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

Undeclared economic activity in central and eastern Europe,how taxes contribute and how countries respond to the problem

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Tax morale, eastern Europe and European enlargement

This study tries to remedy the current lack of tax compliance research analyzing tax morale in 10 Eastern European countries that joined the European Union in 2004 or 2007. By exploring tax morale differences between 1999 and 2008, it shows that tax morale has decreased in 7 out of 10 Eastern European countries. This lack of sustainability may support the incentive based conditionality hypothesis that the European Union only has a limited ability to influence tax morale over time. The author observes that events and processes at the country level are crucial to understanding tax morale. Factors such as perceived government quality and trust in the justice system and the government are positively correlated with tax morale in 2008.

More than 15 years ago, Baldwin (1995) wrote: “The gains from enlarging the EU eastward are potentially enormous. Indeed, it is easy to forget what is at stake. Until recently, millions of men and billions of dollars of equipment stood poised for combat in Europe. Communism‟s demise defused this situation by destroying the existing political and economic structures in the East. However, the outcome of this political creative destruction‟ is still uncertain. If all goes right, rapid Eastern growth would lock in democratic and pro-market reforms, fostering peace and stability throughout the continent. In particular, expanding the market to another 100 million consumers would be a bonanza for West European exporters.

However, if all goes wrong, widespread economic failure in the East could have serious consequences for all of Europe. Even if this did not provoke a return to authoritarianism, serious political or economic turmoil in the East could lead to mass migrations and harm the confidence of investors throughout Europe. An intermediate outcome is the most likely, but these two extreme scenarios serve to illustrate an important fact. Europe is at a turning point in its history.” (p. 475) In the past two decades since this statement was made, Eastern Europe has experienced substantial changes.

Eight countries from that region joined the European Union (EU) on May 2004 (Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, and Slovenia) and two joined the EU in 2007 (Bulgaria and Romania). A democratization and marketization process (Haughton, 2007) has taken place in these countries, and such an enlargement was the most significant since the European Community was created in 1957. It was an important historical event for the EU, termed as the “big bang” enlargement (Noutcheva & Bechev, 2008), and required the building of a suitable tax system (Bernardi, Chandler & Gandullia 2005). However, it is unclear “when, why and how the EU shaped, directed and occasionally determined change in the CEE1” (Haughton 2007, p. 233).

Exploring the effect of the EU on these countries‟ policies and governance is challenging due to causality or internal validity problems: “Based on a counterfactual understanding of causality… the statement that EU causes a particular outcome implies that if the EU were to absent that particular outcome would not occur. (…) However, establishing the causal effect of the EU is far from easy even if one takes full account of alternative explanations. One problem is that factors and mechanisms we associate with European integration often generate similar empirically observable implications rather than rival implications for domestic developments. (…) Moreover, these developments might exhibit similar temporal patterns. European integration, globalisation, neo-liberal ideas, new public management, new information and communication technologies or the individualisation of society emerged in the second half of the last century and intensified in recent decades” (Haverland 2006, pp. 135, 137).

The CEE countries wanted to replicate the political system and economic success of Western Europe or the US, independent of the desire to prepare for EU membership (Haughton 2007). Our study will not be able to solve these problems as our research will be confined to the 10 EU member states mentioned beforehand who experienced the EU integration. One may attempt to disentangle potential factors through a better understanding of the EU‟s transformative power by studying, e.g., the countries and their development over time. Here we focus only on one aspect, namely citizens‟ social norms regarding compliance with tax responsibilities. In line with the literature, we refer to this as tax morale (Torgler 2007a). We will see that institutional and governance conditions are key factors in understanding tax morale. Tax administration reforms also play a key role in promoting tax morale.

However, it is interesting to check whether the EU makes a difference. Haughton (2007), for example, points out that the EU seemed to be extremely powerful, acting as a magnet in the first post-communist years, and as a gatekeeper in the path to the European Union. Noutcheva & Bechev (2008) stress: “EU‟s offer is important because it creates additional incentives to build a pluralistic democracy and pursue liberal economic reforms at home, and thus empowers political and social groups benefiting from Europeanization. On the other hand, the path of non-reform has advantages of its own for rent-seeking elites unwilling to undermine the sources of their domestic power by introducing accountability and transparency in policy making” (p. 115).

Martinez-Vazquez & McNab (2000) also argue that, in countries negotiating their accession to the European Union, the intention to accede acted as a catalyst for rapid tax reform shaped along western lines. On the road to integration with the EU, changes in the tax system were carried out to bring processes in line with developed countries (Owsiak 2007). Schimmelfenning & Sedelmeier (2004, pp. 671-676) developed different models of EU external governance. The incentive model suggests that a state adopts EU rules if the benefits of EU rewards exceed the domestic adoption costs. The effectiveness of rule transfer then increases if rules are set as conditions for rewards and the more determinate they are. The effectiveness of rule transfer increases with the size and speed of the rewards. Moreover, the likelihood of rule adoption increases with the credibility of conditional threats and promises but decreases with the number of veto players incurring net adoption costs from compliance. The social learning model on the other hand suggests that a state adopts EU rules if it is persuaded of the appropriateness of EU rules. Finally, the lesson-drawing model points out that a state adopts EU rule, if it expects these rules to solve domestic policy problems efficiently.

World Bank.Author: Torgler, Benno.Document Date:2011/12/01.Document Type:  Policy Research Working Paper.Report Number: WPS5911.Volume No:1 of 1

Tax morale, eastern Europe and European enlargement

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Opportunities for men and women.Central and Eastern Europe and Central Asia

The countries of Central and Eastern Europe and Central Asia have a long history of striving for gender equality, especially in the public sphere. Not only was this an important goal during the socialist era, but governments continued to pursue gender equality even during the difficult years of transition. The governments in the region allocated substantial resources toward the health and education of both women and men. They also adopted legislation that treated women and men equally in the labor market and they provided child care services.

During much of the last century, the region surpassed countries both developing and developed in establishing the equal treatment of women and men. This report analyzes various markets through a gender lens. It thereby quickly makes two main findings. First, our knowledge of why men and women behave differently is limited. For example, why do women pursue certain fields in education that men tend to avoid or why do more women than men migrate from some countries. Second, average economic indicators can be misleading because they hide the differences in behavior across large groups (in our case, males and females). The importance of the adoption of a gender lens in the development of policies in the region derives in no small part from the high stakes resulting from the dramatic demographic changes and mounting labor resource needs.

Moreover, such a lens helps countries identify the necessary and appropriate policy and institutional framework to allow them to take advantage of underexploited opportunities (for example, bringing more educated women of prime age into the labor force). Ultimately, the use of disaggregated data to undertake analysis will likely lead to better policies that further the long-term objective of shared growth

World Bank. Author: Sattar,Sarosh.Document Date:2011/11/21.Document Type:Working Paper.Report Number: 65932.Volume No: 1 of 1

Opportunities for men and women.Central and Eastern Europe and Central Asia

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A trio of perspectives on corruption:bias,speed money and "grand theft infrastructure"

A number of recent survey articles express hope that new data from enterprise surveys would shed new light on corruption complementing the corruption perception index by Transparency International. The paper explores this using the World Bank's Enterprise Survey data globally and not just the data on Eastern Europe and Central Asia that have been used before.

The authors find that in general the Enterprise Survey data provide aggregate views on corruption that are similar to the corruption perception index. However, massive differences exist for key countries, such as China and India. This suggests that idiosyncratic, country-specific biases are at work in one or both data sources. The authors use the Enterprise Survey data and relate them to measures of bureaucratic complexity from the World Bank's Doing Business data, finding that more red tape is associated with higher corruption.

The data are also consistent with the view that bribe payments reduce the burden of red tape. Finally, the paper looks at corruption in infrastructure. It has been suggested that the natural monopoly characteristics of infrastructure provide the lever to extract bribes. However, based on data on price-cost gaps, the authors find that infrastructure ventures in power and water typically charge prices below cost in developing economies, not anywhere near monopoly prices.

Furthermore, the Enterprise Surveys do not suggest that infrastructure-related bribe payments are more significant than those, for example, related to tax payments or various forms of licensing. Existing sources on bribery surrounding specific projects suggest that the value of bribe payments may not be the biggest problem but the choice of uneconomic and inefficient projects. If infrastructure ventures were entirely dependent on revenue from user fees, they could not afford to pursue inefficient projects, thus reducing the cost of corrupt activity to society. Monopoly pricing would be better than the typical current pricing policy.

Author:Kenny,Charles;Klein,Michael;Sztajerowska,Monika;Document Date:2011/11/01.Document Type:Policy Research Working Paper.Report Number:WPS5889.Volume No:1 of 1

A trio of perspectives on corruption:bias,speed money and "grand theft infrastructure"

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