Taxing Cash

INTRODUCTION

Cash is a paradox. Why do individuals treat certain pieces of metal and paper differently from other similarly valueless objects? Despite the above, cash is an indispensable part of modern economies and is part of a complicated monetary regime. Even though we take it for granted that the pieces of paper in our wallet offer a reliable representation of our consumption power, this monetary regime is anything but trivial Money and cash (as a form of money) allow people to engage in complicated exchanges, to store value and account for it—which is in many ways an extraordinary development.

Cash, however, is just one form of money; unlike other forms it has a dark side individuals use it to conceal certain transactions from their creditors and from state supervision. Why should governments support the use of cash? After all, cash is anything but neutral today, in developed economies where credit and debit cards are widely available, much of the cash in the economy is used for illegitimate purposes. Cash allows income underreporting, which is the most significant source of tax evasion, and it is also used for criminal activities. Countries face dire fiscal deficits that make their debts increasingly difficult to serve. Furthermore, even when they do address this dark side, policymakers rarely do so in a comprehensive way: public finance literature focuses on how to detect unreported incomes in tax transactions; monetary literature focuses on the operational costs of cash as a method of exchange; and criminal law enforcement literature focuses on how to prevent money laundering. None of these literatures, however, addresses the overall social costs of cash usage.

The approach of considering the social cost of usage cash to society would have been understandable half a century ago. In those days, cash was a public good that, despite its imperfections, provided many benefits that allowed the modern industrialized economy to develop. Because cash had no real substitutes and accounted for almost all retail transactions, it made little sense to ask whether policymakers should try to assess the overall costs of cash to determine its optimal social use.

Social reality has changed, however today, cash is an inferior, formal-economy method of exchange (when compared to debit cards, for example), and the use of electronic payment is widespread. If cash no longer remains a bare necessity, maybe the time has come to ask how to use it in an optimal way, what its benefits are, and whether the advantages justify its costs.

It is argued -that, even though money is a public good that is supplied by the state to support modern economic activity, the use of cash as a form of money is a market failure that allows free-riding on government services. Cash allows people to make anonymous, unrecorded transactions and thus to evade tax and avoid regulatory burdens associated with individuals' economic activities. The ability to underreport tax on cash-mediated transactions imposes costs on society and therefore operates as a negative externality. Thus, from a macro-social perspective, policymakers should optimize cash usage by requiring cash buyers and seller in the cash economy to internalize its full range of costs.

It many be proposed that these costs be intimacies through a cash tax imposed on cash withdrawals from any financial service institution. cash tax would not penalize using or depositing cash and would not cover any non-cash transfers or consumption activity. Instead, it would operate as a corrective one intended to have parties internalize the costs that their activities impose on society.

As a result of the cash tax, most of the legitimate, formal economy, which is not engaged in underreporting of cash transactions, would probably shift to non- cash methods of payment. This suggests that the cash-tax burden would fall primarily on participants in illegitimate cash-economy transactions who engage in underreporting to attain the benefits of tax evasion or other regulatory violations.

The justification for a cash tax stems from the difficulty of detecting illegitimate cash transactions. This inherent challenge supports the concept that the costs of using cash should be imposed on cash usage as a whole. It is important to note that the cash tax offers no magic solution for eliminating all harmful effects of cash-based income underreporting. It offers an option to supplement existing policies of developing countries that have an expanding financial sector. Furthermore, even those regimes would require some easy-to ­implement yet important changes before the cash tax could be operational. Nevertheless, cash-tax proposal provides a useful way of optimizing the scope of the cash economy by forcing cash users to internalize some of the negative externalities of tax evasion and criminal activity associated with cash usage.

The proposal for cash-tax has three main contributions. First, it departs from classic tax compliance literature with respect to the cash economy by offering an alternative practical approach to deal with cash-related evasion one that goes beyond the classic paradigm that more audit-based enforcement reduces tax evasion. Nobody likes to pay taxes, so collecting taxes is never easy. Indeed, when it comes to cash-based transactions collection is more difficult than in other types of transactions. While the cash economy is widely recognized as the Achilles' heel of tax collection, the literature on this issue typically emphasize the need to invest more resources in detecting tax-evading cash transactions. The proposal for cash-tax takes a different course by taxing the cash economy indirectly without distinguishing legitimate from illegitimate transactions. Even though it is predicted that most of those paying the cash tax would be individuals engaged in underreporting, the proposal is a rough-justice approach that does not distinguish between evaders and non- evaders. This crude approach suggests that taxing cash transactions on a fault-free basis could help minimize the revenue loss, inefficiencies, and inequities of income underreporting more effectively than existing approaches.

The second contribution relates to the cash tax's ability to calibrate the costs of cash along many margins. The use of the cash tax is not restricted to countering tax evasion costs but could be implemented more generally to reduce the negative externalities associated with cash transactions. This idea of comprehensively optimizing the costs of cash sharply contrasts the current tendency of different government agencies (tax authorities, criminal enforcement, and Bangladesh Bank) to deal with the cash costs from their own micro-perspectives.

The third contribution relates to the way in which the proposal is presented. Rather than offering a bright line solution that is supple yet unreasonable, it is acknowledged that the cash tax solution offers one of an array of tools that should be used to curtail tax easier, the suggestion is not a panacea to the convex phenomenon of income underreporting. Therefore, the analysis elaborates on which steps should be taken to implement a cash tax that would provide a reasonable (and equitable) policy alternative. It is also recognized that realistic constraints may dictate that tax authorities could only impose (theoretically) sub-optimal cash-tax rates.

The cash-tax framework offers an important method to supplement existing policies for limiting the costs of the cash economy. It opens a new debate about the cost of cash as a discrete issue and offers a concrete and realistic reform proposal that enables policymakers to consider the many costs and benefits of using cash as a medium of exchange.

CASHING IN ON PRIVACY: TAX EVASION AND THE SHADOW AND CRIMINAL ECONOMIES

Cash in Context

Money is essential in a modern economy because it functions as an accounting unit, a value storage device, and a medium of exchange. It has emerged as a superior method of exchange because its uniform appearance, divisibility allow it to commensurate values of services and commodities to different individuals.

Many objects can serve as money, and in different times and places many have ranging from pieces of metal to sophisticatedly printed paper notes to cowrie shells. Though cash is just one form of money, until fairly recently, money and cash were synonymous other than barter, cash was used as a method of exchange in almost every transaction. Today, however, money and cash are two separate things for most people living in developing countries. Cash is a set of physical objects that represent money, but most monetary assets are now disembodied and virtual, consisting of electronic accounting entries maintained in banks computers.

This modem system has led to many alternative methods of exchanging money, including electronic transfers, debit cards, checks, and credit card transactions. In recent years, the use of cash as a medium of exchange has been decreasing in developing countries—debit and credit cards have gradually replaced even small, everyday purchases traditionally paid for in cash. The introduction of mobile phone based e-purses in developing countries suggests that this less-cash trend may even accelerate in the near future.
The reduction in cash usage is considered to be a positive development. Even though cash is often perceived as costless, it is in fact a relatively expensive method of exchange that requires central banks and other state agencies to invest resources in maintaining institutional integrity and preventing forgery. In light of these public costs, and in light of other private costs, there is a general agreement that alternative payment methods primarily the use of debit cards involve lower social costs and therefore should be encouraged.

Nevertheless, people continue to use cash for a variety of reasons. Individuals consider cash to be an inexpensive, convenient, and private medium of exchange with a low risk of fraud and abuse. It is especially efficient for small retail purchases and it allows some people to better manage their personal budgets.

Cash and Tax Evasion

A transaction that is not reported for (income or consumption) tax purposes creates an economic advantage in the form of saved tax payments. This economic advantage potentially benefits the seller, as well. as the buyer, thus increasing the demand and supply for such economic activity. Hence, parties to transactions that could easily go unreported for tax purposes have a clear incentive to not report the exchanges.

The classic modeling of tax-evasion behavior views taxpayers' decisions to evade taxes as a rational gamble, in which taxpayers weigh the probability of detection and penalty level against evasion payoffs. The impact of penalties on taxpayers' behavior is mixed, and there is no consistent evidence that imposing higher penalties significantly reduces instances of tax evasion. In contrast, detection probability is undoubtedly the most significant factor in motivating tax compliance payments that are easily traceable and subject to third-party reporting requirements or third-party withholding are typically reported accurately.

It is difficult to characterize tax evasion because it comes in many forms and shapes and occurs in almost every type of profession; it may be done by otherwise legal businesses or by unlicensed or illegal ones. There are, however, two main tax-evasion methods: underreporting income and over reporting deductible or creditable expenses.

Income underreporting of the "hard-to-tax cash" sector.: This sector typically contains small businesses with low to medium incomes that sell primarily at the retail level and often receive and make payments in cash .This can include self-employed taxpayers, such as professionals providing services ; restaurants; sole proprietors; farmers; and other small business owners. The agency costs of these businesses are small, so there are minimal non‑tax business incentives for maintaining adequate accounts. The great number of taxpayers in this sector, and the relatively low income many of them have, render it inefficient to use expensive and intrusive audits to scrutinize more than a small fraction of them . Income underreporting relies on low-visibility transactions and the revenues generated from cash transactions represent the most difficult- to- trace source of income.

Undoubtedly, the understanding of tax evasion as a social phenomenon , requiring historical, cultural, and behavioral psychology explanations. However, it is important to note that despite the great variations among societies, taxpayers, and evasion techniques, the ability to avoid detection by tax authorities offers the key factor in explaining why and how people evade taxes. Taxpayers underreport cash payments rather than payments received through checks or other transfer payments .The only major difference between cash income and income received through other payment methods is how easy it is to conceal cash. Therefore, the common perception among policymakers is that the very nature of cash means that there will always be an opportunity for tax evasion by people dealing in cash.

The tax- evasion practices associated with cash transactions make the way for under reporting of income estimated to be 35% to 50% depending on the nature of business. Concerned authorities estimate that revenues lost because of income underreporting account for half of the taxes evaded from legal activities. Under conservative estimates, the total amount of income and taxes evaded by the cash sector every year is at least Tk. 500 billion, probably the biggest source of revenue loss. The direct costs of tax evasion also impact governmental spending because the need to fight tax evasion requires additional spending on tax administration.

The second adverse effect of cash-related tax evasion is the inefficiency associated with Cash usage and, correspondingly, tax evasion are far from uniform across different sectors of the economy. Hence, the ability to avoid costs by using cash provides taxpayers with an incentive to shift their activities into the cash economy. This subsidy artificially inflates the cash sector without necessarily increasing the after-tax returns of those operating within it. In a competitive market, the increased incentives to work in the cash sector will increase the supply and push down the price for those activities. In addition to the misallocation of resources between the cash and non- cash sectors, the use of cash for tax- evasion purposes imposes operational inefficiencies that reduce the productivity within the cash sector. These include a wide array of costs ranging from anxiety and higher compliance audit-related costs to difficulties of attaining economies of scale . Another tangible cost of underreporting income for tax purposes is the -tendency to avoid depositing cash proceeds into the financial sector. This restricts the credit available for cash businesses, which forces them to rely on self-financing and also requires them to undertake costs associated with storing and spending the cash.

Finally, and perhaps surprisingly, the impact of cash-sector tax-evasion activities on issues of distributional equity is ambiguous. On the one hand, it is clear that many of the people employed in the cash sector are low-paid workers or small businesses. On the other hand, affluent taxpayers own many of these small businesses. Additionally, even though many of those working in the cash economy are not high- income taxpayers, it is not clear that they are the ones who capture the benefits of tax evasion given the increased supply of labor in that sector. Consumers in the cash economy, who tend to have higher incomes and education, share (at least some) of the lack-of-tax cash subsidy because they receive reduced-cost services and goods.
Overall tax evasion is most clearly inequitable for honest and risk-averse sellers and service providers in the cash economy who report their incomes. A housepainter or nanny who reports income cannot charge more for services than the market rate of return (which assumes cash payment and tax evasion). As a result, tax-evasion practices "force" otherwise honest taxpayers who operate in cash-sector activities to misreport their income to align with market practices or to seek different employment opportunities where they can compete without evasion 60 Cash, the Shadow Economy, and Criminal Activities

It is important to explain how cash transactions facilitate two additional types of illegal economic activities—shadow economy, or unregulated, transactions and criminal transactions. The definition of the shadow economy varies and can, under different accounts, include three types of activities: unreported income from legal transactions, which are unreported (mostly) for tax-evasion purposes; unreported income from regulation- avoiding transactions, that aim to evade both taxes and regulation; and unreported income from criminal transactions, in which the sale of goods and services itself is considered to reduce social welfare and is therefore illegal (e.g., drugs and sexual services) There are obviously overlaps among these categories in the sense that they all involve illegal tax evasion, which carries criminal liability. Furthermore, the evasion of income, employment, and consumption tax burdens is typically considered a major incentive for operating within the black market.

The first category represents income- generating activity that is unreported 'Just" to evade taxes. Tax evasion results in lower revenues, increased compliance costs, major misallocation of resources, and some potential inequities The second and third categories, represent off ­the-books economic activities engaged in by unregulated businesses and criminal actors.

To avoid confusion between the different categories, the term "shadow economy" shall refer only to the sale of legal goods and services that is unreported to avoid non-tax related regulations. Accordingly, under this classification, a service provider 's non-reporting of his cash income to evade taxes would be considered a tax-evasion transaction, not a shadow economy transaction but a manufacturer who does not report his income because he is hiring child workers and paying wages less than minimum wage would be considered part of the shadow economy because in this setting cash facilitates both tax evasion and regulatory avoidance. Illegal drug dealing would be considered an illegal transaction and not part of the shadow economy even if the drug dealer hires child worker and even if he pays them less than minimum wage. While evading taxes and violating minimum wage and employment laws may all be subject to criminal penalties, the distinction between those activities and selling drugs is the legality of the commercial activity itself. Selling drugs is illegal , whereas providing service and manufacturing are legal activities, so that the illegality of the above examples stems from the way that these activities are conducted and underreported.

Breakdown of the Activity Categories

The commercial activity itself is illegal
The activity is (typically legal but) conducted in an illegal way to avoid government regulatory scrutiny
The activity (typically) involves illegal tex evasion
Tax evasion transactions X

X

√
Shadow economy transactions X

√

√
Criminal
transactions

√

√

√
The question why individuals choose to operate in the shadow economy has been subject to a considerable amount of social science research. Other than evading their taxes, individuals operating in the unreported economy seek to avoid a whole array of costs associated with interacting with the government. These costs can vary considerably and range from registration and license fees to payments made in order to bribe corrupted officials. Operating in the informal shadow economy also provides flexibility with respect to a wide array of regulatory costs, including immigration restrictions and employment law regulation concerning minimum wage and retirement.

As with tax evasion, in unreported cash transactions, cash is an important component of the shadow economies attempt to hide from government regulatory scrutiny. In fact, when it comes to the shadow economy, there is an almost total reliance on cash, one of the main characteristics of this market. Even though it is very difficult to obtain reliable information about cranial activities, it is clear that both domestic and international criminal activities rely on cash as an almost exclusive method of exchange . As in the case of shadow- economy and tax-evasion activities, the records of non- cash payments are risky and may lead to detection and high-penalty incriminator .

Cash as a supplier of secrecy is an important component of shadow and criminal activities. The anonymity of cash allows sellers, service providers, and buyers (in the case of criminal activities) operating in the cash economy to go undetected. Cash as an institution also provides those operating in these illegal markets with a link to the formal economy in the form of an anonymous and general consumption power.

Because almost all shadow economy and criminal transactions are cash mediated, and therefore easily remain unrecorded, measuring the overall size of the shadow and (even more so) criminal economies is difficult. Nevertheless, the shadow economy is believed to account for roughly 10% to 20% of the GDP in high-income developed countries. Criminal activities are difficult to assess and are estimated at hundreds of billions of dollars annually in the United States alone.
A PIGOVIAN CASH TAX
The Deadlock in Confronting Cash-Based Tax Evasion
The literature on tax evasion suggests that there are no silver bullet solutions for reducing tax evasion associated with underreporting of cash transactions. When detection probabilities are low, high penalties rare, and government services universal (or at least not conditioned upon tax payment), evading taxes is rational free-riding behavior.

The key to effective tax enforcement thus requires reliable as well as readily observable and easily analyzable information Accordingly, third-party information reporting and withholding have been the prime mechanisms through which tax authorities have successfully reduced tax-evasion activities. In the cash economy, however, this type of third-party information reporting is very difficult to enforce— especially with respect to retail activities by the self-employed and small businesses.

The main enforcement tools that tax authorities use to deter the tax evasion of cash-based businesses are audits and the threat of criminal penalties. However, audits are expensive and often insufficient to uncover underreporting of cash income activities. Although audits result in increased revenues, civil and criminal penalties are rarely used against legal small businesses, so their deterrence impact is limited .Furthermore, perhaps because audits are politically unpopular, the rate of audits and criminal prosecution has been decreasing.

There are some useful ways to reduce tax evasion. For example, tax authorities can invest in information technologies and try to trace certain unusual purchases (e.g., luxury goods such as costly vehicles, luxury apartments by self employed taxpayers that typically indicate tax-evasion activities. Nevertheless, while these actions are probably cost-efficient, they are still likely to require (expensive) audits and their effectiveness will be reduced by taxpayers' behavioral adjustments to thern.

The difficulty of confronting income underreporting in the cash economy has long-lasting effects on governments' abilities to raise revenues in the future because the widespread nature of cash-based evasion practices entrenches non-compliance norms. While most people tend to obey the law because of a Mixture of respect for the political process and risk aversion to penalties, non-compliance by the cash sector seems to be an exception. These non-compliance norms make it more difficult to enforce compliance with the tax law.

Taxing the Cash Economy Through cash withdrawal counter of Banks

This is a proposal that would limit the revenue loss, inefficiencies, and potential inequities associated with cash-based tax evasion by imposing a tax on cash. This cash tax would be imposed every time cash is withdrawn from the financial system as a fixed percentage of the overall amount. No tax would be collected, however, when cash is deposited into the financial system

This proposal responds to the facts that mitigating cash-based tax evasion through traditional audits is difficult, that tax is a facilitator of many tax-evasion transactions, and that much of the cash used today is directed towards illegitimate ends. Rather than discovering and punishing tax evasion, the proposal provides more of a level playing field between the formal and informal economies in developing countries like Bangladesh. Its main theme is that, once a cash tax is imposed, taxpayers will adjust their behaviors so that cash will be used primarily for unreported transactions. If that is indeed the case, the incidents of the cash tax will fall primarily on unreported income.

The proposal assumes that it is neither possible nor desirable to eliminate cash-based income underreporting. Cash is an efficient payment method for small transactions or (legal) transactions that require privacy (e.g., to avoid identity theft). Cash would therefore probably still be used as a method of exchange even if all income underreporting were curtailed.

Cash users should nevertheless account for the fact that cash entails many social costs associated with income underreporting. Hence, since the use of cash is not free, to truly optimize the use of cash, its users should internalize the social costs associated with underreporting. Currently, cash is offered to consumers for its par value without carrying the price of its externalities. Naturally, without a clear price signal on its true cost, consumers inefficiently overuse cash.

The use of cash for unreported (tax evading) transactions is not incidental one could expect that many cash transactions within the legal economy are deliberately designed to attain tax-evasion benefits. Additionally, as mentioned, most of the currency stock in developed countries is used to purchase shadow economy or criminal goods and services. Those attributes that make cash attractive fungibility, divisibility, and anonymity are precisely those that prevent tax authorities from identifying cash transactions that are part of an underreporting scheme. Hence, while cash is a legitimate method of exchange, a Pigovian tax on cash would optimize its usage. This tax would not be as precise as income, employment, or consumption taxes in assessing taxpayers' economic well-being, but, it would use an indirect means to ascertain tax liability by cash usage which would roughly aim to capture the taxes lost due to cash-based tax evasion.

The cash tax would be a withholding tax imposed at the point of entry when cash is withdrawn from any regulated financial institution Cash deposited in the financial sector would not be subject to any type of tax. The cash tax would therefore operate as a presumptive tax realistically assuming that much of this cash is probably withdrawn to generate unreported income.

In essence, the proposal puts significant emphasis on the role of the financial sector. The operating assumption is that tax authorities have access to transactions made through financial intermediaries. In the formal economy, financial intermediaries play a crucial role in providing revenue agencies with information about transactions made and assets held by taxpayers. The growing number of information-reporting requirements that tax authorities in developed countries impose upon financial institutions (e.g., reporting income derived from financial investments) suggests this is, indeed, the case. The relatively low level of underreporting with respect to income subject to third-party information reporting suggests that taxpayers have internalized this indirect regulatory function of financial institutions.

It is argued that, when financial intermediaries cannot operate as information providers because they supply their consumers with difficult-to-trace cash, they should operate instead as tax withholders. This proposal conforms well with the tax-administration experience, which suggests that third party information reporting and withholding are the most successful methods of inducing tax intelligence. The cash tax would be an indirect withholding tax also prescribes its limitations namely that it should be a fixed rate and not vary according to the amount withdrawn or the taxpayers' income. Withholding taxes is an effective tax enforcement mechanism when it is crudely enforced because the tax withholder does not have sufficient information about the taxpayer

To some, the use of a presumptive Pigovian tax may seem awkward after all, a certain cash note can circulate multiple times. Some of these transactions may not involve tax evasion and therefore bear no negative externality indeed some cash transactions probably even have certain positive externalities. This type of critique suggests that presumptive advance tax taxes should usually be laid only in those cases in which the harm is directly correlated with the activity. For example, every gallon of petrol one uses inflicts a cost on the environment, in terms greenhouse gases' emission, which is directly correlated with the amount of petrol used.

However, Pigovian taxes are also employed when the harm is not directly correlated with the usage. For example, Government of Bangladesh applied such taxes with respect to public smoking even though consumption at low levels does not result in negative externalities. While excessive tobacco consumption may indeed have significant negative externalities, the same indirect Pigovian tax rate is imposed on all both light and heavy mokers.. Therefore, the observation that a Pigovian tax on cash is inappropriate because some cash transactions have positive externalities serves merely as an example of why the perfect theory is often the worst enemy of a sound policy. Cash is fungible and anonymous, and tax authorities cannot distinguish among its uses at a reasonable cost which is exactly why there is a need for a blunt instrument like the cash tax. As with tobacco, and many other Pigovian taxes, policy makers would impose the cash tax to control the aggregated amount of externalities rather than try to trace the externalities associated with each individual transaction. A determination of this aggregated level derives from two factors: the extent to which cash is misused and the extent to which the cash tax would shift 'legitimate" transactions out of the cash economy and the costs associated with that shift. It suggest that the indirect cash tax on withdrawals would more closely resemble an indirect Pigovian consumption tax on petrol than a similar tax on tobacco because it would apply almost entirely to cash transactions that have negative externalities.

Such a highly visible and salient cash tax would trigger two opposite behavioral responses. The first response would be by taxpayers who use cash in legitimate transactions, which include legal transactions in the formal economy where the consumer is not (knowingly or implicitly) part of an income-underreporting scheme. The crux of the matter is that once a cash-tax is imposed, the amount of cash used to facilitate legitimate transactions would significantly drop. This would mean that most of the remaining cash transactions would involve some type of illegitimate underreporting objective. An example of such a transaction would be payment of cash at the supermarket or any other type of (typically large) business that accepts cash and other methods of payment without offering a cash discount. Consumers in these transactions would limit the use of cash to very small purchases where the convenience value of using cash was greater than the costs imposed by the cash tax. With respect to all other transactions, these consumers would try to shift to other methods of payment assuming that such methods are cheap and widely available to avoid the cash tax. The next subpart elaborates on how to ensure this type of availability, but for now it is enough to assume that buyers and sellers in the fully reported formal economy would not want to absorb the cash tax on top of other tax liabilities.

The other behavioral response would be to avoid depositing cash in the financial sector by shifting to cash substitutes. Given that cash that enters the financial sector would be subject to the cash tax upon withdrawal, non-deposited cash would be worth more than deposited cash. At moderate levels of cash-tax rate, this second response has its limits, however, because holding large amounts of cash assets entails considerable storage and security costs.90 The next subpart addresses this issue in greater detail and considers various low-cost and practical ways to limit the negative impact of these behavioral tendencies on the effectiveness of the cash-tax.

These two behavioral responses highlight why the proposal could only be successfully implemented in high- income developed countries. These countries have advanced financial and communication services that allow for other forms of payment, such as checks and cards. For example, big employers in these economies, and indeed their governments, typically use monetary transfers to pay their suppliers and employees. The financial sectors in these countries offer valuable credit and financial services that allow businesses to expand. Hence, legitimate businesses and taxpayers have incentives not to maintain cash but to channel payments through the financial sector because it is cheap, safe, and reliable and makes them credit-worthy.

Another reason why the cash tax could only be implemented in high- income developed countries relates to the relatively low magnitude of the cash economy in these countries. As mentioned, in high- income countries cash economies comprise a significant part of the GDP but most economic activity takes place in the formal reported economy. Members of the cash economy who want to use their cash purchasing power would have to use a substantial amount of it in the formal economy, which in turn would provide incentives to deposit or invest (at least most of) that cash in the financial sector.

The above analysis suggests that the cash-tax incidence would fall primarily on those taxpayers who participate in cash transactions that involve some type of underreporting. If the legitimate economy shifts to non-tax money transfers, cash holders would be primarily those participating in underreported transactions. Given that the size of the cash economy is relatively small, cash users would not be able to significantly affect marginal prices. This means that, rather than rolling the tax burden to the legitimate economy, cash users would have to internalize it.

Consider a waiter who receives most of his salary as tips paid in cash, which he does not report as income and which he does not deposit. When that waiter decides to purchase goods and services in the legitimate economy he will not be able to ask for a discount for paying in cash when the seller do not prefer cash transaction. Accordingly, the effect of the cash tax on the price equilibrium in the formal economy is likely to be small Put differently, if a high- income developed country employed the cash tax, cash economy participants, who rely on the anonymity of cash to avoid reporting their (essentially free-riding) economic activities, would not have sufficient market power to roll over the tax burden to the legitimate economy.

Theoretically, the appropriate cash-tax rate should, at the very least, attempt to mimic the amount of revenues lost due to unreported transactions. The cash tax is assumed to be a rough approximation of the income, consumption, and employment taxes that would have been levied if all transactions were reported. Hence, the cash-tax burden should aim to reduce the non-compliance benefits of using cash so as to reduce the inefficiencies, and potential inequities of the cash economy.
The Devil in the Details: Assessment of the Proposal's Practicality

While the idea behind a Pigovian cash tax is relatively simple, it is not suggested that it could currently be implemented in any high- income developed country. To make the cash tax a useful policy tool in managing the harmful effects of income underreporting, a few administrative and political concerns should first be addressed. The followings are the three major types of concerns distributional, taxpayers' avoidance by use of substitute (for cash and financial institutions), and windfall to current cash holders .

1. Concerns over the distributional impact of the cash tax

The first set of objections relates to the fact that cash usage is not uniform across society. Certain groups e.g., low-income taxpayers, the elderly, and men tend to use cash to purchase a higher percentage of their overall consumption In fact, as high-income, well- educated consumers have shifted to card payment methods, cash has gradually become identified as the method of exchange among the low-income population. This is partly a result of convenience but also because poor people are more likely to be the services- suppliers and goods-producers in the cash (and shadow) economy and therefore tend to have more cash available.

Moreover, financial institutions under invest in providing and promoting financial services for low- income individuals and small businesses. The relatively small amount of financial resources that low-income individuals possess and the relatively low turnover of small businesses, make it less attractive for private providers of financial services to offer universal checking accounts and electronic transfer services. Hence, unless some actions are taken, the cash tax will have a regressive distributional impact, which would make it politically difficult to implement.

As mentioned, allowing cash-based income underreporting is a very inaccurate and inefficient method of redistribution. Consumers of the cash economy, rather than providers of goods and services who underreport income, are the main beneficiaries of the lack-of-tax subsidy to the cash economy. Furthermore, many of the consumers in illegitimate cash transactions 97 (e.g., gardening and house cleaning services) are high- income, well-educated individuals who are fully aware of income underreporting by their services-providing, cash-receiving counterparts.98

To prevent the cash tax’s burden from falling on low- income individuals who are not willing parties to income underreporting transactions, the following steps should be taken. Some of the cash-tax proceeds should be diverted to creating a "public option" of low-cost financial services. Participating governments should enable every adult resident to open a free checking account, to issue a limited number of personal checks, and to obtain a debit card. Furthermore, the government should assure that low-cost, electronic payment services are available for all small businesses. Additionally, transfers should be made to certain groups for whom adjusting to non-cash methods of payment would be more expensive and time consuming (e.g., the elderly and people living in remote areas). The transfers made to these groups should gradually decrease over time, however: in the long run a shift to non-cash methods of payment requires reasonable learning costs from most people.99

While these measures are not free of cost, they are not terribly expensive or difficult to achieve. Their overall cost should be weighed against the additional cash-tax revenues and the additional income, employment, and consumption tax revenues that would result from the increased reporting. In developed countries, most adults have checking accounts, so the number of individuals who would need the public option should be relatively small. Additionally, most private sector businesses that seek to attract middle-class consumption power already accept card payments. However, if the market for card services is not competitive, as is frequently the case, 10() the cash tax may increase the monopoly rents of card issuers and allow them to increase their interchange fees. While large retailers may have sufficient market power to resist such an increase, this increase may adversely affect small retailers.

The most regulatory- efficient way to address this concern is probably through antitrust regulation but this type of solution may be politically difficult to implement. Hence, to the extent that card interchange fees are considered too burdensome on small to medium businesses, providing a limited refundable tax credit for small businesses interexchange payments should operate as a carefully tailored low-cost subsidy that would substantially reduce these concerns.

Overall, there are reasons to believe that the costs of these public option financial services and transfers would be relatively small as compared to the direct and indirect cash-tax revenue gains. Investment in providing the necessary public option and transfer payments support for the cash tax is even more justified if the cash tax would help reduce the cash economy and some of the inefficiencies associated with it.

2. Concerns over the shift to substitutes

The other concern that should be addressed is how to curtail the attempts of taxpayers to avoid the cash tax either by using cash substitutes or by substituting domestic financial services with other forms of financial services. There are many substitutes to cash as a method of payment (e.g., barter, foreign currencies, and transferable checks). At the outset, it is clear that there are no perfect substitutes for domestic currencies barter transactions would be limited in a cash-tax environment as they are today, foreign currency carries foreign exchange risk, and anonymous checks carry considerable credit risks and legal enforcement risks (which result from the high possibility of fraud). Nevertheless, the cash-tax regime should try to limit the scope of abuse by taking a few simple steps: Taxing foreign cash withdrawals from domestic financial institutions requiring that all personal checks be made-to-order checks (so that they are paid only to the named payee) as a default; 104 and/or stipulating that non-order checks be subject to the cash tax when refunded or deposited.

The cash tax cannot prevent some of the more sophisticated barter transactions. However, as the following examples illustrate, the scope of this manipulation is costly and limited. Consider a lawyer operating in the non-cash economy who can purchase groceries on behalf of his house owner while using his debit card. This transaction would be subject to consumption tax (VAT), but would still allow the house owner's income to remain unreported. This type of manipulation is unavoidable, but it also has some serious limitations. The transaction may involve substantial time-related transaction costs (to the lawyer) and may not account for some of the houseowner's most substantial expenses (e.g., mortgage). Therefore, the lawyer is probably unable to afford to engage in such a transaction with most of his service providers, with whom he may have little acquaintance, or when large amounts of money are involved. Perhaps most importantly, the payment in this transaction severely limits the circulation of cash because the money is immediately deposited in the non-cash economy. The housekeeper can avoid reporting but cannot then use that income to further engage in unreported cash transactions.

Alternatively, the lawyer may pay his house owner through gift cards. By buying these gift cards with his debit card, he would pay the consumption taxes associated with this purchase. The benefit of this transaction is that the house owner can then use those gift cards as cash-equivalents to make tax-free purchases in the cash economy. While it is possible to eliminate this avenue of abuse by forcing some type of identification requirement for purchasing and subsequently using the gift cards, this type of strategy may involve non-trivial regulatory costs . However, it is important to bear in mind that these costs may not be necessary because of the "natural" limitations of such a strategy. As in the previous example, the house owner may be unable to pay for all expenses using gift cards and there could be a problem in verification that would make these exchanges unpractical when there is no personal acquaintance or when large amounts of money are involved. Evidence suggests that there may be a market for cash - substitutes but that these are typically sold at a significant discount and rational taxpayers would therefore prefer to pay the (probably) lower cash-tax rate.
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Cash taxpayers may also seek to avoid the cash tax by looking for substitutes in the domestic financial sector. Because cash accumulation is a low-yield yet risky investment strategy, many taxpayers may seek to either continuously spend their cash or deposit it in foreign banks. It is myortant to note that individuals operating in the cash economy already engage in this type of behavion' 08 Accordingly, to provide a

better (rather than a perfect) policy alternative, the proposal should not be concerned with tax accumulation per se but should try only to make sure that participants in the formal economy do not also begin to engage in this type of behavior. For example, consider service providers in a family business who underreport their cash earnings and avoid depositing them. As long as they store or (more likely) spend the money, the probability of detection is negligible, and the possibility that they will face substantial penalties is practically non- existent. The important challenge, therefore, isi not to get them to deposit their cash proceeds but to get those businesses in which they subsequently spend their cash to deposit most of that cash. Meeting this challenge is plausible because, in developed economies, a substantial portion of the economic activity is undertaken by big firms, the government, and other formal-economy businesses. Hence, the service providers would find it difficult to realize the consumption power of their cash assets solely within the cash economy.

To further prevent a situation of never-deposited cash proceeds, a government can Inpose a requirement that a certain amount of cash business receipts be deposited. For example, such a requirement can say that every business should deposit any cash received as business proceeds that exceeds the higher amount of either $4,000 or 5% of annual gross receipts. While this requirement is likely to have no impact on sellers in the cash economy, it can provide members of the formal economy with an additional incentive to deposit cash received. Put differently, such a requirement would not induce the drug lord to deposit cash, but it could affect the behaviors of his lawyer and accountant. It would likely assure that the manager of the department store (where the drug lord does his shopping) deposits the cash received.

Another way to limit cash accumulation behavior is to require eilyloyers to pay wages via pay-to-order checks or by direct deposits. Furthermore, tax authorities could deny part or all of the deduction of certain (large) business expenses paid in cash These suggestions do not aim to eliminate cash storage entirely but rather to ensure that the formal economy deposits most of its cash proceeds.

The ability of taxpayers to substitute foreign financial institutions, that presumably do not impose a cash tax, for domestic ones creates a serious concern for policymakers. Even though tax-related information- sharing technologies, practices, and agreements have seriously developed over the course of the last ten years, 109 foreign financial institutions have no information- reporting or -withholding obligations. Hence, taxpayers can deposit and withdraw cash from those institutions and use it back home.

Although this state of affairs is unlikely to change in the near future, channeling cash abroad involves considerable transaction costs. While managing a foreign bank account through the Internet is relatively easy, depositing and withdrawing cash on a regular basis is not. Because most individuals do not live within a reasonable distance of an open border, withdrawing cash in a foreign country won hl be a tax- avoidance scheme with prohibitive transaction costs. To be effective in the EU, the single currency and open borders may require that the cash tax be imposed by all major high- income developed countries. 110 Alternatively, a single EU country can impose the cash tax unilaterally as long as there are strong information-sharing mechanisms in neighboring countries that would report large cash deposits,

transfers, and withdrawals by its residents. 111 Nevertheless, taxpayers with considerable amounts of cash would seek to channel large amounts of funds to foreign banks in offshore financial centers with low tax rates and bank-secrecy laws. Cash channeling abroad is already taking place and is potentially a risky practice subject to criminal penalty. 11 2 The cash tax shoe old not be expected to solve all problems and this set of problems is probably better dealt with through money- laundering legislation.

3. Concerns over cash-tax windfalls

A cash tax would result in a windfall to existing cash holders. While taxpayers with deposited funds would have to pay a tax upon withdrawing the cash, existing cash holders would have their cash assets tax-free. These concerns may not be substantial in the case of typical households, where cash is generally held in relatively small amounts. However, this windfall may turn out to be significant in the case of certain cash economy participants, particularly those involved in criminal transaction (e.g., the drug trade).' 13 In this context, the cash-tax windfall may increase political resistance to the tax. Policymakers can address this problem via two policies: demonetize existing cash assets and inflate deposited amounts. However, the cash tax would still offer a superior alternative to the current regime even if policymakers tried to implement the tax without addressing the windfall problem.

Demonetizing, requires replacing all cash assets with new ones during a given time period after which the old notes and coins would not be valid anymore. 114 Because the replacement of cash requires depositing it or exchanging it financial institutions, a withholding cash tax can easily be imposed. However, demonetization involves significant administrative and compliance costs, especially in the case of cash assets that are frequently used by non-residents (namely the Euro, and the U.S. dollar). Additionally, trying to impose a cash tax on foreign financial institutions may prove to be a difficult move from a foreign policy perspective.
Policymakers can also choose to inflate deposited currencies to counterbalance the windfall of cash holders. In fact, unless a government wants to implement capital control measures, such a step may be necessary as a transitional policy to avoid a scenario in which large withdrawals are made prior to the introduction of the tax-cash 115 This, however, may increase inflation and result in problems associated with cash assets deposited by individuals and corporations in foreign institutions.

Finally, policymakers can choose to adopt partial policies (e.g., only demonetize large notes above the value of 100 U.S. dollars, which are those typically used in drug trade) or to adopt neither option. As noted, the cash tax is a rough justice

approach If no adjustment is made to offset the windfall, a drug lord may indeed experience a short-term windfall However, in the long run, when the drug lord wishes to realize his cash-based consumption power, by buying a house for example, the money would enter into the financial system and thus be subject to the cash tax.

III. BEYOND TAX ANALYSIS : DETERMINING THE CASH-TAX RATE BY CALIBRATING THE SOCIAL COSTS OF CASH
As demonstrated in Part I, the costs and benefits associated with tax anonymity have been recognized by different strands of economics, including the literature dealing with public finance, the shadow economy, economic crime, and monetary regulation. Interestingly, each of these literatures views the case for and against cash only from its relatively narrow perspective. This Part argues that the Article's Pigovian framework allows the cash tax to look beyond the tax-evasion question. Sound policymaking should determine the cash-tax rate that would optimize the use of cash. To be clear, the Article does not argue that the cash tax should eliminate other cash-related practices such as the shadow economy. It does suggest, however, that when determining the cash-tax rate, policymakers should try to view the externalities of cash in a broad way and not restrict themselves to curtailing tax evasion

The suggested approach is very different from current scholarship. With some important exceptions, 1 16 most tax policy literature focuses on the costs of tax evasion and offers traditional mechanisms of more information-reporting and audit-based enforcement to reduce it without considering alternative anti-evasion methods. 117 Similarly, monetary regulation literature typically offers solutions that only aim to reduce the cost of cash as an inefficient payment method when comparedto debit card payments. 118 The literature dealing with international money laundering and economic crime examines ways to reduce the use of cash by organized crime groups but usually fails to consider other negative externalities associated with cash usage." 9

While the different solutions advanced typically do not conflict with each other, they all fail to consider the social costs of cash and who should bear them. The cash- tax framework, on the other hand, allows policymakers to do precisely that—aggregate the costs of cash and suggest that the majority of those costs should be borne by cash users. As such, the cash-tax proposal can operate as an important and

effective supplement to many policies that seek to limit some negative externalities associated with the usage of cash
The starting point of the analysis is that anonymous cash transactions are an unavoidable feature of the modern economy. Moreover, as long as cash is a legal method of exchange, a great number of cash transactions will not be reported. The analysis further assumes that optimal cash policy will not require eliminating all unreported cash transactions. Instead, the problem of underreporting should be approached as a collective action problem 120 in which the state can promote the efficient use of cash by forcing cash users to internalize the externalities of their cash preference. The rate of this tax should aim to reflect the true costs of cash anonymity as closely as possible it should be calibrated against many margins and not restricted to questions of tax evasion.

The direct effects of revenue loss associated with underreporting of cash transactions were discussed in the previous Part. 121 Most of the social costs associated with cash are easy to notice but difficult to quantify. Hence, rather than trying to model the true costs of cash, subpart points to the full range of cash externalities that policymakers should consider when setting the cash-tax rate.

First, income underreporting makes goverments' attempts to monitor their economies much more difficult. 122 For example, if many of the state welfare programs are means-tested and depend on recipients' incomes, then having a cash economy can reduce many of these programs' accuracy. 123 This would result in inefficiency because it would provide welfare recipients incentives to remain in the inefficient cash economy. Furthermore, if the welfare system is considered inaccurate, inefficient, or unfair, the willingness of the more affluent taxpayers operating in the formal economy to subsidize it would be reduced.

Another example of the economic monitoring difficulty associated with cash is how the cash economy distorts the structure of tax collection. The difficulty in raising revenues from the cash sector requires changing the overall tax mix so that other sources of income (e.g., wages in the formal economy) or fiscal instruments (e.g., various consumption taxes) are taxed at a higher rate. 124 These higher marginal tax rates (laid on the formal economy) can be very distorting in fact, high marginal income tax rates are known to reduce work incentives. 125

Second, as mentioned in Part I.C, cash provides a method of exchange to the shadow economy. In addition to being less productive than the formal economy, 126 the shadow economy creates efficiency costs that are very similar to those of cash-based regulated businesses that evade a significant amount of taxation 127 The actual costs of the cash economy are more difficult to measure because the cost of regulation and the lack of it are both hard to assess. The unregulated shadow economy may be welfare-reducing if, for example, one assumes that labor law regulation represents social preferences on issues of minimum wage, immigration requirements, labor safety, and product liability. However, many of the unreported and unregulated shadow economy activities are not antisocial doings but simply byproducts of the temporary and informal employment realities of low-skilled individual that are often too small to justify reporting. 128 Additionally, many shadow economy activities would not exist if taxpayers were required to comply with the costs of government taxes and labor law regulations. 129 Some studies suggest that the size of the shadow economy is correlated with the more rapid growth in developed countries. 130 Cash may therefore allow governments in developed countries to engage in price discrimination putting tax and regulatory requirements only on productive industries without hankering the existence of the less productive ones. This Article does not argue that the shadow economy is good or bad but that all these effects should be taken into consideration.

Additionally, in weighting the employment and growth benefits of a shadow economy, pohcymakers should assess whether there are alternative means to promote employment and productivity among unskilled workers.' 31 The contribution of the current proposal is that it does not take the traditional course of fighting the shadow economy through deterrence. 132 Instead, the Article's proposal leaves it to policyrnakers to try to establish the optimal level of shadow economy activities by adjusting the cash-tax rate.
Third, as noted in Part I.C, cash helps facilitate criminal. activities. Estimating the overall costs of crime is a relatively new field of study, 133 and the costs themselves range over a large spectrum of direct costs (e.g., law enforcement expenditures and tax revenue losses) and indirect costs (e.g., insurance costs and lost work days). 134 The difference between the shadow economy and criminal activities is that, in the case of criminal activities, governments should seek to more actively

eliminate them, rather than to just optimize their frequency. While crime is welfare-reducing, attempts to eliminate it are likely to be very costly and therefore not desirable. Just as a government should not place policemen at every street comer to eliminate crime, the cash tax should not aim to make criminal activities entirely unprofitable. Instead, the tax cash should make participation in these markets less profitable and more costly, which would hopefully encourage their contraction. Policymakers should account for the fact that a non-trivial amount of the cash used in developed economies is directed towards purchasing drugs, illegal sex, and gambling services and facilitating other criminal activities. 135 This suggests that a Pigovian cash tax should be adjusted upwards to account for more than the estimated revenue and efficiency costs of tax evasion.
Fourth, one of the major costs of the cash economy is that it fosters norms of tax evasion by income underreporting and facilitates mistrust in the tax regime. This is a vicious cycle because tax evasion norms and fiscal- mistrust make tax enforcement more difficult and are very hard to change. 136 While the cash tax would not eliminate the problems associated with underreporting, it would help to reduce the amount of unreported income. It would also create a more level playing field between the formal and informal economies by reducing the (lack-of-tax) subsidy to the cash economy.
Fifth, cash supplies anonymity for a wide range of purposes. Cash can therefore serve as a way to hide assets from non-tax-authority creditors. To the extent that this activity is considered to be an antisocial behavior that requires government intervention, policymakers may wish to take it into account as well
Sixth, cash assets are already subject to an implicit inflation tax. Ina low-inflation environment, inflation offers a sub-optimal cash-tax solution because of its low-salience and the fact that it is imposed on all holders of nominal assets (many of which are not necessarily in the form of cash). Accordingly, inflation may have little effect on extensive cash tax users who do not have significant net- cash- holdings.137 Nevertheless, policymakers should take into account this implicit inflation tax when calibrating, the cash-tax rate.
Finally, against the negative externalities of cash, it is important to bear in mind that cash has some positive externalities as well. Apart from providing a convenient payment method for small purchases, cash can provide privacy for a wide range of legal transactions. Taxpayers may value privacy for many reasons because they purchase discrete goods and services (e.g., legal pornography), want to avoid identity theft and providing marketing infuriation to third parties, or want to make a private transfer to a friend. While these privacy concerns do not render the cash tax an inappropriate method for monitoring the negative externalities of cash usage, they may counterbalance some of these negative externalities. When entering this discussion, one must remember that making privacy (somewhat) more expensive is not necessarily equivalent to infringing on it. While the cash-tax proposal definitely makes cash-purchase-related privacy more expensive, it maybe considered less intrusive than other measures to counter cash-related tax evasion (e.g., aggressive

audits). Privacy as a social value has many dimensions and when considering how to best balance it in light of other public values and interests, policymakers should weigh the potential effects of each policy on it.

Regardless of what the costs of cash are determined to be, it is important to remember that the cash-tax rate would be a process of trial and error. As a Pigovian tax, the cash tax has the objective of promoting a shift of most formal economy transactions to non- cash methods of payment. Hence, while the cash tax could be raised gradually to reduce the political objections to it, it needs to ultimately be high enough to encourage this shift. On the other hand, the cash tax should not be prohibitive if set too high, formal and informal economy participants would avoid depositing cash by shifting to cash substitutes to avoid the tax upon withdrawal The rate of the cash tax should therefore start low (perhaps around 5%), with the notion that policymakers should determine the ultimate rate through an ongoing process that aims at setting a wise rather than a correct rate.

Ideally, policymakers would aim to set the cash-tax rate above the ordinary consumption tax rate to account for tax evasion and other negative externalities of cash However, the ultimate goal of the cash tax is to allow a more efficient use of cash by imposing as many of the costs as possible that are associated with cash usage on those participating in and benefiting from the cash economy. Accordingly, a wise (and cautious) policymaker would take into account the probable market salience of the tax, 138 and therefore likely prefer a lower cash- tax rate to avoid an inefficient shift to cash substitutes. This suggests that many of the cash economy participants would prefer to pay the lower cash-tax than to report their activities. This result would fall short of eliminating the benefits of underreporting but won hl result in higher revenues and greater resource allocation efficiency when compared to the zero effective tax rate currently imposed on these activities.

CONCLUSION

The cash-tax proposal presented in this Article asserts that, instead of focusing on finding and prosecuting the wrongdoers, tax policymakers should put more emphasis on trying to tax them

This proposal is built on two prongs: First, cash is no longer as much of a necessary medium of exchange in developed countries and therefore could be shifted away from with relatively low social costs. Second, transactions that create tax evasion, shadow economy, or criminal negative externalities all involve cash. Therefore, policymakers can use the supply and price of cash to control some of its negative externalities.

The Article offers a Pigovian tax framework to deal with one of the oldest problems haunting human civilization--tax evasion and underreporting. Some humility is in order when approaching a phenomenon that has persistently troubled enforcement agencies since the days of the Pharaohs. The cash-tax proposal cannot, and does not aim to, eliminate tax evasion and does not argue that investment in other tax enforcement mechanisms should be abandoned. It does, however, wish to supply tax authorities with an additional fiscal tool that deviates from their current more­audit-enforcement arsenal to deal with this issue. Adding this tool can help tax

authorities gain an important advantage in the long war of attrition that they have been fighting against participants in the cash economy.