metadata: authors: 0: author: Sung,Myung Jae
1: author: Awasthi,Rajul
2: author: Lee,Hyung Chul
count: Korea, Republic of
docna: 0: docna: Can tax incentives for electronic payments
            reduce the shadow economy? : Korea's attempt to reduce
            underreporting in retail businesses
docty: Policy Research Working Paper
subtopic: Tax Administration,Macro-Fiscal Policy,Taxation & Subsidies,Economic Adjustment and Lending,Tax Law,Public Sector Economics,Tax Policy,Public Finance Decentralization and
            Poverty Reduction
teratopic: Governance,Law and Development,Public Sector Development,Macroeconomics and Economic Growth
abstracts: cdata!: Increasing tax revenues by reducing the
            shadow economy has been a central goal of tax policy and
            administration in the Republic of Korea since the National
            Tax Service was established as an independent agency in
            1966. This paper examines the Tax Incentive for
            Electronically Traceable Payments, which was introduced by
            the Korean tax authorities in 1999 to promote payments made
            using credit cards, debit cards, and electronic cash
            receipts in business-to-consumer transactions. The tax
            incentive allows wage and salary earners to claim tax
            deductions for eligible purchases made using electronically
            traceable payments when they file their year-end income tax
            settlements. The tax incentive scheme greatly contributed to
            changing the Korean economy into a cashless economy over the
            past decade and a half. Card payments as a ratio of
            Korea's gross domestic product have ranked the highest
            in the world since 2005, reaching 49 percent in 2014. The
            Tax Incentive for Electronically Traceable Payments scheme
            has changed the taxpayer ratio over business income earners
            from stagnant at around 30 percent through the late 1990s,
            to approximately 80 percent at present. The effective
            personal income tax rate for business income followed a
            continuous upward trend, from 3.4 percent in 1998 to 6.3
            percent in 2013. The total revenue increase driven by the
            tax incentive scheme was estimated as W 3.4 trillion, with
            the scheme's costs reaching W 1.9 trillion. The net
            gain was an estimated W 1.4 trillion (approximately US$1.3
            billion), which increased personal income tax revenue by 4.2
            percent. The tax incentive scheme also had a positive impact
            on income redistribution, decreasing the Gini coefficient by
            0.11 percentage points.
geo_reg_key: 119225,517191
repnme: repnme: Can tax incentives for electronic payments
            reduce the shadow economy? : Korea's attempt to reduce
            underreporting in retail businesses
display_title: Can tax incentives for electronic
            payments reduce the shadow economy : Korea's attempt to
            reduce underreporting in retail businesses
listing_relative_url: /research/2017/01/27081595/can-tax-incentives-electronic-payments-reduce-shadow-economy-koreas-attempt-reduce-underreporting-retail-businesses
topicv3: Tax and Revenue Policy and Administration
            m1327008 720,Tax Crime m1327485 2075,Taxation m1327615 1121,Tax Policy m1327616 983,Tax Incentives m1327701 883
publishtoextweb_dt: 2017-01-09T00:00:00Z
historic_topic: Governance,Law and Development,Public Sector Development,Macroeconomics and Economic Growth
no_of_pages: 55
author_keys: 0: author_key: 867107
1: author_key: 1305776
model_extractions: WPS7936 Policy Research Working Paper 7936 Can Tax Incentives for Electronic Payments Reduce the Shadow Economy?

Korea’s Attempt to Reduce Underreporting in Retail Businesses _Myung Jae Sung Rajul Awasthi Hyung Chul Lee_ Equitable Growth, Finance and Institutions Global Practice Group January 2017
Policy Research Working Paper 7936

# **Abstract**

Increasing tax revenues by reducing the shadow economy has been a central goal of tax policy and administration in the Republic of Korea since the National Tax Service was established as an independent agency in 1966. This paper examines the Tax Incentive for Electronically Traceable Payments, which was introduced by the Korean tax authorities in 1999 to promote payments made using credit cards, debit cards, and electronic cash receipts in business-to-consumer transactions. The tax incentive allows wage and salary earners to claim tax deductions for eligible purchases made using electronically traceable payments when they file their year-end income tax settlements. The tax incentive scheme greatly contributed to changing the Korean economy into a cashless economy over the past decade and a half. Card payments as a ratio of Korea’s gross domestic product have ranked the highest in the world since 2005, reaching 49 percent in 2014. The Tax Incentive for Electronically Traceable Payments scheme has changed the taxpayer ratio over business income earners from stagnant at around 30 percent through the late 1990s, to approximately 80 percent at present. The effective personal income tax rate for business income followed a continuous upward trend, from 3.4 percent in 1998 to 6.3 percent in 2013. The total revenue increase driven by the tax incentive scheme was estimated as W 3.4 trillion, with the scheme’s costs reaching W 1.9 trillion. The net gain was an estimated W 1.4 trillion (approximately US$1.3 billion), which increased personal income tax revenue by 4.2 percent. The tax incentive scheme also had a positive impact on income redistribution, decreasing the Gini coefficient by 0.11 percentage points.

This paper is a product of the Equitable Growth, Finance and Institutions Global Practice Group. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted at at mjaesung@hongik.ac.kr, rawasthi@worldbank.org or hlee14@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# Can Tax Incentives for Electronic Payments Reduce the Shadow Economy?

Korea’s Attempt to Reduce Underreporting in Retail Businesses By Myung Jae Sung, Rajul Awasthi, and Hyung Chul Lee

## **JEL** : H26 Tax Avoidance and Evasion

**Key words** : Shadow economy, informal economy, electronic payment, cashless payment, credit card payment, electronic tax administration, tax compliance, tax evasion, tax fraud, underreporting, undeclared work, personal income tax, tax on business income, and tax incentive.
# Contents

|**I.**|**Introduction ................................................................................................................. 1**|
|---|---|
|**II.**|**The Shadow Economy and Countering Policy Measures ............................................... 5**|
|1.|What Is the Shadow Economy? .......................................................................................... 5|
|2.|What Are the Key Characteristics of the Shadow Economy? ............................................. 6|
|3.|What Policy Measures Can Reduce the Shadow Economy? .............................................. 8|
||Deterrent Policy Measures Against Undeclared Work ........................................... 8|
||Incentive Policy Measures on Undeclared Work .................................................. 10|
||Normative Policy Measures .................................................................................. 13|
||Policy Measures Against Underreporting ............................................................. 13|
|**III.**|**Korea’s Attempt to Reduce Underreporting in Retail Businesses ............................... 16**|
|1.|Efforts to Broaden the Tax Base ....................................................................................... 16|
|2.|Introduction and Failure of Mandatory Cash Register Use .............................................. 17|
|3.|Introduction of Tax Incentives for Electronically Traceable Payments (TIETP) ................ 19|
|4.|Rationale for TIETP ............................................................................................................ 21|
||Policy Shift to Measures Encouraging End‐Consumers ........................................ 21|
||TIETP Theoretical Framework ............................................................................... 23|
|5.|TIETP Incentive Structures ................................................................................................ 25|
|6.|The TIETP Process ............................................................................................................. 27|
|7.|Expansion of Electronically Traceable Payments: Electronically Traceable Cash Receipts<br>29|
|8.|Expansion to Mobile Transactions .................................................................................... 29|
|**IV.**|**TIETP Performance Evaluation ................................................................................... 30**|
|1.|Descriptive Analysis for TIETP ........................................................................................... 30|
||Increase in Electronically Traceable Payments ..................................................... 30|
||Increased Tax Net for Business Income ................................................................ 33|

i
|Effective PIT Rate of Owner‐Operated Businesses ............................................... 34|
|---|
|2.<br>Quantitative Analysis for TIETP ......................................................................................... 35|
|Methodology and Data ......................................................................................... 35|
|Tax Revenue Effects of TIETP ................................................................................ 37|
|Effects on Tax Equality .......................................................................................... 40|
|**V.**<br>**Conclusion**........................................................................................................................ 41|
|**References............................................................................................................................. 44**|
|Appendix 1 Household Income and Expenditure Survey ............................................................. 48|
|Appendix 2 Methodology of PIT Estimation ................................................................................. 49|

# List of Figures

|Figure 1 Shadow Economy and Electronic Transactions ............................................................... 1|
|---|
|Figure 2 Two Types of Shadow Economy and Their Structures ..................................................... 7|
|Figure 3 Korea's Policy Shifts to Reduce the Shadow Economy .................................................. 23|
|Figure 4 Credit, Debit, and Prepaid Card Transactions as Percentage of GDP ............................ 31|
|Figure 5 Personal Income Taxpayers as Percentage of Relevant Income Earners (%) ................ 33|
|Figure 6 Effective PIT Rate for Business Income and Wage and Salary Income (%) .................... 34|
|Figure 7 Tax Revenue Effects of TIETP per Household by Decile in 2014 ..................................... 39|

# List of Tables

|Table 1 Cash Payment Restrictions in the European Union .......................................................... 9|
|---|
|Table 2 Tax Incentives for Household Services ............................................................................ 11|
|Table 3 Policy_Measure Matrix_.................................................................................................... 15|
|Table 4 Korea's Policy Experiments to Reduce Underreporting in Retail Sectors ........................ 22|
|Table 5 Payoff Matrix of Non‐TIETP and TIETP ............................................................................. 24|
|Table 6 Changes to TIETP .............................................................................................................. 26|
|Table 7 Electronically Traceable Payments as Percentage of Private Final Consumption|
|Expenditure ................................................................................................................................... 32|
|Table 8 Distribution of Average Income and PIT Burden per Household by Gross Income Decile<br>....................................................................................................................................................... 38|
|Table 9 Total PIT Revenue Impact of TIETP .................................................................................. 39|
|Table 10 Changes of Gini Coefficients ......................................................................................... 40|
|Table 11 HIES 2014 Descriptive Statistics .................................................................................... 48|

ii
# Abbreviations and Acronyms

|ASMTD|Act on the Submission and Management of Taxation Data|
|---|---|
|B2B|business to business|
|B2C|business to consumer|
|BIPC|bearer‐identifiable prepaid card|
|CFDI|digital tax receipt issued|
|CR|cash register|
|DRM|domestic resource mobilization|
|EC|European Commission|
|ECB|European Central Bank|
|ECR|electronic cash register|
|EID|eligible income deduction|
|ETCR|electronically traceable cash receipt|
|ETP|electronically traceable payment|
|FinCEN|Financial Crimes Enforcement Network|
|HIES|Household Income and Expenditure Survey|
|KNTS|Korean national tax simulator|
|MOFE|Ministry of Finance and Economy|
|NTS|National Tax Service|
|PIT|personal income tax|
|POS|point of sale|
|TIETP|Tax Incentive for Electronically Traceable Payments|
|TIS|Tax Integrated System|
|TLI|total labor income|
|UR|underreporting|
|UW|undeclared work|

iii
# I. Introduction

Tax administrations around the world are losing valuable tax revenues due to noncompliance by members of the shadow economy. According to some estimates, on average, one‐third of the world economy is informal (see, for example, Schneider, Buehn, and Montenegro 2010). Many consumers are all too familiar with the seductive temptation of buying goods without a bill or a receipt and saving on the value‐added tax (or sales tax) that would otherwise be paid. Whenever a consumer uses the services of a plumber or a carpenter and forks over the fees in cash, it may not have even crossed his or her mind that a VAT on the service rendered should actually have been added to the billed amount.

Cash has always been a facilitator of the shadow economy, since transactions made in cash do not leave an audit trail. Cash transactions between businesses and individual consumers are a typical risk area. Individuals are consumers of business goods and services, and if they purchase these goods and services in cash, they provide businesses with the opportunity not to report or to underreport those sales. However, consumers do not have any incentive to receive invoices or receipts from businesses, since they ordinarily do not claim input tax credit for VAT or report it as an expense for their income tax. Hence if business sellers offer customers prices lower than their competitors’ on the condition of cash payment, customers are very likely to accept that offer. In this case, it is very difficult for the authorities to detect and curb cash transactions, since sellers and buyers have no conflicting interests and provide no cross‐checks.

In this context, measures to encourage businesses and consumers to pay their bills using banking channels or electronic means of payment can and should be designed and implemented to secure audit trails. There appears to be a strong negative relationship between use of electronic or formal payments and the size of the shadow economy. A study of the European economy by A. T. Kearney and Schneider confirms this association (2009).

Figure 1 Shadow Economy and Electronic Transactions <!-- Start of picture text --> 50<br>40<br>30<br>20<br>R2 = 0.453<br>10<br>0<br>0 50 100 150 200 250 300<br>Average number of electronic transactions per person per year<br>percentage of GDP<br>Shadow economy as a<br><!-- End of picture text --> _Source:_ A. T. Kearney and Schneider (2009).

1
Many countries, therefore, are making concerted attempts to encourage reporting of sales transactions and the use of formal payment systems and to discourage cash transactions to the extent possible. Adoption of tax measures—policy and administrative—is required to incentivize formal payments for business transactions through banking channels, including electronic payments and the use of “plastic money.” Tax policy and tax administration can be important components of a broader strategy to increase the level of cashless transactions; the tax system can either provide a stimulus for moving to noncash payment methods or it can discourage the use of cash. Of course, encouraging cashless transactions and promoting the use of banking channels is a holistic effort requiring the participation of several government agencies (from tax authorities to ministries of finance, from central banks to financial intelligence units).

To move successfully in the direction of a cashless economy requires the strong political will to adopt the necessary measures. Among the measures adopted by some countries to reduce the shadow economy are incentives for payments by electronic means, limitations on cash payments, limits on legal entities and individual businessmen of cash withdrawals from bank accounts, partial exemptions from taxation turnover for businesses conducted in noncash form, restrictions on buying and selling operations for a single transaction or for a certain time period, mandatory use of point‐of‐sale (POS) terminals in the trade and service sectors, expansion in other economic sectors of obligatory use of cash registers with SIM cards, and so on. Arguments continue over the effectiveness of these various measures, but recent comments support the conclusion that these efforts, if backed by public outreach campaigns communicating the benefits of cashless transactions, can help promote the use of banking channels among citizens and businesses.

Several countries around the globe have taken specific tax measures to encourage reporting of business‐to‐consumer (B2C) transactions and to promote cashless transactions and banking channels (Awasthi and Engelschalk, forthcoming). For example, in Colombia, a 2 percent VAT refund is available for individuals on purchases made by debit and credit card or electronic banking for products and services paid at the general 16 percent rate or at the 5 percent rate. Argentina launched a VAT discount for debit card use at point of sale in 2001, giving cardholders a 5 percent reduction in the basic VAT rate of 21 percent on all purchases under Arg$1,000 (US$220). In 2003, Argentina added credit cards to the policy, giving cardholders a 3 percent reduction on their purchases. The government also introduced a further 2 percent reduction on purchases of gasoline via debit or credit payments. Credit card rebates were abolished in 2009, but debit card rebates remain in force.

Countries in the European Union have established quantitative limits (the highest limit is €12,700 in the Czech Republic, and the lowest is €1,300 in Denmark) on the permissible amount that can be spent in cash purchases of goods and services. The idea is that individuals will be forced to use electronic means of payments—such as credit, debit, and ATM cards—which necessarily go through the banking system and hence are far easier to track. Several other countries also have 2
policies directly prohibiting the use of cash for business transactions over a certain limit. In Peru, obligations fulfilled through cash payments exceeding S/. 3,500 (US$1,000) must be made via bank account deposits, wire transfers, payment orders, credit cards, nonnegotiable checks, or other means of payment as provided by entities of the Peruvian financial system. In Turkey, payments of amounts over TL 8,000 and any rental payments over TL 500 must be made through the banking system or postal offices. The effectiveness of these limits at curbing cash transactions is not clear, however, and confirmation is lacking that transactions are not being split to avoid the limits on cash use.

Countries often mandate limits on the use of cash for expenses that can be allowed as business deductions. In Colombia, starting in January 1, 2014,<sup>1</sup> any expenses allowed as deductible for tax purposes had to be made through one of the following payment methods: deposits in bank accounts, bank transfers, checks, and credit or debit cards. Cash payments are fiscally deductible only if they are below certain ranges. In Mexico, allowable deductions of a company’s expenditures must be backed by a digital tax receipt issued (CFDI), and payments exceeding 2,000 pesos must be made through electronic transfer of funds, by personal check or credit, debit, or service cards, or using an electronic pocketbook. In India, sections 40A (3) and (3A) of the Income Tax Act provide that any expense over Re 20,000 in one day will not be deductible if the payment is not made through bank instruments.

Several countries have mandated use of point‐of‐sales (POS) devices and accept card payments. In Kazakhstan, individual businesses of certain types are obliged to accept payment cards and, accordingly, must install POS terminals. In Turkey, self‐employed doctors, dentists, and veterinarians must use POS devices in their offices. Another measure is to mandate enterprises employing more than 10 employees to pay their salaries, including bonuses, through banks. This rule also affects payroll taxes, requiring that they be paid on behalf of employees, and personal income taxes, which are deducted from salaries as they are paid through banking channels, creating a clear audit trail. Other countries with cash payment caps—including France, Turkey, Greece, Italy, Sweden, Norway, and the Netherlands—legally require merchants to issue receipts for each transaction and have allowed merchants to refuse payment in cash to compel the use of cards at the POS. If followed, these measures are designed to make fiscal controls easier, but the success of these direct prohibitions is not clear.

A number of countries have introduced special reporting or withholding requirements for cash payments to businesses. In Mexico, financial‐sector institutions must report cash deposits made to taxpayers’ accounts when the accumulated monthly amount of cash deposits exceeds Mex$15,000. In 2009, the Mexican Central Bank set a Mex$20,000 ceiling for checks payable to the bearer, to combat fraud. The 2014 Tax Reform package also allows Mexican tax officials to

> 1. “Medios de pago para efectos de la aceptación de costos, deducciones, pasivos e impuestos descontables,” added under Law 1430 of 2010.

3
screen credit card data. Using cash or precious metals for certain transactions over amounts specified in the law is prohibited. An example of a general major cash payment reporting system is the Form 8300 system in the United States. Any person engaged in a trade or business who receives more than US$10,000 in one transaction or several related transactions must file a cash payment report to the Internal Revenue Service (IRS). The system, developed jointly by the IRS and the Financial Crimes Enforcement Network (FinCEN), is used by the government to track tax evaders and individuals profiting from criminal activities.

Considering the difficulties of ensuring the correct reporting of cash income, tax administrations are simultaneously aiming at tracing the deposit and use of cash revenues. Cash income will eventually be deposited in a private bank account, spent, or transferred abroad. Matching data on the wealth and spending behavior of a shadow economy business operator with data in his income tax return can reveal major discrepancies and hidden sources of income. Developing 360‐ degree profiles of high net‐worth individuals is useful to track this hidden income and wealth.

Increasing tax revenues by broadening the tax base and further reducing the shadow economy has been at the center of tax policy and administration in the Republic of Korea since the National Tax Service (NTS) was established as an independent agency in 1966. The tax incentive regime to promote use of electronically traceable payments made through credit cards, debit cards, and electronic cash receipts that the Korean government introduced in 1999 was a pioneering policy to broaden the tax base in business‐to‐consumer (B2C) transactions. It is now believed that these measures contributed to broadening the tax base to a great extent by curbing cash transactions. This paper will examine how Korea successfully reduced the shadow economy using this methodology.

4
# II. The Shadow Economy and Countering Policy Measures

## 1. What Is the Shadow Economy?

Although _shadow economy_ has been variously defined depending on research objectives and data, one widely accepted definition is “concealed production and the underground economy,” adopted by the System of National Accounts in 1993 and subsequently readopted in the Organisation for Economic Co‐Operation and Development handbook, _Measuring the Non‐ Observed Economy_ (2002), as follows: Certain activities may be both productive in an economic sense and also quite legal (provided certain standards or regulations are complied with) but deliberately concealed from public authorities for the following kinds of reasons: (a) To avoid the payment of income, value added or other taxes; (b) To avoid the payment of social security contributions; (c) To avoid having to meet certain legal standards such as minimum wages, maximum hours, safety or health standards, etc.; (d) To avoid complying with certain administrative procedures, such as completing statistical questionnaires or other administrative forms.

(Commission of the European Communities et al. 1993, 153) This paper focuses on the shadow economy comprising productive legal activities concealed from tax authorities to avoid the payment of income, value‐added, or other taxes, that is, category (a) of the definition cited above. However, category (a) sometimes, or even usually, overlaps with (b), (c), or (d); therefore, any tax policy measures intended to reduce category (a) may have effects on other subcategories of the shadow economy as a positive byproduct. Unregistered microfirms, for example, because they operate completely outside the formal economy, attempt to avoid meeting minimum wage standards or paying social security contributions, nor do they pay income or value‐added tax as a matter of course. Therefore, any tax measures aimed at bringing such unregistered firms into the formal economy and getting them to pay taxes will simultaneously reduce instances of the type of noncompliance described in subcategories (b), (c), or (d). Tax compliance measures aimed at registered firms that partly underreport their sales to avoid income or value‐added taxes would also have but limited effect on the other categories in the shadow economy.

5
# 2. What Are the Key Characteristics of the Shadow Economy?

Many countries, whether developed or developing, have shadow economies. The causes generating a shadow economy and motivating participation in it have many folds and implications. According to Feld and Schneider’s summary of 32 studies on the shadow economy and its causes, “increase of the tax and social security contribution burdens” was by far the most important single contributor to the increase of the shadow economy, followed by “tax morale,” “quality of state institutions,” and “specific labor market regulations” (2010). However, contrary to traditional thinking that the tax burden is a significant driver of the shadow economy, some scholars have presented opposing empirical research results showing that the tax burden has a negative correlation with the shadow economy (Friedman, Johnson, and Kaufmann 2000; Stankevičius and Vasiliauskaite 2014). Cumbersome labor‐market restrictions, loss of access to the formal financial sector, and weak governance and institutions also determine the size of the shadow economy (Singh, Jain‐Chandra, and Mohommad 2012).

Apart from the argument on causes of the shadow economy, however, participants in shadow economies evade taxes and social security contributions and avoid various other government regulations. Therefore, public authorities, including tax policy and administration authorities, have a very keen interest in making participants in the shadow economy comply with taxation and social security contribution and other public requirements. Even when the tax burden is not a key driver of the shadow economy, noncompliance with tax laws remains one of its manifestations. Any measures to bring people into compliance with tax laws would reduce the shadow economy and at the same time contribute to curing causes of the shadow economy other than taxation.

The shadow economy defined from the perspective of taxation comprises two types of activities: (i) activities of unregistered informal enterprises (including individuals) operating completely outside the formal economy ( _undeclared work,_ or UW), and (ii) activities of registered companies in the formal sector intentionally underreporting their sales ( _underreporting,_ or UR). Informal firms that do not register and that operate outside formal economy completely evade taxes and do not comply with other mandatory legal requirements, such as the minimum wage or social security contributions. Registered formal firms can also underreport their income to evade taxes, especially in cash‐intensive businesses. In some cases, formal firms can also avoid legal requirements through undeclared work by unregistered workers. Meanwhile, people who want work but who are not competitive in the labor market, such as old people, women, ethnic minorities, illegal immigrants, or recipients of government transfers, are also voluntarily or involuntarily hired informally. Shadow economy firm owners tend to hire those people at very low wages, do not pay their share of social security contributions, and do not abide by other legal obligations in relation to hiring. Firms can evade income tax, VAT, and social security contributions completely or partially, while informal employees in those firms are not subject to 6
<!-- Start of picture text --> Undeclared Work (UW) Underrporting (UR)<br>Informal firms or individuals Consumers Formal firms or individuals Consumers<br>cad - —_ UU © Goods & services O O<br>without tax as )~ J without tax r~{ )-%<br><!-- End of picture text --> <!-- Start of picture text --> ¥<br>¥.<br>Labor<br>Labor Cash<br>Cash<br>a<br>| x ¢ Less CIT, PIT<br>* No VAT, sales tax<br><!-- End of picture text -->

<!-- Start of picture text --> Unregistered; workers * andLess othersocial obligationscontributions<br>* No CIT, PIT, VAT, sales a<br>* tax, social contributions @ i<br>No minimum wages,<br>work: hour, safety,Y. Tax administrationswe n<br>environment, etc.<br><!-- End of picture text -->
# 3. What Policy Measures Can Reduce the Shadow Economy?

Measures to reduce the shadow economy that do not tackle its above‐mentioned core aspects or that focus on piecemeal reforms may be ineffective. For example, lowering the barriers to business registration, such as by simplifying the registration process, scrapping unnecessary registration documentation, and lowering legal requirements for registration, may facilitate formalization and yet fail to make significant headway toward reducing the shadow economy in the absence of other comprehensive measures to turn informality into formality. Although liberalization on registration _per se_ is a good policy for the business environment, it may not be enough to break through all the various collusive aspects of the shadow economy. Since informal firms have various reasons for remaining informal, such as avoiding taxation and onerous social security contributions or other labor condition standards, it would be difficult to convert informality to formality merely by deregulating registration. Mexico provides an example. Mexico reformed and simplified its local business registration process, increasing the number of new business registrations, but the reforms do not seem to have induced unregistered businesses to register (Rruhn 2008). In this context, Perry et al. (2007) suggested a wider, more integrated approach to inducing formality by combining carrot and stick policies. Policy measures directly focused on a key aspect of the shadow economy—collusive cash transactions—are necessary to induce informal firms to enter the formal economy. If participants in the shadow economy find it difficult to use cash for payment by any means, the shadow economy would shrink. Any circumstances or incentives that can break the collusion facilitated by cash among participants in the shadow economy will reduce its size. Recent support for this approach has been supplied by K. S. Rogoff (2016), who envisions a bold currency policy that phases out cash to eliminate tax evasion and reduce crime. Also very worth keeping an eye on are the longer‐term effects of India’s abrupt revocation in 2016 of two of its highest‐denomination notes (the 500‐ and 1,000‐ rupee notes), seemingly undertaken to pursue methods and achieve goals similar to those advocated by Rogoff. This section explores various tax policies or administrative measures used by a number of countries to switch informality to formality.

## Deterrent Policy Measures Against Undeclared Work

The EU countries regard undeclared work as more problematic than underreported goods or services (Jensen and Wőhlbier 2012, 27). Undeclared work accounts for roughly two‐thirds of the shadow economy—the other one‐third comes from underreporting—and half of the roughly 200 measures in use in European countries against the shadow economy focus on undeclared work (A. T. Kearney and Schneider 2013). The EU member states have adopted either deterrent measures (sticks) or incentive measures (carrots) to turn the shadow industry toward the formal 8
economy. Until recently, deterrent measures, such as detecting, criminalizing, and penalizing undeclared work, have been prevalent, but EU countries have increasingly adopted incentive measures for inducing voluntary compliance (Williams 2009). According to a survey of policy measures adopted in the EU countries, almost all countries impose administrative or penal sanctions on either purchasers or suppliers of goods and services involved in undeclared work (Dekker et al. 2010). However, despite buyers’ gains from tax evasion, fewer countries impose penalties on purchasers (Jensen and Wőhlbier 2012, 28). The concept of a penalty for the purchase of undeclared work is based on the buyer’s illegal benefit from the low price of undeclared work resulting from tax evasion.

In Italy, for example, under the Decreto Bersani, a law passed in 2006, a retailer that fails to issue a sales receipt three times in a five‐year period can be closed, and construction sites can be shut down if employment irregularities are found. It is also illegal to use cash to pay more than €100 for professional services (A. T. Kearney and Schneider 2009). Buyers of undeclared work must keep receipts to present to tax authorities, if asked, to avoid sanctions. Norway requires purchasers to pay using electronic means or to keep invoices for a specified time to avoid criminal liability for purchases of undeclared services (Jensen and Wőhlbier 2012, 28). Penalizing both providers and buyers of undeclared work can be effective in that it more effectively breaks the collusive relationship between them. However, the process of monitoring a large number of small and micro businesses to determine if they are issuing receipts—and then ensuring that the general public keeps those receipts—is almost impossible, given the tax authorities’ limited resources. Those measures have potential deterrent effects, but they may not be implementable in practice. With this in mind, many scholars have questioned the effectiveness of deterrent measures, in general, including detecting and punishing (Williams and Schneider 2016, 147–48).

Another noticeable deterrent measure for reducing overall cash transactions that can lead to tax evasion and fraud has been rolled out by some of the EU countries. Belgium, Bulgaria, the Czech Republic, Denmark, France, Greece, Hungary, Italy, Portugal, and the Slovak Republic have introduced cash payment limits, mostly since the crisis of 2012, as shown in Table 1 below.

Table 1 Cash Payment Restrictions in the European Union

|Belgium|€3,000|January 1, 2014|
|---|---|---|
|Bulgaria|lev 10,000(≈ €5,112)|July 1, 2011|
|Czech<br>Republic|CZK 350,000 (≈ €12,763)|January 1, 2013|
|Denmark|DKr 10,000 (≈ €1,340)|July 1, 2012|
|France|€3,000 (resident and nonresident traders)|January 1, 2002|

9
||€15,000 (nonresident consumers)||
|---|---|---|
|Greece|€1,500|January 1, 2011|
|Hungary|Ft 1.5 million (≈ €5,000) (legal persons)|January 1, 2013|
|Italy|€999.99|December 6, 2012|
|Portugal|€1,000|May 14, 2012|
|Slovak<br>Republic|€5,000<br>€15,000 (natural persons who are not entrepreneurs)|January 1, 2013|
|Spain|€2,500 (residents)<br>€15,000 (nonresidents)|November 19,<br>2012|

_Source:_ Beretta 2014.

Such limits force people to make electronic payments, leaving a trail tax authorities can trace. However, for tax authorities to access information on financial transactions, relevant legislation enabling such access must be prepared, which has not happened in all EU member countries (Jensen and Wőhlbier 2012). In addition, the European Central Bank (ECB) warns that although such limitations on cash payments are compliant with EU law, they should be carefully weighed to achieve the desired balance between the policy’s objectives and its possible negative effects on public benefits (European Central Bank 2014a, 2014b).<sup>2</sup> Although cash payment limitations are intended to have a direct impact on cash transactions, a core aspect of the shadow economy, they might overly restrict individuals’ freedom of economic activity. Another question regarding this approach is how cash limits can be enforced. As noted earlier, cash transactions mostly occur in collusive situations. If buyers and sellers agree to pay and receive cash without leaving a financial footprint, the relevant authorities’ ability to detect those transactions and enforce cash limits remains questionable.

# Incentive Policy Measures on Undeclared Work

Measures to induce voluntary compliance by providing monetary or nonmonetary incentives have been introduced in several EU countries. One prominent incentive scheme addresses household services, which tend to remain undeclared work in the European Union. In recent

> 2. “In any case, limitations on cash payments should be proportionate to the objectives pursued and should not go beyond what is necessary to achieve such objectives. . . . Any negative impact of the proposed limitations should be carefully weighed against the public benefits expected to be derived from them” (European Central Bank 2014a, 2014b).

10
years, tax deductions or direct subsidies for purchasers of household services have been introduced to support their expense for cleaning, cooking, laundry, home maintenance, or care services for children and the elderly or disabled. The overall goals are to induce undeclared work to enter the formal economy and to create jobs in several EU countries. The scope of eligible services, the form of support, the amount of tax deduction or subsidy, and the specific conditions for monetary incentives differ between countries; however, the intention is to move undeclared services to declared services by subsidizing household service expense to reduce the expense gap between the formal and informal economies. Public interventions in different countries to narrow the expense gap for formal versus informal service provision range from direct subsidies to household service providers or users to public revenue expenditure through tax deductions, tax exemptions, or VAT reduced rates. Table 2 provides a summary of representative EU countries’ tax incentives, excerpted from the European Commission report, _Developing Personal and Household Services_ (2013).

Table 2 Tax Incentives for Household Services

|Belgium|Tax reductions are linked to the use of vouchers used to hire household services.<br>Two types of vouchers, the cheque AlE and the Titre‐services, are eligible for tax<br>deduction, the former 30 percent and the latter 30 to 40 percent. The ceiling<br>for voucher tax deductions is €2,400 Euros (the total of both vouchers).|
|---|---|
|Denmark|In 1994, Denmark became the first country to introduce a subsidy of 50 percent<br>of cost to support household services, such as garden work, snow clearance,<br>shopping for daily goods, cooking, cleaning, laundry, and window cleaning.<br>The benefit was reduced in 2004, and benefits were limited to people aged 65<br>or more.<br>In 2011, tax credit was allowed to all private persons; however, it is expected to<br>be abolished as of 2013.|
|Finland|A tax deduction system was introduced in 1997 for household services within<br>the taxpayer’s own house or in an elderly relative’s home.<br>If the tax deduction is larger than the amount of the central government income<br>tax, local government taxes can also be reduced.<br>Since 2009, eligible services include household work, caregiving, and day‐care<br>work at home; repair work; services for a leisure house; and IT services.|

11
||The tax deduction is 40 percent of expenses paid to a company, small<br>entrepreneur, or a nonprofit organization (60 percent until 2011) and 15<br>percent of wages paid for hiring an employee.<br>When employing an individual, the employer social contribution is exempt.|
|---|---|
|France|France allows 50 percent of expenses for cleaning, ironing, IT assistance, or<br>private lessons as deductions for income tax.<br>Tax deductions are given to households either directly employing an individual<br>service supplier at home or hiring a service company.<br>The ceiling of tax deduction is €12,000 per year, but it can be increased<br>depending on the number of children, of residents aged 64 or older, and of<br>disabled residents.<br>From 2007, if the eligible tax deduction surpasses the income tax, the difference<br>over the income tax is reimbursed to help low income households.|
|Germany|Tax credit is allowed up to 20 percent of the costs for household‐related<br>services, such as gardening, cleaning, laundry services, or childcare.<br>In addition, 20 percent of the wage costs for craft services, such as repairs or<br>renovations, can be offset with income tax.|
|Italy|Tax incentives are linked to purchases of vouchers, but the scope of covered<br>work is very broad. It includes maintenance of buildings, seasonal and<br>agricultural activities, organization of sporting events, and so on.|
|Luxembourg|Tax reduction for the expense of housework services and care services for<br>dependent persons or children is allowed but with maximum tax rebate of<br>€3,600 per year and €300 per month.|
|Sweden|The tax reduction system in Sweden has two components: RUT (cleaning,<br>maintenance, servicing) and ROT (home renovation services).<br>Tax credits are allowed up to 50 percent of labor costs (including VAT) for<br>household services. The sum of the tax credits for RUT and ROT must not exceed<br>around €5,500 per person per year.|

_Source:_ Authors’ summary from European Commission (2013).

Contradictory assessments have been put forward regarding monetary support for household services. The European Commission (EC) in 1998 issued a positive evaluation of such policies, stating, “Tax‐deductions and subsidies for re‐furbishing and improvements of houses have been 12
particularly successful in encouraging more people to use the opportunity to repair their houses legally, and had the effect of moving work which might have been done informally to the formal registered sector” (European Commission 1998). A later paper published by EC (Jensen and Wőhlbier 2012) indicated an altered stance, however: “Although such tax credits and subsidies may have a positive impact on employment in the formal economy, they tend to be expensive in terms of forgone revenue, and the experienced results in terms of reduction of the shadow economy have not been convincing, in particular when compare to the cost of the measure. Moreover, these measures tend to introduce a ‘trap’ which might lock in this kind of household jobs.” The most recent EC report acknowledges that these policies “proved to be quite costly,” but it also presents some analytical results comprising not only gross public expense but also direct and indirect earn‐back effects; for example, the data show a 45 percent reduction in net cost for public expense in Belgium and positive returns in Finland and France (European Commission 2013).

# Normative Policy Measures

Use of traditional economic incentives and disincentives as preferred measures in the EU member states is now being considered in tandem with a softer approach that cultivates tax morale, enhances tax‐system fairness, and encourages social norms for tax compliance. These approaches are widely discussed and perceived as effective in the literature. However, the EU countries still depend heavily on traditional stick and carrot policies, with very few adopting normative compliance measures, such as appeals to people to declare their activities, campaigns to encourage a culture of commitment to declaration, and efforts to change perceptions of the tax system’s fairness (Williams and Schneider 2016, 153–54).

# Policy Measures Against Underreporting

In addition to undeclared work, some OECD countries have become aware of the risk of huge levels of underreporting in B2C retail sectors prone to falling into the shadow economy due to their heavy volume of cash transactions.<sup>3</sup> It is a world‐wide phenomenon that electronic cash registers (ECR) or electronic point‐of‐sale (POS) systems are often manipulated and altered to underreport sales by using electronic sales suppression software known as Phantomware and Zappers (OECD 2013). To counter this kind of fraud, the Irish government, as of July 2008, has made it mandatory that electronic cash registers record and retain sales entries in electronic format with uniquely identifiable sequential number, date, and time, and it has issued guidelines

> 3. The Canadian Restaurant and Food Services Association estimated suppressed sales of CAN $2.4 billion for 2009 in the restaurant sector; Sweden recovered €150 million in 2,000 audits over four years; and Norway found a single case involving underreporting of €7 million (OECD 2013).

13
on requirements for proper record keeping (e.g., securing the integrity of data) for cash registers (Revenue Irish Tax and Customs 2015). Many countries, including Argentina, Brazil, Bulgaria, Greece, Hungary, Latvia, Lithuania, Malta, Poland, the Russian Federation, Turkey, the República Bolivariana de Venezuela, and Canada Quebec, have increasingly made mandatory the use of certified electronic cash registers or POS systems in targeted business sectors (e.g., restaurants), which can prevent cash receipt skimming by adding monitoring devices to the POS system, securing data with digital signatures, or transferring transaction data to tax authorities (OECD 2013). This approach may not ultimately solve underreporting fraud, however, in cases where business sellers and customers agree to off‐the‐record cash transactions or when business sellers simply do not register cash transactions without receipts. Other problems with the certified cash register approach are the potential for too much interference by governments in private businesses and the high cost of the registers, which will restrict the scalability of mandatory adoption to certain business sectors (Ainsworth and Hengartner 2009).

Another approach countering underreporting fraud is incentivizing customers to request receipts from businesses. Taiwan, China, introduced “receipt lottery” in 1951 to encourage people to get receipts when purchasing goods or services from businesses. It was intended to broaden the tax base by providing an incentive (a lottery prize) to request receipts from businesses and hence prompt businesses to file their sales correctly according to their receipts issued. Mainland China also announced a guideline on lottery receipts in 1989 and introduced mandatory lottery receipts in all tax bureaus in China in 2009 after experimenting with the concept in more than 80 big‐city‐ level tax bureaus, including Beijing, Shanghai, and Tianjin (Wan 2010). According to Wan’s analysis, lottery receipts increased sales tax and total tax revenues significantly in the experiment areas (2010). Puerto Rico also introduced a sales‐and‐use tax lottery in 2011. In contrast to this program of indirect incentives in the form of lottery prizes, Sao Paulo, Brazil, introduced VAT rebates for receipts. End‐consumers collecting receipts could take tax rebates of 30 percent (currently 20 percent) of the VAT paid by the final sales establishment. In addition, lottery tickets are given for every US$50 purchase. This Nota Fiscal Paulista program in Sao Paulo increased firms’ reported revenues by at least 22 percent (Naritomi 2015).

Table 3 offers a summary of policy measures for reducing informal firms’ or individuals’ undeclared work (UW) or formal firms’ underreporting (UR). Policy measures can be categorized according to targets: “seller” or “buyer.” A further classification is by policy approaches: “deterrent,” “encouraging,” or “normative.” The policy measures mapped in this matrix reduce undeclared work, underreporting, or both. Normative approaches can be divided into “seller” and “buyer” categories but they are presented here without distinction.

14
Table 3 Policy _Measure Matrix_

||Seller (pushing)|Buyer (pulling)|
|---|---|---|
|Deterrent|Criminalization (UW)<br>Monitoring and auditing (UW & UR)<br>Penalties for not invoicing (UW & UR)<br>Mandatory use of ECR or POS (UR)|Criminalization (UW)<br>Penalties for not getting receipts<br>(UW &UR)<br>Cash payment limits (UW & UR)|
|Encouraging|Deregulations on registration, lowering<br>expenses for formalization (low tax, low<br>burden for employment, and other<br>deregulations) (UW)<br>Tax incentives for e‐payments (UW & UR)|Tax incentives or direct subsidy<br>for home services (UW)<br>Tax incentives to make<br>electronically traceable payments<br>(UR)<br>Cash rebates for receipts (UR)<br>Receipt lotteries (UR)|
|Normative|Tax education and public awareness (UW<br>Enhancing tax morale and cultivating a co<br>Building trust regarding tax policy and adm|& UR)<br>mpliance culture (UW & UR)<br>inistration (UW & UR)|

_Source:_ Authors’ categorization of currently implemented policy measures discussed above.

15
# III. Korea’s Attempt to Reduce Underreporting in Retail Businesses

## 1. Efforts to Broaden the Tax Base

The history of domestic resource mobilization (DRM) in the Republic of Korea is characterized by the tax authority’s efforts to increase revenue and enhance tax equity by broadening the tax base, taxing on the basis of tax information and evidence to finance Korea’s economic and social development needs. The National Tax Service (NTS) was established as a separate organization from the Ministry of Finance in 1966 to mobilize more effectively the tax revenue needed to finance the country’s Five‐Year Economic Development Plan, a series of government‐led national economic development plans consisting of seven five‐year spans from 1962 to 1996. In 1975, global income taxation on aggregate income, including labor income, business income, real‐ estate rent income, and other miscellaneous incomes, was introduced to enhance tax equity. Value‐added tax was introduced in 1977 to enable evidence‐based taxation and to prevent tax evasion by cross‐checking VAT invoices. Initially, this cross‐check was accomplished by requiring taxpayers to submit all invoices when they filed VAT returns. Currently cross‐checks are done electronically through mandatory e‐invoicing. In 1993, mandatory use of real names and a prohibition on the use of pseudonyms for financial transactions were introduced to enhance the transparency of financial transactions and to prevent illicit financial flows. The mandatory use of real names set the stage for the global financial income tax levied on aggregate financial incomes, including interest and dividends, introduced in 1996 to enhance tax equity in financial income taxation.

Another drastic change in tax administration in 1996 was the shift from taxation based on the government’s assessment to taxpayers’ voluntary tax returns. Before the voluntary income tax returns were instituted, NTS either assessed taxpayer’s income tax liabilities based on their bookkeeping and other records, or it accepted taxpayer income tax returns that complied with preset standards or that reported income above the preset standard income‐to‐sales ratio NTS set depending on business sectors, geographical areas, and business scales. After abandoning the government assessment system, however, NTS faced a big challenge: how could it verify taxpayers’ voluntary income tax returns? The most problematic areas were the B2C retail sectors with heavy cash transactions; examples include professional individual‐service sectors, hotels, restaurants, bars, salons, pharmacies, and other retail stores. While business‐to‐business (B2B) transactions were traceable through VAT invoice audit trails, B2C transactions, especially cash sales, could not be traced by tax authorities. End‐consumers did not have any incentives to obtain receipts or to report purchases to tax authorities, unlike businesses that claim input VAT credit 16
against their output VAT. Accordingly, tax policy and tax administration authorities began exploring more fundamental approaches to create audit trails for B2C cash transactions.

# 2. Introduction and Failure of Mandatory Cash Register Use

Since 1977 when VAT was introduced, Korea’s tax authorities had made efforts to effectively capture the sales of cash‐intensive industries using the invoice credit VAT system. The same year, the Ministry of Finance rolled out comprehensive legal provisions to prevent underreporting in retail sectors.<sup>4</sup> VAT law made the use of cash registers (CR) mandatory for designated cash‐ intensive businesses, with penalties for failing to install CRs, neglecting to issue receipts, and altering cash sales.<sup>5</sup> In addition to the deterrent measures, tax incentives were instituted for both retailers and consumers. Retailers using CRs received a tax credit against VAT payable (0.5 percent of CR recorded sales). In addition, customers who collected and submitted CR issued receipts to the government were given cash compensation: 1 percent of the purchase value. In line with the government support for CR use and receipt exchange in the retail sectors, Korea’s Chamber of Commerce and Industry and many consumer NGOs allied with the NTS to run a nationwide campaign to educate and encourage retailers and consumers to issue and receive receipts.<sup>6</sup> In fact, the receipt campaign had been widely conducted, although without substantial success, since NTS was established in 1966, but it was relaunched when VAT was introduced. Believing that receipt‐exchange practices were vital to the success of the newly adopted VAT and of their efforts to tax on the basis of information and evidence, tax authorities strongly drove CR installation in cash‐intensive retail sectors and receipt exchanges between retail businesses and consumers.

These policy measures failed, however, despite the continuous efforts by tax authorities to encourage receipt exchange in retail sectors into the early 1990s. Retailers, urged to install CRs by NTS’s strong administrative recommendation, were reluctant to issue receipts through them, and if consumers did not request receipts, they continued to drop off cash sales to evade the tax burden. In response to taxpayers’ presumed underreporting and tax evasion, tax authorities even denied retailers’ VAT and income tax returns and assessed much higher taxes above the sales

> 4.  Article 32, Value Added Tax Law and Articles 82 and 83 of VAT Presidential Decree, effective as of January 1, 1977. 5. The penalty was very strong: a 15‐day business suspension for two detected instances of non‐provision of receipts or manipulation of cash sales within a 90‐day period, and business closure for three detected instances. The penalty for failure to install CRs was W 500,000.

> 6. “Korea Chamber of Commerce Campaign for Issuing and Receiving Receipts,” _Kyunghyang Shinmun,_ January 18, 1977.

17
recorded in the CRs.<sup>7 , 8</sup> This contradictory move by tax authorities provoked friction with taxpayers, criticism from the public, and distrust against government policies and authorities. In addition, consumers’ tendency to neglect to obtain receipts did not change substantially. Despite compensation for obtaining CR receipts, consumers did not actively do so because the application process for receipt compensation was cumbersome and inconvenient and the economic benefit was relatively small.<sup>9</sup> Even worse, finding the system ineffective, the Korean government abruptly abolished CR receipt compensation after only three years, thus eliminating the only incentive for consumers to learn over the long term the benefit of obtaining receipts.<sup>10</sup> Distrust between taxpayers and tax authorities, low tax morale of taxpayers, repeal of receipt compensation, and even functional defects in CRs eroded the effectiveness of the cash register policy. Following the presidential and parliamentary elections in 1978, tax authorities sought to reduce friction with taxpayers, and in the early 1980s they reduced and almost totally suspended investigation into and penalties for failure to issue receipts.<sup>11, 12</sup> In 1988, the mandatory use of cash registers was _de facto_ abolished, on the reason that it had been enforced for the convenience of tax administration and that it in fact discouraged issuing and receiving receipts, despite its original objectives,<sup>13</sup> after a number of swings between strong enforcement and soft encouragement. In 1993, the article in the VAT law making CR use mandatory was officially deleted and changed to support voluntary use of CRs.<sup>14</sup> Tax credits to business sellers for issuing CR receipts (0.5 percent of concerned sales) were maintained to encourage voluntary CR use. In 1996, however, even the tax credit for CR receipts was repealed as CRs had proven ineffective in reducing underreporting of cash sales.<sup>15</sup>

> 7. A news article in the _Kyunghyang Shinmum_ (September 27, 1979) reported that cash registers became useless due to the businesses’ neglect in issuing receipts and consumers’ lack of awareness of receipts. It also reported that fewer than 1 in 10 customers in restaurants obtained receipts, and no one obtained receipts in grocery stores. According to a taxpayer who equipped his business with a very expensive cash register at the urging of tax officials, tax inspectors did not assess taxes based on the cash register records but levied a 20 percent additional tax.

> 8. “Equipped with an Expensive Cash Register but Distrusted,” _Dong‐a Ilbo,_ February 20, 1979.

> 9. “Urgent to Make Receipt Exchange a Practice After One Year of Campaign,” _Mail Economy,_ February 7, 1978. 10. “Receipt Compensation Abolished from Next Year After Three‐Year Trial with Less Effectiveness,” _Dong‐a Ilbo,_ September 24, 1979.

> 11. “Lost Enforcement of Cash Registers,” _Mail Economy,_ March 19, 1980.

> 12. “Retarding VAT,” _Dong‐a Ilbo,_ April 14, 1981.

> 13. “Retailers, Allowed to Use Cash Registers Voluntarily,” _Mail Economy,_ August 2, 1988.

> 14. Article 32, VAT Law, effective as of January 1, 1994.

> 15. Paragraph 2, Article 32, VAT Law, effective as of January 1, 1996.

18
# 3. Introduction of Tax Incentives for Electronically Traceable Payments (TIETP)

After the mandatory use of CRs proved to be a failure, tax authorities in Korea decided to develop other policy and administrative options to prevent underreporting. In the late 1980s, they began to focus on electronic payments, such as credit card payments, that enabled tax authorities to follow the retail sectors’ audit trails. In 1984, to encourage use of credit cards in retail service sectors, the Ministry of Finance introduced regulations<sup>16</sup> requiring large‐scale businesses (above W 10 billion in sales) to submit detailed lists of tax‐deductible business entertainment expenses to the NTS, with the exception of expenses paid using credit cards. In 1986, the NTS first requested credit card companies to submit taxpayers’ credit card transaction data, which was allowed under the Credit Card Business Law when requested by tax authorities for purposes of tax inquiries or investigations. The NTS thereafter began to use credit card transaction information to verify retail businesses’ tax returns (Jang 1997, 178). The effects of this approach were limited, however, since significant numbers of transactions were still paid with cash.

From the mid‐1990s, when personal income taxation in Korea shifted from use of government assessments to voluntary reporting using tax returns, cash transactions without receipts and underreporting became much more serious challenges to the Korean tax authorities. NTS would receive taxpayers’ voluntary tax returns without assessment if it did not have clear counterevidence to taxpayers’ assertions. NTS could no longer enforce income taxation on the basis of its own income‐to‐sales ratio criteria, as before. Korean tax authorities attempted to fill the gap between taxpayers’ voluntary reporting (underreporting) and NTS’s deficient tax information and evidence.

Against this backdrop, in 1994, the Ministry of Finance introduced a tax incentive for credit card use—0.5 percent of credit card sales credited to VAT payable for retail sellers dealing mainly in goods or services to consumers<sup>17</sup> —and it abolished the similar tax credit for issuing CR receipts. Subsequently, in 1996,<sup>18</sup> the ministry increased the tax credit rate from 0.5 percent to 1 percent (the ceiling of three million won was put in place beginning in 1999<sup>19</sup> ). As of January 1, 2000, the tax credit rate was increased to 2 percent, with a ceiling of five million won.<sup>20</sup> The policy direction slowly turned from CR receipts to credit card payments.

Allowing tax incentives to end‐consumers paying with credit cards was a contentious issue, however. In 1995, the Ministry of Finance started to review tax deductions for wage earners who

> 16. Article 44‐3, Corporate Income Tax Presidential Decree, effective as of October 5, 1985, and Article 106‐2, Personal Income Tax Presidential Decree, effective as of October 5, 1985.

> 17. Paragraph 1, Article 32‐2, VAT Law, effective as of January 1, 1994.

> 18. Paragraph 1, Article 32‐2, VAT Law, effective as of January 1, 1996.

> 19. Paragraph 1, Article 32‐2, VAT Law, effective as of January 1, 1999.

> 20. Paragraph 1, Article 32‐2, VAT Law, effective as of January 1, 2000.

19
used credit cards to increase electronically traceable payments.<sup>21</sup> In 1999, tax incentives for electronically traceable payments (TIETP) was finally introduced.<sup>22</sup> TIETP is a completely different form of tax incentive for individual consumers. While it gave tax incentives to the general public for almost all credit card payments, and hence its fiscal impact was estimated to be substantial, its effectiveness in preventing underreporting remained unclear. Korea already had experience in giving consumers incentives under the program mentioned earlier that provided compensation for collecting CR receipts, but this had proved to be a failure due to taxpayers’ disregard of CR receipts, the inconvenient compensation application process, delays in compensation due to poor management, and the government’s slow budget allocation or budget shortfalls.<sup>23, 24, 25, 26</sup> Despite these problems in the implementation process, consumer compensation nonetheless slowly took a root, as evidenced by the compensation amounts disbursed: W 1.4 billion in 1977, W 2.76 billion in 1978, and W 2.52 billon in the first half of 1979.<sup>27</sup> Despite the problems in implementation process, the budget proposal for consumer compensation submitted by NTS was abruptly dismissed by the Economic Planning Board after only three years of implementation, however, on the basis that it was costly but ineffective in reducing underreporting.<sup>28</sup> The government policy to encourage receipt exchange in retail sectors to prevent underreporting and to enable evidence‐based taxation was significantly undermined by this retrograde measure.<sup>29</sup> After the revocation of the receipt compensation program, intermittent requests for and discussions of reintroduction took place.<sup>30, 31, 32, 33</sup> Not until the introduction of TIETP in 1999 was it reinstated, however.

Starting in 1998, the Ministry of Finance and Economy (MOFE) undertook a series of measures to encourage credit card payments in the belief that these would provide reliable tax information on sales in retail businesses and would contribute to enhancing business transaction

> 21. “Tax Deduction for Credit Card Use,” _Mail Economy,_ May 18, 1995; “Tax Deduction for Credit Card Use to Wage Earners,” _Mail Economy,_ July 26, 1995.

> 22. Paragraph 126‐2, Preferential Tax Control Law, effective as of August 31, 1999.

> 23. “Urgent to Make Receipt Exchange a Practice After One Year of Campaign,” _Mail Economy,_ February 7, 1978.

> 24. “Delayed Compensation for Receipts Is Not Trivial,” _Mail Economy,_ July 10, 1978.

25. “Problems with Receipt Compensation,” _Kyunghyang Shinmun,_ March 26, 1979.

26. “Receipt Compensation,” _Kyunghyang Shinmun,_ December 27, 1979.

27. “Receipt Compensation Abolished from Next Year After Three‐Year Trial with Less Effectiveness,” _Dong‐a Ilbo,_ September 25, 1979.

28. Ibid.

29. “After the Abolishment of Receipts Compensation, Receipt Exchange Petering Out,” _Mail Economy,_ August 26, 1980.

30. “The Way to Make Receipts Exchange as a Practice, Introduction of Receipts Compensation Desirable, Effective in Reducing Underground Economy,” _Mail Economy,_ April 6, 1983.

31. “NTS Reviews Revival of Receipt Compensation,” _Mail Economy,_ May 18, 1985.

32. “The Federation of Korean Industries Suggested to Introduce Tax Deduction for Receipts or to Revive Receipt Compensation,” _Dong‐a Ilbo,_ August 5, 1985.

> 33. “NTS, Insufficient Measures for Receipts Exchange,” _Mail Economy,_ November 4, 1985.

20
transparency.<sup>34</sup> First, the MOFE revised the Income Tax and VAT laws to enable the NTS to designate specific retail businesses primarily selling goods and services to individual consumers as credit‐card‐membership target businesses and to strongly recommend to those businesses that they join credit card membership.<sup>35</sup> In practice, such recommendations made by NTS, which had power to initiate tax audits, was seen as _de facto_ mandatory.<sup>36, 37</sup> Simultaneously, regulations on tax‐deductible business entertainment expenses were strengthened, so that any business entertainment expense exceeding W 50,000 (approximately US$50) had to be paid with a credit card or VAT invoice to be eligible for tax deduction.<sup>38</sup> Such tight deductibility rules on business entertainment expenses were believed to enhance transparency of business expenses and to uncover hidden sales by retail businesses.

From early 1999, the MOFE reviewed TIETP with due care to prevent double tax deductions; for example, medical expenses or insurance premiums deductible from wage income under the Income Tax Law could under TIETP also be tax deductible if paid by credit card, leading to a double deduction. In July 1999, the MOFE finally announced TIETP with adjustments to eliminate double deductions and to minimize the fiscal impact of the new experiment.

# 4. Rationale for TIETP

## Policy Shift to Measures Encouraging End‐Consumers

Policy experiments adopted by Korean tax authorities thus far to reduce underreporting in the retail sectors are presented in Table 4, following the framework presented in Table 3 of chapter 2. Deterrent measures such as mandatory CR installation and penalties for not issuing receipts proved to be failures and were abandoned. Policies encouraging compliance by sellers and buyers, including tax incentives for CR receipts and cash compensation to consumers for submitting receipts, were transformed into tax incentives for credit card sales and TIETP.

> 34. “Mandatory Credit Card Membership for Hospital, Pharmacy, and Hotel Businesses,” _HanKyoreh,_ June 5, 1998. 35. Article 162‐2, Income Tax Law, effective as of January 1, 1999. Article 32‐2, VAT Law, effective as of January 1, 1999.

> 36. “Mandatory Credit Card Membership for Hospital, Pharmacy, and Hotel Businesses,” _HanKyoreh,_ June 5, 1998 _._ 37. “Hospital, Private Education Institute, Restaurant, Hotel Businesses Will Be Subject to Tax Investigation, If Declining Credit Card Payments,” _Kyunghyang Shinmun,_ December 14, 1998.

> 38. Article 35, Income Tax Law, effective as of January 1, 1999. Article 25, Corporate Income Tax Law, effective as of January 1, 1999.

21
Table 4 Korea's Policy Experiments to Reduce Underreporting in Retail Sectors

||Seller (pushing)|Buyer (pulling)|
|---|---|---|
|Deterrent|<S‐D cell><br>Monitoring and auditing (UR)<br>Penalties for no receipts (UR)<br>Mandatory use of CR (UR)|<B‐D cell><br>NA|
|Encouraging|<S‐E cell>|<B‐E cell>|
||Tax incentives for CR receipts (UR)|Cash compensation for receipts<br>(UR)|
||Tax credit for credit card sales (UR)|TIETP (UR)|
|Normative|<S‐N cell>|<B‐N cell>|
||Campaign and education on receipt<br>exchange (UR)|Campaign<br>and<br>education<br>on<br>receipt exchange (UR)|

_Source:_ Authors’ depiction of policy shift.

Korea’s experience prior to introducing TIETP was that deterrent measures were ineffective and had been complete failures in terms of enforcement. Normative approaches were also not effective in Korea, a strongly government‐led country in which public education and awareness campaigns, intrusive government guides, and recommendations were rampant. In addition, pushing policies targeting business sellers, including tax incentives for CR receipts, was ineffective, because tax benefits given to sellers could not exceed the illegal gains obtainable from underreporting, especially in a society with low tax morale. Therefore, the question became whether a pulling policy encouraging end‐consumers to provide third‐party information would be effective in reducing underreporting. Under the invoice credit VAT system, business buyers report business sellers’ sales by claiming their input VAT credit in B2B transactions. In B2C transactions, however, end‐consumers do not provide tax authorities with any information on business sellers’ sales. Therefore, pulling policies encouraging end‐consumers to play an active role in providing such information could be a very powerful tool for unveiling hidden transactions in cash businesses. If end‐consumers, encouraged by tax incentives, used electronically traceable payment means for purchases, tax authorities could access secure and reliable sales data on cash‐ intensive businesses. In the period after Korea revoked what hindsight shows to have been a poorly managed and failed receipt compensation policy, greatly different economic and social 22
<!-- Start of picture text --> =<br>2<br>oo S<br><!-- End of picture text --> <!-- Start of picture text --> bad Implementation need<br><!-- End of picture text -->
will be, e.g., 10 (gain from tax evasion) if he does not report the sale. However, if a customer uses a credit card, the seller’s payoff will be zero (no gain) because he should honestly report his sale, or, e.g., ‐20 (loss from the detection and punishment) when he does not report his sale. Therefore, the equilibrium, in most cases, will be the worst case, the shaded area of the left matrix of Table 5 (Not use CC – Not report). That is because a seller has a strong incentive not to report sales to maximize payoffs when customers do not use credit cards. Sometimes, in expensive deals, a seller can collude to share the tax benefit with the customers; such payoffs are displayed in parentheses.

Introducing TIETP to give tax benefits to end‐consumers, however, can alter the equilibrium. TIETP will give end‐consumers incentives to use credit cards, making the payoffs to end‐ consumers 2, for instance, as shown in the right payoff matrix in Table 5. The payoffs of business sellers are the same as without TIETP. In that case, the highest possibility will be the case where end‐consumers request to use credit cards and business sellers report the sales accordingly (the shaded area of the right matrix; Use CC – Report). Nonetheless, again, the possibilities remain for collusion between sellers and buyers and benefit sharing. For example, sellers can offer customers lower prices by sharing the tax evasion benefit and can request that their customers not use credit cards, especially for expensive transactions, the payoffs of which are displayed in parentheses in Table 5. TIETP clearly cannot eliminate all underreporting. However, we can expect that, in most ordinary retail transactions, such as in restaurants, bars, pharmacies, and other small retail stores, the equilibrium will be “credit card use and honest report.” Table 5 Payoff Matrix of Non‐TIETP and TIETP

|<Wi<br>|thout TIET<br>End‐co|P> <W<br>nsumer|ith TIETP<br>End‐co|><br>nsumer|
|---|---|---|---|---|
|Seller|<br>Not use<br>CC|<br>Use CC|Not use<br>CC|Use CC|
|Not report|0(5)<br>10 (5)|Not report<br> <br>0<br>‐20|0(5)<br>10 (5)|2<br>‐20|
|Report|0<br>0|Report<br>0<br>0|0<br>0|2<br>0|

_Source:_ Authors’ conception.

24
If the equilibrium changed from “Not use CC—Not report” to “Use CC—Report” with TIETP, except for expensive transactions with collusion between business and end‐consumers, TIETP might contribute to reducing the shadow economy. According to Jang’s survey (1997), conducted before TIETP’s introduction, while only 8.9 percent of survey respondents definitely obtained receipts in retail stores, approximately 90 percent<sup>39</sup> answered that they would pay with a credit card if the government introduced tax deductions for credit card payments. Another survey’s results showed that 75.8 percent of respondents would use credit cards more frequently if tax incentives for their use were introduced.<sup>40</sup>

# 5. TIETP Incentive Structures

In 1999, the MOFE designed TIETP to encourage people to use credit cards but at the same time to limit the fiscal impact of the policy. TIETP offered tax deductions only from taxable labor income. It did not allow tax deductions from business income, real‐estate rent income, or forest income, since expenses related to those incomes were already tax deductible under the Income Tax Law. The credit card tax deduction was limited at both ends by a minimum threshold and a maximum ceiling, and it also included a sunset clause. Until 2002, eligible income deductions (EID) were allowed at the 10 percent (deduction rate) of electronically traceable payments (ETP), including credit card or debit card payments exceeding 10 percent of total labor income (TLI) in a taxable year, within the ceiling set at the lesser of three million won (approximately US$2,600) or 10 percent of TLI.<sup>41</sup> To avoid double deductions, insurance premiums paid to public insurance funds, including National Health Insurance, National Employment Insurance, and National Pension Fund, and for commercial indemnity insurance, as well as tuition and entrance fees paid to public and private regular educational institutions, were not included in eligible ETP.<sup>42</sup> In addition, the following areas, for which underreporting was not a problem, were also not included in eligible ETP: national and local taxes; utility payments, including electricity, water, telephone, television, heating and cooking fuel gas, and so on; and transactions abroad.<sup>43</sup> However, medical expenses, tax deductible if in excess of the deduction threshold under the

> 39. Use credit card without exception (56%), transact only with credit card member stores (5%), use credit card even for the payment of small amounts (26%), less interest (10%), no interest (2%), no response (1%).

> 40. “More Use of Credit Cards If Tax Incentive for Credit Card Use Were Introduced: Samsung Card’s Survey to 300 Customers,” _Kyunghyang Shinmun,_ July 19, 1999.

> 41. Article 126‐2, Preferential Tax Control Law, effective as of August 31, 1999.

> 42. Article 121‐2, Presidential Decree of Preferential Tax Control Law, effective as of October 30, 1999.

> 43. Ibid.

25
Income Tax Law, were included as eligible ETP to reduce underreporting in medical service sectors.

Since TIETP was introduced in 1999, it has been revised a number of times. Its sunset clause has been extended every successive sunset year, thus leaving TIETP in effect. In addition, in 2001, TIETP was strengthened. The deduction rate was increased from 10 percent to 20 percent, and the ceiling on deductions was also increased to the lesser of five million won or 20 percent of TLI. In 2003, after overconsumption and credit card debt defaults had become social problems, the deduction rate for debit cards rose to 30 percent to favor use of debit cards over use of credit cards. Starting in 2005, the scale of tax incentives began to decrease. The deduction threshold was increased from 10 percent of TLI to 15 percent in 2005, 20 percent in 2008, and 25 percent in 2010. In 2010, the deduction ceiling decreased from five million won to three million won. The deduction rate for credit cards also decreased from 20 percent to 15 percent in 2013. However, in 2012 and 2013, TIETP was expanded again by including, as ETP for non‐tax policy purposes, payments to vendors in traditional markets and for public transportation costs. Table 6 summarizes the changes to TIETP made since 1999.

Table 6 Changes to TIETP

|**Year**|**Eligible**<br>**electronically**<br>**traceable**<br>**payments (ETP)**|**Deduction rate**|**Threshold for**<br>**TIETP**|**Deduction ceiling**|
|---|---|---|---|---|
|1999|Credit cards<br>Debit cards|10%|10%�TLI|����10%<br>����, � 3 ��������|
|2001|Same as the above|20%|Same as above|����20%<br>����, � 5 ��������|
|2003|Credit cards|20%|Same as above|Same as above|
||Debit cards|30%|||
|2004|Credit cards|20%|Same as above|Same as above|
||Debit cards||||

26
<!-- Start of picture text --> ee ee<br><!-- End of picture text -->
Wage earners eligible for tax deductions for credit card payments may submit to NTS, via their employers, the credit card tax deduction application form and a credit card transaction report issued by their credit card companies. These materials must accompany the wage earners’ labor income tax settlements filed at the end of the tax year. Credit card companies must issue credit card transaction reports to their customers upon request, or they may voluntarily issue the reports to their customers even without the request.<sup>44</sup> After TIETP was introduced, credit card companies began voluntarily sending their customers annual transaction reports at the end of the tax year as a customer service. In 2000, when TIETP was fully implemented, the Act on the Submission and Management of Taxation Data (ASMTD) became law. According to the act, credit card companies must regularly submit member stores’ credit card or debit card transaction data to NTS. As of 2012, wage earners can claim TIETP tax deductions by confirming prefilled credit card transactions data forms provided by NTS through its Home Tax Service, the NTS tax service internet portal. This service was enabled under ASMTD, which requires credit card companies to submit credit card transaction data to NTS.

If the credit card tax deduction application is valid, employers, acting as the withholding tax agents as to wage earners’ income, subtract the taxes saved by TIETP together with other tax deductions and credits from the tax due in the month following the year‐end tax settlement.<sup>45</sup> If the withholding tax agents should refund overpaid taxes, they can subtract the refund amount from the taxes due in subsequent months or request a refund from the regional NTS office.<sup>46</sup> The TIETP process differs completely from the receipt compensation process adopted in 1977. People who wanted to receive receipt compensation had to submit to a cumbersome application process. They had to collect their receipts and take them to a regional NTS office or commercial bank commissioned to deal with receipt compensation, where they submitted the receipts to get compensation. Since compensations was confined to an allotted budget, consumers often could not get compensation due to delayed budget allocations or budget shortfalls. The TIETP application and refund process, in contrast, is easy and simple. The tax deduction is credited to wage earners’ income taxes along with other tax deductions and credits, so refunds due from eligible refund applications are not delayed or declined. In addition, applicants do not need to collect all the credit card receipts, as credit companies issue aggregate annual transaction reports, and now prefilled credit card transaction information is presented to taxpayers by the NTS Home Tax Service. TIETP’s convenience and secure credits distinguish the approach from the failed attempts using receipt compensation.

> 44. Article 121‐2, Presidential Decree of Preferential Tax Control Law, effective as of Oct 30, 1999.

> 45. Article 201, Presidential Decree of Income Tax Law; Article 93, Order of Ministry of Strategy and Finance for Income Tax Law.

> 46 _._ Ibid.

28
7. Expansion of Electronically Traceable Payments: Electronically Traceable Cash Receipts After the introduction of tax incentives for credit card use in 1999, Korea introduced electronically traceable cash receipts (ETCR) and made them an eligible form of electronic payment for TIETP in 2005. ETCR makes even cash payments electronically traceable by NTS. People who for any reason prefer to pay in cash rather than using a credit card can ask retailers to issue ETCRs. The consumer provides a Resident Registration Number (Korean citizens’ ID number), a registered mobile phone number, or a credit or debit card number for personal identification purposes; the retailer then issues the ETCR through its credit card payment terminal. ETCR transaction data is automatically transferred to NTS. End‐consumers do not need to collect ETCRs for their income tax deduction; NTS provides ETCR transaction data to wage earners, together with credit card and debit card transaction information, through the Home Tax Service portal. Wage earners just confirm their prefilled ETCR, credit card, and debit card transaction data and submit the TIETP application to their employers as described above.

8. Expansion to Mobile Transactions Even without an additional mobile application, TIETP also allows the purchase of goods and services by using credit cards and debit cards on a mobile phone. Therefore, B2C mobile phone transactions in Korea now fall into the TIETP category. In addition, NTS has made efforts to reinforce its mobile tax service. Since 2005, NTS has provided a mobile tax‐related certificate issuing service, covering a range of documents, such as business registration certificates, tax payment certificates, and business closure certificates.<sup>47</sup> In 2014, NTS started a Mobile Newsletter Service offering tax news, tax return and payment notifications, and information on tax legislation and rulings.<sup>48</sup> In 2015, NTS began providing a mobile Home Tax Service allowing taxpayers to issue ETCR and e‐invoices and to receive other tax‐related services, including tax returns, tax inquiries, tax certifications, the tax news service, and many more.<sup>49</sup>

> 47. NTS, “Mobile Tax Certificates Service Launch,” NTS Press Release, December 27, 2005.

> 48. NTS, “NTS Mobile Newsletter Service Launch,” NTS Press Release, July 21, 2014.

> 49. NTS, “User Friendly Mobile NTS App Service Launch,” NTS Press Release, October 29, 2015.

29
# IV. TIETP Performance Evaluation

This chapter analyzes the effects of TIETP to substantiate whether such incentive measures to encourage end‐consumers to use electronically traceable payments help reduce underreporting in cash‐intensive retail sectors, the motivation for this policy as described in the previous chapter. First, as a descriptive analysis, we will examine the volume of electronically traceable payments, the taxpayer ratio as a percentage of business income earners, and effective PIT rates in Korea, which will provide broad evidence for reductions in underreporting. We then estimate TIETP’s quantitative tax revenue effects using counterfactual analysis.

## 1. Descriptive Analysis for TIETP

### Increase in Electronically Traceable Payments

TIETP allowed wage and salary income earners to claim tax deductions for their credit card, debit/check card, and bearer‐identifiable prepaid card spending, which is believed to have had a substantial impact on cashless payments since its introduction in 1999. Figure 4 shows the volume of electronically traceable payment (ETP) as a percentage of GDP from 1991 to 2014. Credit card transactions increased very sharply immediately after TIETP’s introduction in 1999. They had been merely 4.9 percent in 1999, but they had skyrocketed to 34.3 percent by 2002. In absolute terms, ETP soared from W 28.5 trillion (approximately US$26 billion) to W 261.7 trillion (approximately US$238 billion) during the same period.

Since 2003, when the TIETP deduction rate for debit cards increased from 20 percent to 30 percent to favor them over credit cards, debit card payments started to rise sharply. In 2005, the electronically traceable cash receipt (ETCR) was included as eligible for TIETP. With these two changes, a considerable amount of credit card payments seems to have shifted to these two alternatives, moderating the increase of credit card transactions since 2003, as shown in Figure 4.

In 2014, the total value of credit, debit, check, and prepaid cards, not including ETCR, reached W 631.6 trillion (approximately US$574 billion), 42.5 percent of GDP. Since 2005, card payments as a ratio to GDP in Korea ranks highest among the 23 member countries of the Committee of Payments and Market Infrastructures, Bank for International Settlements.<sup>50</sup>

> 50. Card payments (not including e‐money) as a ratio to GDP was 30.5 percent in 2005, 36.7 percent in 2010, and 42.5 percent in 2014. Data retrieved from statistics on payment, clearing, and settlement systems in the CPMI countries (each year; see table 9e for comparative tables).

30
If ETCR payments (W 91.9 trillion<sup>51</sup> in 2014) are included, ETP as a ratio of GDP is around 49 percent for 2014.

Figure 4 Credit, Debit, and Prepaid Card Transactions as Percentage of GDP <!-- Start of picture text --> 45<br>Prepaid Cards<br>40<br>Debit Cards<br>35 Credit Cards<br>30<br>25<br>20<br>15<br>10<br>5<br>0<br>1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013<br><!-- End of picture text --> _Source:_ Authors’ aggregation of data from Bank of Korea (http://ecos.bok.or.kr).

_Notes:_ a. Debit card payments include check cards. b. Electronically traceable cash receipt payments are not included. c. Payments by all consumers, including not only wage and salary income earners but also self‐employed businesses.

Table 7 shows the ETP increase as compared to private final consumption expenditure. The proportion of ETP over private final consumption expenditure increased from 45.2 percent in 2005 to 88.9 percent in 2015. The absolute majority of private consumption, other than indispensable cash transactions, are now paid with ETPs in Korea, which brings the country near to having a cashless society.

> 51. ETCR payments were W 18.6 trillion in 2005, W 76.0 trillion in 2010, and W 91.0 trillion in 2014. Data retrieved from _Statistical Yearbook of National Tax_ (NTS 2006–2015).

31
Table 7 Electronically Traceable Payments as Percentage of Private Final Consumption Expenditure

|**Yea**|**r**|**2005**|**2006**|**2007**|**2008**|**2009**|**2010**|**2011**|**2012**|**2013**|**2014**|**2015**|
|---|---|---|---|---|---|---|---|---|---|---|---|---|
|Priv<br>con<br>exp|ate final<br>sumption<br>enditure (1)|480.2|509.9|546.4|579.1|594.9|636.7|679.1|707.6|727.8|748.2|771.2|
||Credit card<br>(2)|190.5|214.8|241.1|279.3|303.9|350.7|398.5|451.3|441.7|453.9|503.6|
||Check card<br>(3)|7.8|12.7|18.8|27.9|36.7|51.5|66.9|82.8|92.7|112.7|131.5|
|ETP|<br>Cash receipt<br>(4)|18.6|30.6|50.2|61.5|68.7|76.0|80.9|82.4|85.5|91.7|96.6|
||National<br>taxes,<br>etc.<br>(5)|<br>∙∙|∙∙|∙∙|∙∙|∙∙|∙∙|8.1|19.2|18.9|22.6|46.3|
||Sum (➅=<br>2+3+4‐<br>5)|216.9|258.1|310.1|368.7|409.3|478.2|538.2|597.3|601.0|635.7|685.4|
|Rati<br>(➅|o<br>/1)|45.2%|50.6%|56.8%|63.7%|68.8%|75.1%|79.3%|84.4%|82.5%|85.0%|88.9%|

_Source:_ The Ministry of Strategy and Finance.

_Notes:_ ∙∙ = negligible.

a. MoSF, Korea, put together data from private final consumption expenditure (National Accounts, Bank of Korea), credit card and check card payments (the Credit Finance Association), debit card payments (Bank of Korea), and cash receipts (National Tax Service).

- b. Business card payments were subtracted from credit card and check card payments.

- c. National taxes and four other national insurance premiums paid by credit cards were subtracted from ETP.

32
# Increased Tax Net for Business Income

In many countries, business income earned by the self‐employed is more frequently underreported than is wage and salary income, due to the lack of third‐party information accessible to tax authorities (Pissarides and Weber 1989; Lyssiotou, Pashardes, and Stengos 2004; Gërxhani 2004; Wangen 2005; Martinez‐Lopez 2012). Korea was no exception. According to Sung (1999, 69), between 1994 and 1998, before the introduction of TIETP, only about half of business income earned by the self‐employed was reported to the NTS. Such low tax compliance among owner‐operated businesses often led to a low number of active taxpayers as a percentage of relevant income earners.

As shown in Figure 5, the ratio of taxpayer to business income earners in Korea lingered aground 30 percent from early 1980s to the mid‐1990s, but it began to increase gradually and substantially from the late 1990s onward. It rose to about 50 percent in the early 2000s and dramatically to 86.4 percent in 2014. Such an increasing trend in the business income taxpayer ratio may be largely due to the introduction of TIETP, but it is also attributable to increasing nominal income due to economic growth and, in some part, to inflation (the inflation rate is low in Korea and thus has a moderate effect). Since Korea increased the PIT exemption threshold only once, in 2008 (from 10 million won to 12 million won), after introducing TIETP in 1999, and since it does not adopt inflation‐adjusted PIT brackets, income increases may result in a higher active taxpayer ratio. However, given the economic growth and inflation effects at all times, TIETP seems to have changed the trend from stagnant at around 30 percent to around 80 percent since its inception.

Figure 5 Personal Income Taxpayers as Percentage of Relevant Income Earners (%) <!-- Start of picture text --> 90 86.4<br>Business Income Tax<br>80.5<br>80 Wage and Salary Income Tax 77.9<br>71.8 72.4 73.0<br>70 68.6 66.8 67.6<br>62.6 63.8<br>60.8<br>59.7<br>60<br>59.6<br>57.8 56.7 51.9<br>50 52.4<br>46.4 46.8 48.3 50.0 51.2 52.2 51.1<br>40 37.8 39.4<br>36.0 36.6 38.7<br>33.9<br>31.3 31.9 33.7<br>34.1 35.1<br>30 33.0<br>29.3<br>20<br>1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013<br><!-- End of picture text --> 33
_Source:_ Authors’ calculation based on _Statistical Yearbook of National Tax_ (NTS, 1988–2015).

_Note:_ The wage and salary income taxpayer ratio precipitated in 2014 due to changes in the PIT income deduction system in 2014. The income deduction for education expenses, medical expenses, private insurance premiums, and charity contributions were shifted to tax credits, which made many marginal taxpayers tax exempt.

# Effective PIT Rate of Owner‐Operated Businesses

The effective PIT rates are estimated through micro‐simulation analysis developed by Sung (2008) using Household Income and Expenditure Survey (HIES) data, a household survey data set, collected monthly and compiled, and released by Statistics Korea every quarter year. HIES data provide monthly and quarterly income and expenditures, along with each household’s demographic characteristics, that can be used to estimate household PIT. Detailed PIT estimation methods using the HIES and summary statistics of HIES are attached in Appendixes 1 and 2.

Figure 6 illustrates the longitudinal changes of effective PIT rates both for self‐employed business income and wage and salary income for the last three decades. The two effective PIT rates have different trends. The effective PIT rate of wage and salary income increased from 1.6 percent to 4.0 percent from 1982 to 1988 and then oscillated within the range of 2.2 percent to 3.5 percent from 1989 until recently. For business income, the effective PIT rate decreased from 5.6 percent to 3.4 percent from 1982 to 1998 but turned to a continuous upward trend from 3.4 percent in 1998 to 6.3 percent in 2013 after the introduction of TIETP, except for the two dips caused by Korea’s economic crises in 2002–2003 and 2008–2009.

Figure 6 Effective PIT Rate for Business Income and Wage and Salary Income (%) <!-- Start of picture text --> 7<br>PIT for Business Income 6.3 6.2 6.3 6.2<br>6 PIT for Wage and Salary Income 5.9 6.0 6.0<br>5.6<br>5.6 5.4<br>5 4.7 5.0 4.9 5.1<br>4.7 4.7<br>4.5 4.6<br>4.3<br>4.4 4.2 4.1<br>4.2 4.2 4.0 4.0<br>4 4.0 3.8 3.8 3.8 3.6 3.5 3.8 3.4<br>3.5 3.2 3.2<br>3.0 3.0 3.1 3.1<br>3 3.3 3.1 3.3 2.9 2.9 2.7<br>2.6 3.0 2.6 2.6<br>2.9 2.7 2.5<br>2.3 2.6 2.7 2.4 2.5 2.5<br>2 1.8 2.2 2.3 2.4<br>1.6<br>1.6<br>1<br>1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014<br><!-- End of picture text --> _Source:_ Author’s estimation using Household Income and Expenditure Survey (Statistics Korea, 1982–2014).

34
These two different trends since 1999 show that TIETP contributed to the broadening tax base for self‐employed businesses while it alleviated wage and salary earners’ tax burdens. Since the introduction of TIETP in 1999, wage and salary earners have actively used credit cards to get the tax incentives and, as a result, self‐employed business income earners have reported their business income more honestly, mindful that third parties were reporting transactions to the tax authorities. These trends give broad support to the theoretical framework—the TIETP‐induced equilibrium change from “Not use CC—Not report” to “Use CC—Report”—discussed in the previous chapter. It should be noted, however, that the upward trend in the effective PIT rate of business income may also be strengthened by an income tax creeping effect caused by nominal income increases due to economic growth and inflation, fixed income tax brackets, and PTI exemption thresholds, as in the case of the active taxpayer ratio described in the previous section. However, such creeping effects might not have been realized automatically without TIETP, because business income tends to be underreported to offset such effects.

One notable phenomenon in this PIT rate trend is that the effective PIT rate of business income is greater than that of wage and salary income, without an exception, for the whole period considered. This is seemingly against the common understanding that self‐employed workers’ business income tends to be underreported. One possible interpretation is that the Korean PIT system allows more generous income deductions to wage and salary earners, considering that wage and salary earners’ incomes are correctly reported by third parties, while self‐employed workers’ business income is underreported in the absence of third‐party information. Another interpretation is that the average income of the self‐employed is greater than that of employed workers, and as a result the self‐employed are subject to a higher progressive income tax schedule.

# 2. Quantitative Analysis for TIETP

## Methodology and Data

TIETP’s effects were analyzed using micro‐simulation methods through counterfactual analysis adopted by Song and Sung (2012). This study updated the Song and Sung (2012) approach, using 2014 the HIES data set. Three different scenarios were set up to evaluate policy effects by establishing the counterfactual and the observable. When estimating true business income in each scenario, income data obtained from HIES were adjusted under the assumption that they were also underreported, as in tax reporting.<sup>52</sup> Real business incomes were estimated by

> 52 . Hurst, Li, and Pugsley (2014) showed that in U.S. household surveys the self‐employed systematically underreport their income by about 25 percent.

35
comparing the income and expenditures of self‐employed workers with those of wage and salary earners. The ratio of business income reported to tax authorities over real business income as of 2014 was estimated by applying the same method employed in Sung (1999, 2008). Business income reported to tax authorities per household was estimated with the real business income and income reporting ratio obtained in the previous stage. The PIT burden was calculated based on the business income reported to tax authorities as well as demographics and expenditure data obtained from HIES. However, it was assumed that wage and salary income were reported correctly. The detailed methodology is described in the Appendix 2. Following are the three scenarios employed.

**Scenario A** ( _counterfactual scenario 1: baseline_ ): Average PIT burden per household in 2014 was estimated under the assumption that business income earners reported their income based on the past increasing trend without the intervention of TIETP. The average reported business income in 2014 was estimated by extrapolating the past ratio of business income earners’ reported income to their real income. In this study, Sung’s estimate (1999) for the ratio of business income earners’ reported income to real income in 1996 (47.7 percent) and another Sung estimate (2008) for 2001 (53.9 percent) were used to linearly extrapolate the estimate for 2014.<sup>53</sup> It should be noted that the 2001 estimate was used for extrapolation, considering that the estimates between 1997 and 2000 were outliers due to the financial crisis in Korea, and that if 2001 estimate affected by TIETP at the early stages of TIETP introduction were extrapolated as a baseline, it would underestimate the effect of TIETP when compared to the observable. In other words, considering that the extrapolation using inflated data would result in a conservative estimate of the TIETP effect, we compromised by using the 2001 estimate.

It was assumed that this counterfactual scenario only included tax‐base‐broadening effects caused by factors other than TIETP. Those factors could be taxpayers’ voluntary compliance, tax authorities’ tax enforcement efforts, or other unknown socioeconomic changes. Therefore, this counterfactual scenario reflected all causal factors other than TIETP, thus differentiating them from TIETP effects.

**Scenario B** ( _counterfactual scenario 2_ ): The average PIT burden per household in 2014 was estimated under the assumption that TIETP is in effect but has not led to tax losses. The average reported business income was estimated by applying the ratio of reported

> 53. When the two data points _(Yt1, t1)_ and _(Yt2, t2)_ are given, the linear extrapolation function will be Y(t<sup>*</sup> ) ~~=~~ ���  � ��� � ����� ��<sup>∗</sup> ���� + Yt1. In our case, it will be Y(t<sup>*</sup> ) = 1.24�∗�2427.34 . Therefore, the reported income to real income ratio in 2014 was Y(2014)=70.1(%).

36
business income to real business income, which reflected the base‐broadening effects of TIETP. However, when estimating the PIT burden, contrary to the facts, tax forgone for TIETP was not factored in. Accordingly, this scenario shows the gross effect of TIETP’s base broadening as of 2014 under the assumption that the same tax‐base‐broadening effects caused by TIETP were realized without tax revenue loss for TIETP.

**Scenario C** ( _observable scenario_ ): The average PIT burden per household in 2014 was estimated under the current PIT law, as of 2014, which includes TIETP. Tax forgone for TIETP was also factored in when calculating the average PIT burden.

The comparison among these scenarios will show how much TIETP broadened the tax base and increased tax revenue on average in 2014 and how much tax revenue was forgone to finance TIETP. The difference between Scenarios A and B (1) illustrates the gross base‐broadening effect of TIETP on tax revenue. The difference between Scenarios B and C (2) will show the revenue cost to finance TIETP. The gap between the two differences (1-2) is the net gain of TIETP. TIETP would be justified only when its net gain is positive.

# Tax Revenue Effects of TIETP

Table 8 illustrates the average income and PIT estimation per household by decile as of 2014. The table consists of four sections. The first nine rows display the distributions of the average income, PIT burdens, and the revenue effects of TIETP by decile as of 2014. The second section, in the next six rows, indicates the relative ratios of each income and PIT to gross income. The third section, in the following three rows, indicates the ratios of PIT burdens to wage and salary income or business income, that is, the effective PIT rates. The fourth section, in the last six rows, indicates the shares of each income and PIT by decile.

Gross revenue effects of TIETP (GE), the difference between Scenario B and A ranges from W 3,000 to W 704,000 by decile. Tax forgone for TIETP (TF), the difference between Scenario B and Scenario C ranges from zero won to W 317,000. Therefore, net gains of TIETP ranges from W 3,000 to W 387,000. On average, gross revenue effects of TIETP are W 186,000; the cost of TIETP, W 108,000; the net effect, W 78,000. In sum, TIETP is quite costly but still yields positive tax revenue increases.

Figure 7 graphically shows these revenue effects. Net gains in the PIT burden increase as income does. The net gain curve is upward at an accelerating rate. In particular, revenue gains in the 10th docile are striking. TIETP increases the PIT burden of higher income earners more than that of lower income earners, although it gives more tax relief to them.

37
Table 8 Distribution of Average Income and PIT Burden per Household by Gross Income Decile

|**(thousand**|**KRW)**|**1st**|**2nd**|**3rd**|**4th**|**5th**|**6th**|**7th**|**8th**|**9th**|**10th**|**Avg.**|
|---|---|---|---|---|---|---|---|---|---|---|---|---|
|MY||6,425|13,526|20,948|28,186|34,946|40,503|49,322|58,353|71,975|106,312|43,046|
|GY||10,456|18,383|25,769|32,866|39,752|46,557|54,083|63,508|77,086|112,455|48,088|
|GN & BY||3,584|9,749|17,087|24,215|31,906|37,690|46,463|54,889|68,011|99,601|39,316|
||Scenario A|10|72|191|378|698|1,015|1,500|2,437|3,741|8,670|1,871|
|PIT|Scenario B|13|88|235|454|812|1,175|1,694|2,678|4,057|9,374|2,057|
||Scenario C|13|83|224|428|739|1,074|1,566|2,500|3,816|9,057|1,949|
||GE (B‐A)|3|16|44|76|114|160|194|241|316|704|186|
|Revenue<br>effect|TF (C‐B)|0|‐5|‐11|‐26|‐73|‐101|‐128|‐178|‐241|‐317|‐108|
||NE (GE+TF)|3|11|33|50|41|59|66|63|75|387|78|
|**Ratios to G**|**Y (%)**|**1st**|**2nd**|**3rd**|**4th**|**5th**|**6th**|**7th**|**8th**|**9th**|**10th**|**Avg.**|
|MY||61.45|73.58|81.29|85.76|87.91|87|91.2|91.88|93.37|94.54|89.52|
|GY||100|100|100|100|100|100|100|100|100|100|100|
|GN & BY||34.28|53.04|66.31|73.68|80.26|80.95|85.91|86.43|88.23|88.57|81.76|
||Scenario A|0.1|0.39|0.74|1.15|1.76|2.18|2.77|3.84|4.85|7.71|3.89|
|PIT|Scenario B|0.13|0.48|0.91|1.38|2.04|2.52|3.13|4.22|5.26|8.34|4.28|
||Scenario C|0.12|0.45|0.87|1.3|1.86|2.31|2.9|3.94|4.95|8.05|4.05|
|**Ratios to G**|**N & BY (%)**|**1st**|**2nd**|**3rd**|**4th**|**5th**|**6th**|**7th**|**8th**|**9th**|**10th**|**Avg.**|
||Scenario A|0.29|0.74|1.12|1.56|2.19|2.69|3.23|4.44|5.5|8.71|4.76|
|PIT|Scenario B|0.37|0.9|1.37|1.88|2.54|3.12|3.65|4.88|5.97|9.41|5.23|
||Scenario C|0.35|0.85|1.31|1.77|2.32|2.85|3.37|4.55|5.61|9.09|4.96|
|**Shares by d**|**ecile (%)**|**1st**|**2nd**|**3rd**|**4th**|**5th**|**6th**|**7th**|**8th**|**9th**|**10th**|**Total**|
|MY||1.49|3.14|4.87|6.55|8.12|9.41|11.46|13.56|16.72|24.7|100|
|GY||2.17|3.82|5.36|6.83|8.27|9.68|11.25|13.21|16.03|23.39|100|
|GN & BY||0.91|2.48|4.35|6.16|8.12|9.59|11.82|13.96|17.3|25.33|100|
||Scenario A|0.06|0.39|1.02|2.02|3.73|5.42|8.02|13.03|20|46.35|100|
|PIT|Scenario B|0.06|0.43|1.14|2.21|3.95|5.71|8.23|13.02|19.72|45.56|100|
||Scenario C|0.06|0.43|1.15|2.19|3.79|5.51|8.03|12.82|19.57|46.46|100|

_Source:_ Authors’ estimation using data from HIES 2014.

_Notes:_ a. MY, GY, GN & BY, and PIT denote market income, gross income, wage and salary and business income, and personal income tax, respectively. b. GE denotes the gross revenue effect of TIETP. TF denotes tax revenue forgone for TIETP. NE denotes net effect of TIETP.

38
Figure 7 Tax Revenue Effects of TIETP per Household by Decile in 2014 <!-- Start of picture text --> 316 387<br><!-- End of picture text --> <!-- Start of picture text --> 78<br><!-- End of picture text --> <!-- Start of picture text --> 0 ‐5 ‐11 ‐26<br>‐73<br>‐101<br>‐128<br><!-- End of picture text --> <!-- Start of picture text --> 0 ‐5 ‐11 ‐26<br>‐73<br>‐101 ‐128 ‐108<br>‐178<br>‐241<br><!-- End of picture text --> _Source:_ Authors’ depiction.

Table 9 shows the total PIT revenue effect, which was calculated by multiplying the average PIT burden per household and the total number of households (18,001,541 households in 2014). The total gross effect of TIETP was W 3.4 trillion, while the cost of TIETP reached W 1.9 trillion. The net gain was estimated at W 1.4 trillion (approximately US$1.3 billion), which increased PIT revenue by 4.2 percent as compared to baseline Scenario A without the intervention of TIETP. If the revenue increase in VAT and CIT is considered, the revenue impact of TIETP would be much larger.

Table 9 Total PIT Revenue Impact of TIETP

||**Avg. (thousands in KRW)**|**Total (billions in KRW)**|
|---|---|---|
|Scenario A|1,871|33,675|
|PIT<br>Scenario B|2,057|37,036|
|Scenario C|1,949|35,090|
|<br>GE (B‐A)|186|3,361 (10.0%)|
|Revenue<br>effect<br>TF (C‐B)|‐108|‐1,946 (‐5.8%)|
|NE (GE+TF)|78|1,415 (4.2%)|

_Source:_ Author’s calculation.

_Note:_ Numbers in parentheses under “Revenue effect” indicate the percentage increase from the revenue in baseline Scenario A.

39
# Effects on Tax Equality

Table 10 shows changes in the Gini coefficient between gross income and gross income less PIT. PIT under the baseline Scenario A, without the intervention of TIETP, decreased Gini coefficient from 0.3357 to 0.3230 by ‐3.79 percent. When TIETP is considered (as in Scenario C), it decreased to 0.3227 by ‐3.90 percent. However, this enhancement of income redistribution was undermined by 0.14 percentage points (from ‐4.04 percent to ‐3.90 percent) by the tax forgone for TIETP, which was unevenly given to higher income deciles due to the progressive tax structure. The Gini coefficient would have decreased to 0.32216 by ‐4.04 percent if there were only the same tax broadening effect as with TIETP but no tax forgone for TIETP. In sum, TIETP had a positive impact on income redistribution due to the broadened tax base, despite the greater tax relief given to higher income earners. Gini Coefficient decreased by 0.11 percentage points (from ‐3.79 percent to ‐3.90 percent) This means that the tax‐base‐broadening impact of TIETP on income redistribution outweighs its negative effect on income redistribution caused by tax relief, and as a result it eventually enhanced income redistribution.

Table 10 Changes of Gini Coefficients

||**Scenario A**|**Scenario B**|**Scenario C**|
|---|---|---|---|
|**MY**|0.36942|||
|**GY**|0.33574|||
|**GY less PIT**|0.32303|0.32216|0.32265|
|**% change between GY and GY less PIT**|‐3.79|‐4.04|‐3.90|

Source: Authors’ calculation 40
# V. Conclusion

TIETP incentivizes end‐consumers to pay electronically for their purchases, and at the same time, it induces owner‐operated retail businesses to honestly report their incomes to tax authorities. End‐consumers, to claim tax deductions, use electronic payments that are then automatically reported to tax authorities. It is equivalent to business buyers reporting their business sellers’ sales to claim their input VAT credit in B2B transactions. Thus, retail businesses whose sales are reported by third parties (the consumers) file their income tax returns honestly; in fact, they are only required to confirm their electronically traceable sales on prefilled tax return forms provided by NTS if they find no errors. This paper shows TIETP’s effectiveness as a tool for reducing underreporting in cash‐intensive retail businesses by incentivizing end‐consumers to use electronic payments. In Korea, TIETP was successful in turning a predominantly cash economy into one based on cashless transactions, with a consequent considerable reduction of the shadow economy, in a relatively short period of time.

Future implications and challenges for countries pursuing an incentive structure to induce electronic payment are as follows: First, critical to TIETP’s success is a legal framework and tax information system that enables tax authorities to gain access to and to analyze the financial transaction information. Without the tax authorities’ legal and technical competence to collect and process the information, TIETP would not induce retail businesses’ voluntary compliance. Korea’s 2000 Act on the Submission and Management of Taxation Data played a pivotal role in enabling tax authorities to gather electronic financial transaction information and in inducing voluntary tax compliance in cash‐ intensive business sectors. In addition, NTS established its Tax Integrated System (TIS) in 1997 to integrate all transaction data obtained from electronically traceable payments, including credit cards, debit cards, cash receipts in B2C transactions, e‐invoices in B2B transactions, financial income information, property transaction information, and other third‐party information provided by public and private institutions. NTS now make use of TIS to verify taxpayers’ tax returns and to analyze risk assessments and tax audits. NTS, using TIS, also provides improved taxpayer services by providing prefilled tax return forms and other tax payment guide services.

Second, ensuring that the tax rebate process is easy and guarantees assured return of the rebate are important success factors. The incentives given to end‐consumers to encourage electronic payments are relatively small, so if the application process for the tax rebate is inconvenient or cumbersome, or if rebate payments are unreliable, people would be discouraged from using the system. While Korea’s VAT compensation for receipts, introduced in 1977, failed due to its inconvenience and unreliable cash compensation, TIETP was successful because of its convenience, which was enabled by making electronic data processing and application processes 41
part of existing year‐end tax settlement processes. Wage and salary earners can easily file year‐ end PIT settlement returns with prefilled ETP information provided by NTS and get TIETP tax refunds along with other tax credits due them.

Third, the size of tax incentives should be carefully set so that the revenue forgone for TIETP does not exceed the revenue increase gained. One way to do this is by setting thresholds and maximum ceilings for TIETP; another is by containing eligible payments of TIETP. Sophisticated tax incentive structures would ensure net gain from TIETP.

Fourth, countries wishing to introduce similar tax incentives for electronic payments should consider their citizens’ financial literacy and their financial sectors’ technological preparedness. Developing countries pursuing a cashless economy may need to make considerable efforts to establish electronic payments among the people, especially those who regard cash payment as more convenient and secure than electronic payment (Nwankwo and Eze 2013). If a majority of a country’s people are still heavily dependent on cash payments, either due to financial illiteracy, unfamiliarity with banking transactions, or lack of IT infrastructure in the financial sectors, TIETP should be introduced gradually, in line with the development of other relevant areas. In particular, in low‐income developing countries where many people do not have access to the financial sector or credit cards, instituting TIETP for credit or check cards might be challenging. In this case, ECTR could be an alternative, given that it does not require credit cards or bank accounts. Anyone who does not have a credit card or access to the financial system can pay with cash and make it electronically traceable by using a mobile phone number or ETCR card registered to the tax authorities. Technological preparedness in retail sectors and financial sectors is still prerequisite, however.

Fifth, retail vendors’ costs for installing electronic payment terminals and credit card payment fees paid to credit card companies can be a big challenge. If retail vendors are reluctant to install credit card payment terminals and accept credit cards due to high fees, increasing credit card payment will be difficult. As mentioned earlier, NTS, supported by the 1999 Income Tax Law and VAT Law, made strong administrative recommendations encouraging vendors to join credit card membership. The Korean government strongly drove lowered credit card fees,<sup>54, 55, 56</sup> which were justified with increasing credit card sales and the profits of credit card companies. In addition, tax credits for credit card sales by retail vendors, introduced in 1994, helped to relieve the burden on small retail vendors.

Sixth, tax policy makers should carefully design the tax incentive structure, keeping in mind the distortive effect of overconsumption through credit cards, which can have a negative impact on

> 54. “Lowering 1–2% of Credit Card Fees,” _Mail Economy,_ September 11, 1999.

> 55. “Government, Induce Lowering Credit Card Fees,” _Mail Economy,_ December 18, 1999.

> 56. “Credit Card Fees, Maximum 10% Lowered Within This Year,” _Dong‐a Ilbo_ , December 17, 1999.

42
the economy. TIETP could spur consumption with the expectation of tax cuts (seemingly, very marginal but a clear reduction in the cost of the expenditure) and even more with the credit provided by credit cards. According to the survey conducted by the Korea Institute of Public Finance (2016, 209), 31.3 percent of respondents selected payment possibility without cash at hand as the first reason to use credit cards; 16.6 percent selected the convenience of payment without changes; 13.2 percent cited various rewards provided by credit card companies; 12.4 percent noted the tax deduction; 10.7 percent appreciated the possibility of installment payments; 10.1 percent opted for credit cards because of payment possibilities without a balance in the account. In this sense, tax incentives for debit cards or electronically traceable cash receipts may have fewer distortive effects on consumption and saving choices but relatively bigger substitution effects between nontraceable and traceable payments. Korea experienced the negative effect of overconsumption in the early stages of TIETP. Credit card transactions in Korea skyrocketed between 1999 and 2002 after the introduction of TIETP, as shown in Figure 3. While such a drastic increase in credit card transactions contributed to broadening the tax base to a great extent, overconsumption based on credit facilitated by credit cards put the Korean economy under tremendous stress. It was believed that TIETP coupled with deregulation of the credit card business, credit companies’ reckless issuance of credit cards, and lax credit controls caused widespread credit‐card‐debt defaults and led to the collapse of at least one credit card company during 2002–2003. In response to this negative effect of TIETP, the Korean government in 2003 increased the deduction rate of TIETP for debit card transactions from 20 percent to 30 percent to favor debit card usage, while maintaining the deduction rate for credit card transactions. In addition, ETCR was introduced in 2005. These measures shifted a substantial portion of credit card transactions to debit cards or ETCR transactions.

Seventh, given that tax deduction unevenly benefits higher income deciles over others, under the progressive PIT structure, tax credits as a format of TIETP are worth reviewing as a policy alternative. As mentioned in the previous chapter, although Korea’s TIETP has net positive effects on the GINI coefficient due to the tax‐broadening effect, regressive effects of tax deductions were also seen.

Lastly, it should be admitted that TIETP broadens the tax base by taking advantage of tax incentives. TIETP provides a tax relief, which has a lock‐in effect as do other tax incentives. Many discussions conclude that TIETP should be repealed because it has broadened the business income tax base sufficiently; nonetheless, TIETP remains in place in Korea because it has created vested interests among wage and salary earners. Furthermore, it is not clear if business income would continue to be reported honestly if TIETP were withdrawn. Given these questions, further research may be needed to support a definitive conclusion that TIETP has actually enhanced voluntary compliance and changed taxpayers’ behavior for good.

43