no part of the administration of government that requires tween the private and public sphere is often unclear, cor- extensive information and a thorough knowledge of the principles Johannes Karlsson: Master of Science in Economics from the De- ** We would like to thank two unknown readers for their remarks. We partment of Economics, University of Iceland. The present paper would also like to thank Mikael M. Karlsson, Professor at the Univer- is partially based on Karlssons’ qualifying essay, which he wrote sity of Iceland, for helpful criticisms on various points in need of im- under the supervision of Professor Matthiasson provement, and Ólöf Pétursdóttir for reading through the whole doc- *Corresponding Author: Thorolfur Matthiasson: Professor of ument. The authors themselves bear full responsability for the con- Economics, University of Iceland; Email: [email protected] tents. © 2015 J. Karlsson and T. Matthiasson, published by De Gruyter Open. This work is licensed under the Creative Commons Attribution-NonCommercial-NoDerivs 3.0 License. 2 Ë J. Karlsson and T. Matthiasson ruption has been defined as: “abuse of entrusted author- 2 Magnitude of tax evasion in ity for illicit gain” (NORAD (2009)). For a developed country, such as Iceland, this definition is too broad. There- Iceland, 1930 to present fore, we will use the definition of the World Bank (2006) and the UNDP (2004) for corruption: “the abuse of pub- 2.1 Introduction lic office for private gain”. This sort of corruption includes bribery, fraud, nepotism, falsification of records, and illicit The term Non-Observed Economy (NOE) refers to all gain- campaign contributions. Corruption and governance fail- ful activities not officially declared, whether payments are ures also include behaviors (e.g. lobbying) that may or may made or not. These include: underground production, il- not be legal, but are driven by the narrow and self-serving legal production, informal sector production and produc- interests of powerful elites, in particular, policy-makers tion of household goods for one’s own final use. Tax eva- (bureaucrats and politicians) and special interest groups sion is an integral part of the NOE, whether the purpose (SIG). Sources of revenue are central to shaping elite in- of non-declaration is to evade taxes or to an illegal activity centives and strategies. For example, it makes a difference from the tax authorities. Hence, measuring the size of the whether or not the elite consists of employees, i.e. bureau- NOE in general, and of tax evasion in particular, is difficult crats, who ’earn’ their pay, or whether their revenues are and prone to errors. ‘unearned’, for instance rents arising from high-value nat- Three different methods have been used to assess ural resources, as in the case of the owners of fishery quo- the Gross Domestic Product (GDP): the production ap- tas in Iceland. For both groups, the incentive is to increase proach, the expenditure approach, and the income ap- their income and power by increasing spending and the proach (UN (1993)). The results of applying these three control of resources, or else by relying on specific insti- methods should ideally be identical, yet they are not, for tutional details of budgeting, taxation and the legislative a variety of reasons. The first estimates of the Icelandic process. GDP, produced in 1953, were based on the expenditure ap- This paper focuses on tax evasion and tax avoidance proach. Estimates based on the income approach, utiliz- in Iceland, and on the way special interest groups have ing tax-return data, were not published until 1964. The used lobbying and other avenues of influence to shape income approach indicated significantly lower GDP than the taxation system to serve their own ends. The period the expenditure approach, see Figure 1. Early researchers covered is from 1930, when the present Icelandic sys- suggested that the difference could be attributed, at least tem of power was formed, to the present. Special inter- partly, to tax evasion. It is now recognized that the discrep- est groups transmit the policy preferences of their con- ancy is caused by many factors, in addition to tax evasion, stituents to elected officials, while political parties are fo- tax avoidance, and corruption; for instance, mismatches cused on maximizing their representation in forums of for- where a buyer dates a transaction differently from a seller, mal power (Parliaments, local governments). These com- errors in registration, definitional misunderstandings, dif- peting goals have important implications for the rela- ficulties in evaluation caused by inflation, etc., (see Box 1). tionship between SIGs and the political parties (Brunell (2005)). The ethics and morality of lobbying are double-edged, 2.2 Up to WWII sometimes normal and natural, but often not; and there- fore, in most countries, lobbying predicated upon cam- Icelandic GDP for the period from 1930 to 1940 has been paign contributions and other such ’inducements’, is reg- calculated retroactively, using both the expenditure and ulated by law. In Iceland, campaign-contribution legisla- the income approach. Producing fresh estimates for GDP tion did not exist until after the crisis of 2008 and, ac- for years long gone is more prone to mistakes than esti- cording to international observers (GRECO (2013)), both mating GDP for the current or a very recent period. But the the legislation and the monitoring system in Iceland are difference of 13 to 30 percent during the period is substan- in need of improvement. tial, see Figure 1. This paper is organized as follows. In the next section, However, the income approach might render figures we seek to estimate the magnitude of tax evasion in Ice- that are too low, since it has been shown that the munic- land since 1930. In section 3, we describe the influence of ipality income tax base was much higher than the central clientelism on the structure of the taxation administration income tax base. The estimate of the GDP from the income in Iceland. In the last section, we present our general con- side was based on the latter. Yet the difference between the clusions. Taxation in Iceland from 1930 to the Present Ë 3 Source: Authors calculations Figure 1: The percentage difference (right hand scale) between GPD estimated by the Expenditure Approach and the Income Approach 1930–1976. BOX 1 Until 1931, there were no special laws or regulations ruling the Central Government Accounts, and the records de- pended rather on the whims of the Finance Minister than on any accounting system. Certain tax collectors-the Dis- trict commissioners-freely dispensed accrued taxes without prior authorization from the Treasury or Parliament (Atvin- numálaráðuneytið (1931)).

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