Upper bound expenditure estimate

The expenditure approach to estimating GDP is, in principle, independent of the income and production methods as it is estimated from the demand side. In practice, however, it does utilise some common data sources and ultimately it is balanced with the other two approaches in the supply-and-use framework. As part of the review, a judgment was also made as to the possible significance of underground activity for each expenditure item.

The areas of expenditure considered most likely to be affected by underground activity are: • residential construction and alteration and additions;

• household final consumption expenditure on goods and services.

The remaining expenditure items are unlikely to be affected to any extent. In particular, it is assumed that public sector transactions are not affected. Data for the public sector comes from

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administrative sources and expenditure of public funds is subject to strict financial and audit controls. Exports and imports would only be marginally affected by underground activity through either undeclared transactions or the undervaluation of declared transactions.

Expenditure on intangible fixed assets, e.g. computer software and mineral exploration, and ownership transfer costs are also unlikely to be affected to any significant degree (the former because they are depreciable costs to the business and the latter because transactions are unlikely to be in cash). In relation to expenditure on machinery and equipment, the national accounts use supply-side data (i.e. domestic production and imports of machinery and equipment) in conjunction with expenditure data, thereby providing a crosscheck to some degree. Also as machinery and equipment is a depreciable item for taxation purposes and because transactions are unlikely to be in cash, the degree of under reporting is likely to be limited, although businesses may write off some purchases as a business expense.

6.2.1 Residential construction and alterations and additions

The example most often mentioned in relation to the underground economy in Australia is that of building tradesmen doing work 'off the record'. ABS believes, however, that the estimates of investment in residential construction are reasonably reliable in spite of underground activity because of:

• the requirement for local government building permits for new buildings and significant alterations and additions;

• the targeting in surveys of prime contractors rather than sub-contractors; • the involvement of financial institutions in making progress payments;

• the use of household survey data rather than data from businesses to periodically benchmark alterations and additions;

• the estimates not being based on the income declared by builders to income tax authorities.

The value of work done on new residential buildings is collected in ABS Building Activity Survey (BACS) quarterly. The population list from which jobs are selected for inclusion in the survey comprises all approved building jobs which were notified to ABS up to, but not including, the last month of the reference quarter. Statistics on the value of building work approved are derived by aggregating the estimated value of building work when completed as reported on building approval documents provided to local councils or other building approval authorities.

While it is difficult to build a dwelling without a building permit, values reported on building permits could be subject to understatement. While ABS generally accepts values provided by approving bodies, every effort is made to ensure data are provided on a consistent basis. Given the potential loss of revenue, councils are unlikely to issue a building permit for a house with a value that is unreasonably low. The price of new homes on the market is also well advertised and is a good gauge of their cost of construction. There may, however, be instances where data reported do not reflect the building completion value. For most project homes the reported value is the contract price, which may include the cost of landscaping as well as site preparation. In other cases, where a builder is contracted to construct a dwelling based on the owner's plans, the value may only be the builder's costs.

When compiling the national accounts, allowances are also added for net expenditure on new dwellings not included in the survey (e.g. dwellings on rural properties not requiring local government permits and architects' and professional fees).

Notwithstanding the use of a range of checks and balances, it is recognised that there could still be some understatement at the margin. For the purposes of the upper bounds analysis, an arbitrary (but generous) 10% understatement to value of building work done was allowed.

For alterations and additions to existing dwellings, the value of the work undertaken is estimated using data from the periodic Household Expenditure Survey (HES) in combination with information provided periodically from an external source on the home improvement market.

ABS has no evidence that the household-based HES collection significantly understates expenditure on alterations and additions. The following factors would act to minimise the level of understatement:

• there is nothing illegal about paying cash or agreeing on a competitive (low) price; • the survey is confidential;

• the homeowner is not asked for details of the contractor or whether the correct taxes were paid on the transaction.

Nevertheless, some expenditure may remain unreported. In particular, individual respondents who are deriving income from the underground economy may have an incentive to also understate their expenditure in HES to have consistency between their recorded income and recorded expenditure. To allow for this, an arbitrary figure of 15% was allowed for the possible underestimation of alterations and additions. It was estimated that this amount combined with the 10% allowance for missing transactions in new construction would add around 0.6% to the overall level of GDP.

6.2.2 Household final consumption expenditure

Sales of goods and services to households are the other major area where underground transactions are known to take place. Personal expenditure on goods and services accounts for around 60% of Australia's GDP.

In Australia, household final consumption expenditure (HFCE) is calculated quarterly and annually using a wide variety of sources including business and household surveys as well as administrative data. The use of retail industry and other service industry surveys data are examples of the counterparty approach to estimation in the national accounts—the receipts of businesses selling to households are taken as the estimate of expenditure by households. If the receipts of businesses are subject to skimming or are completely unrecorded (‘under the table’ transactions), then the counterpart household expenditure estimates would be understated where these sources are used.

Many goods and services, however, are unlikely to be subject to significant skimming of receipts or cash settlements. Examples include the purchase of new motor vehicles, motor fuel, heating fuel, electricity, gas and water, medical and hospital care, telephone, postage, transport provided by public authorities, lotteries, banking and insurance. The operating expenses of non- profit organisations, which are included in personal expenditure, are not affected either, as non- profit organisations are not subject to income tax. Additionally, some expenditure items in the national accounts do not reflect actual monetary transactions. The most significant example is

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imputed rents for owner-occupied dwellings, which is calculated by multiplying average rents for privately rented dwellings by the number of owner-occupied dwellings.

Taking all these factors into account, expenditure on goods and services which are not subject to underground activity to any significant degree total around 50% of HFCE. For the 50% of personal expenditure items that could be subject to underground activity, it is unlikely that sales by large businesses would go unreported to any significant extent. According to ABS publication,

Small Business Statistics in Australia, (2001)(cat. no. 1321.0), large and medium businesses (those

with 20 or more employees) are the source of supply for around 73% of the goods and services sold to households.

Small businesses with few or no employees are the most likely to engage in the non- declaration of sales, particularly those engaged in the provision of services where it is easier to omit a proportion of their receipts. However, even here the scope for understatement of receipts has some limits, as businesses reporting their income to the ATO are likely to be detected by the taxation authorities if they hide too much income in relation to their operating costs or in comparison to other similar businesses.

Areas such as restaurants and take-away food, personal care, most repair services and miscellaneous goods and services, such as domestic services, are examples of areas where small businesses are a significant source of supply of consumer goods and services to households. Repair and maintenance work undertaken for households is often paid for in cash directly to the owner of the business so there is ample scope for under-reporting the value of this type of work. In contrast, purchases of goods such as food, clothing and furnishings are predominantly made from larger retail chains although purchases from small businesses are still significant in value.

Bearing in mind these restrictions on the extent of underground activity within HFCE, upper bounds were postulated. Factors that were taken into account included:

• the areas of expenditure unlikely to be affected by underground activity, as detailed above;

• the relative significance of government enterprises as sources of supply; • the relative significance of large businesses as sources of supply;

• the relative significance of very small employing or sole trader businesses as a source of supply;

• the degree of government regulation;

• the likelihood of the various data sources used to compile HFCE estimates to pick up underground transactions, e.g. Household Expenditure Survey based estimates are thought to be less likely to understate or exclude the value of underground transactions than are estimates based on business survey data;

• the methodology used to derive the estimates.

Based on these assumptions, it was estimated that the upper bound for underground transactions relating to expenditure on goods and services excluded from the national accounts could at most amount to around 5.6% of personal spending or 3.4% of GDP. Given the large proportion of expenditure considered to be unaffected by underground activity (at least 50%) and the significance of large businesses in most industries, these percentages could be considered as very generous upper bounds.

The following examples illustrate the type of reasoning behind the choice of the upper bound estimates made. In the case of food, a 10% upper bound was used. ABS retail industry estimates indicate that around 70% of purchases are made from large businesses, so the 10% estimate implies a 33% understatement on average on the part of small businesses. For hotels, cafes and restaurant services provided to households, a total understatement of around 19% was used. In this case the proportion of these services provided by small businesses account for around 40% of the total. This means that the implied average understatement by small businesses would be 43%.

Given that only a proportion of small businesses within each industry are likely to be engaged in underground activity to any significant extent, the implied understatements would be even greater for those businesses actually engaged in underground activity.

Some corroborating evidence was obtained by comparing the results of the Household Expenditure Survey (HES) with the estimates provided in the national accounts. As previously mentioned, the HES is entirely independent of business reporting to either ATO or ABS, although there may be some tendency for people who derive income from the underground economy to also under-report their household expenditure in the HES. Comparative analysis of 1998–99 HES results with the national accounts household final consumption expenditure estimates for that year indicate that the HES estimates, when adjusted for known scope and definitional differences, are in fact around 11% lower than the corresponding national accounts figure. Much of this difference is attributed to some areas of well known understatement in household expenditure surveys—alcohol, tobacco and gambling. After correcting for this, the HES estimate is still around 6% less than the national accounts HFCE estimate and hence there is not a strong suggestion from that source that HFCE is understated.

In summary, the expenditure analysis indicated an extreme upper bound of 4% for underground activity using the expenditure-based GDP measure, made up of a maximum possible understatement of 0.6% from GFCF and 3.4% from HFCE. This is 3.8% higher than the current adjustment to the expenditure estimate of 0.2% of GDP. However, given the large part of expenditure that is not susceptible to underground activity and the generous assumptions used to determine an upper bound, the actual extent of understatement is thought to be considerably less than the upper bound of 4.0%.