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FEATURE STORY

Getting People in from the Shadow in Eastern Europe

September 10, 2012

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The World Bank's report ventures a general conclusion about what policy makers can do to bring more economic activity in from the shadow.

STORY HIGHLIGHTS
  • Shadow economy: sum of people & firms doing business in a country's untaxed and unregulated markets for goods, labor and services; more likely to be men, less educated and working more low-skill jobs
  • Convincing people of the benefits of paying taxes and building trust in their governments are fundamental to get informal workers and business owners to turn to formal economy
  • Making formal work and business viable through tax incentives, smarter social safety benefits and better regulation is also critical

  

September 10, 2012
– Even as countries in Eastern Europe battle the effects of the global financial crisis, one aspect of their local economies has come under particular scrutiny – the extent of work and business in the "shadow economy".

What is a "shadow economy" and who is part of it?

Magda makes a good example. She is a hairdresser who works at home, has a select and loyal clientele, and steady income. Magda also does not pay income taxes, and her business is unregistered.

Jacek, Magda’s neighbor, is another example. He owns a small construction business and employs men by the day. He is paid in cash, pays his men in cash and reports only part of what he makes as income to the authorities.

Magda and Jacek are among millions of workers in a similar position who work or run a business by avoiding taxation, and outside the boundaries of social, labor and business regulations.  They make up the shadow economy.

Studies show that people working informally in the shadow economies of the newest European Union members are most likely to be men working manual, casual and low-skill jobs such as construction, transport, agriculture, and light manufacturing.  Most have completed secondary education, and a substantial minority even has some university education.  They are also more likely to be native born.

Measuring the exact size of a country’s shadow economy, however, is challenging.

WHY NOW?

One way to measure it is to look at how many workers and business owners are likely to be informal. Taking those workers who do not have a written work contract and certain types of self-employment as informal allows us to measure informal employment as a share of total employment in a country.

Gauging the shadow economy as a percentage of a country’s gross domestic product (GDP), is one indicator of its size. At its highest, the shadow economy made up 33 percent of Bulgaria’s GDP in 2007, while it was 17 percent at its lowest in Slovakia. The Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania and Slovenia fell somewhere in between.

Those numbers have improved slowly since then, but amid the ongoing financial crisis, tackling the issue has taken on a renewed sense of urgency.

With many Eastern European countries struggling to consolidate their fiscal positions, convincing citizens that they can benefit from contributing their fair share of taxes and social security contributions is critical. While this helps shore up countries’ finances, citizens also reap the benefits of participating in the formal sector in the long run through better protection for them, their families, and their businesses.

Not participating in the formal economy brings its fair share of trouble.

For individuals and their families, this could mean less protection, less income security, a lack of legal rights if the need arises, inability to plan for their future, lack of access to health care, and inadequate income in old age.

Businesses would not be able to grow meaningfully or avail of credit or legal protection when they need it. This also takes a toll on society, where there is a substantial lack of financing for public services and goods, making the system underfunded and inefficient in several instances.

EARNING CITIZEN TRUST

“In From the Shadow – Integrating Europe’s Informal Labor” is a report that addresses these issues by providing policy guidance for the European Union’s new member countries.

Governments have to make it viable for people to work or run their business in regulated and taxed markets. This means a friendlier tax system and making it useful to people to accurately report income by making the resulting social and employment protection viable. Low-paying, casual part-time jobs, mostly done in the informal sector, need to become more attractive when done formally. This means granting tax incentives for low-wage earners and designing smarter social benefits that reward formal work.

It is also critical to tweak labor market regulations to encourage companies to employ workers through official channels, by working on minimum wage requirements and the process of hiring workers or letting them go.

But improving structural incentives is not enough. 

Changing social norms about paying taxes is most important. Building trust in government is a key factor in convincing citizens paying taxes is useful. Good governance, treating taxpayers respectfully and delivering high quality of public services is essential.  

Structural reforms and improvements in institutional credibility may be a long drawn and tough process, but is critical to drawing people in from the shadows.

By Aarthi Sivaraman