Monday, January 2, 2012

Undeclared economic activity in Central and Eastern Europe,how taxes contribute and how countries respond to the problem

Undeclared work is commonly defined as employment, which according to the law should be declared but is kept fully or partially outside the scope of taxation and social insurance (European Commission, 1998). There are several reasons why people work in the informal sector or – when working in the formal sector - declare only part of their income. In an environment where formal sector jobs are scarce, the informal sector is often the only place individuals can find work, and thus survive. Work opportunities in the formal sector may be lacking because of weak labor demand due to low economic growth or overburdensome regulations, including high taxes, red tape, and strict labor market regulations. 

Further, some individuals may choose an informal sector job because the net income is higher – employees don‘t have to factor in taxes and social benefits in their wages so they can keep more of it. This may result in a decline of labor supply to the formal sector. Indeed, high taxes and other regulations for formal sector activity are often the main reasons why firms and individuals shift activities to the informal sector or declare only part of their income. Some people also feel that the poor quality of government services is a valid reason to work in the informal sector, since they believe that money given to the government is wasted. Under such conditions, tax enforcement is difficult. Furthermore, tax administration may not be adequately equipped with skilled and dedicated staff nor with adequate technical facilities, and the will to enforce the law may be weak due to corruption or a lack of autonomy.   

2. The societal approach to tax compliance may also differ between countries. Informality and tax evasion are more widespread  when tax systems are complex; paying taxes entails high administrative costs for firms and individuals and the burden of tax enforcement is too high. From this perspective, widespread and sustained informal work can be seen as a warning signal that something is wrong within the framework under which formal sector activity operates. The root causes may include excessive taxes and other regulations in labor and product markets, as well as inefficient bureaucracy. 

3. In addition to these structural problems, undeclared work also has a cyclical component. When the economy is booming labor demand in the formal sector increases and workers are in a better position to fight employers seeking to underdeclare their wage, which reduces their unemployment and pension benefits. However, at the time of writing this report, the global economic crisis of 2009 has pushed most Central and Eastern European countries into severe recessions and unemployment has increased. It is very likely that this will lead to an increase in undeclared work in countries that have achieved some progress combatting informality in the past. Additionally, when taxes are raised to reduce fiscal deficits the problem of undeclared work could be exacerbated.

4. Undeclared work raises both equity and efficiency problems. Inequity arises as those who dutifully abide by the law have lower net incomes than dishonest evaders who receive the same gross income.  There is also unfair competition between honest firms and firms that underdeclare wages; the latter may also benefit from public procurement if open tendering focuses only on prices. A high incidence of non-declaration of work also creates a vicious cycle of lower government revenues, poor public services, a higher tax burden on fully declared work, and unfair competition between firms and individuals, thus reinforcing incentives for shifting activities to the informal sector. If evasion rises above a critical level it may also become a herd phenomenon leading to less moral qualms (as ―everybody does it- Hanousek and Palda, 2008). Furthermore, large informal sectors tend to restrain productivity and growth of the economy, as informal firms are generally less productive than formal firms because they prefer to remain small and ―invisible‖ and because informal workers tend to receive less training than formal workers. The incidence of informal activities should therefore be considered when making economic analysis and designing policies.

World Bank.Author:Leibfritz, Willi.Document Date:2011/12/01. Document Type:Policy Research Working Paper.Report Number:WPS5923