Shadow Economy

V. Žukauskas. To fight the shadow economy one should not resort to fees alone

„The shadow economy in Lithuania is shrinking – but it still remains a considerable problem. In 2014, the shadow economy will make up as much as a quarter of all Lithuanian GDP, as the newest research from the Lithuanian Free Market Institute shows. Thus, the black market is still bigger than it was before the recession.

At the moment, about 20% of the citizens work illegally or receive at least partially undeclared pay. The black market of strong liquors constitute 27% of all alcohol market; for cigarettes, the number is 28%, for gas – 26%. It would be hard to argue against a stance that the shadow economy still remains a problem in Lithuania.

Alternative to legal business

One of the reasons why the fight against the parallel market in Lithuania yields few victories is because the relation between taxes and regulations and the black market is not adequately assessed.

The black market is the  alternative to the legal market. The choice between them depends on how each participant of the market understands the possible benefits and costs of these alternatives. Taxes and regulations are unfortunate costs of legality – hence, if the burden of taxation and regulations becomes heavier, the incentive to go to the black market only increases. The black market is always founded on the wish to escape taxes and regulations.

It is no coincidence that the black market is largest for the most heavily taxed goods and services. The excise and VAT in Lithuania for diesel makes up 40% of its price, 50% of the price of gas, 60% for alcohol, and 80% for cigarettes. Labor in Lithuania is taxed at 40%, meaning that the difference between how much the employer pays and how much the employee gets in wage reaches 40%. In these sectors, the black market comprises at least one-fifth of the market.

Do taxes really bring the shadow economy?

Sometimes we hear arguments claiming that there is little correlation between taxation and the black market. The defenders of such position usually show that there is no direct link between tax tariffs and the size of the black market in various countries. However, such claim is as illogical as claiming that the air temperature has no influence on the heating costs.

It is true that each household in a particular area receives a different heating bill while the temperature is the same for everyone because there is a multitude of variables in the equation: the house, the heating system installed, even preferences of the residents. But the temperature is the basic determinant of how much we spend for heating – the colder it is outside, the more we heat our homes. The same principle applies when we are discussing the causes of the black market. While there are many factors influencing its size (the state of the economy, living standards, attitude towards the parallel markets, efficiency of the public institutions, etc.), but taxation remains the main determinant of the size of the black market.

The influence of taxation is also confirmed by the results of 36 different scientific studies analyzing different factors in the black market of labor. The size of taxes and social security contributions is the most important factor influencing the black market – it explains 35-52% of the size of the black market in various countries. The second most important factor – the attitude towards paying taxes – explains 22-25% of the black market. The third factor is the quality of public institutions, the fourth – regulations of labor laws.

The harder to buy, the bigger the black market

Analyzing the black market of the excise goods, a natural question arises: why in Lithuania, where the excise taxes are not too burdensome by the EU standards, the black market is so large? There are multiple answers to this problem.

The Lithuanian citizens are quite tolerant to the black market; Lithuania borders two non-EU countries where excise taxes are significantly smaller. Other important reasons are the low Lithuanian wages and low affordability of the excise goods.

Judged by the average wage, Lithuanians spend about twice as much for 50 liters of petrol than the citizens of other EU countries and four times as much as Germans, Belgians, or the French. Only Bulgaria and Romania rank worse in terms of affordability of petrol.

The situation is very similar in strong liquor and cigarette markets. Even though the excise taxes are not the highest by the EU standards, it is nonetheless difficult to afford these goods due to low Lithuanian wages. Precisely because of this that the excise tariffs – even if not as burdensome in absolute terms – influence the black economy greatly in Lithuania. Having trouble to afford the excise goods, the citizens resort to purchasing them illegally.

Control alone is not enough

An important problem concerning the Lithuanian fight against the shadow economy is that the black market is associated firstly with the activities of the financial control and judicial institutions (State Tax Inspectorate, customs, the police, etc.). The assumption is that the black market should be battled with a more efficient system of control and punishment.

For example, the task and measures plan for 2013-2014 of the State financial control and judicial institutions, from the 64 devised measures, 56 are attributed to control mechanisms, obstruction of participation in the black market, and increasing the risks and costs of participating in the black market.

Obviously, control is important – the attractiveness of the parallel market must be minimized for it to shrink. This approach to fighting the black market, however, causes many problems and is largely inefficient. The control mechanisms may work but the black market will still expand or remain the same if the economic incentive to go to the black market remains high. If the costs of legality are high, there is a lot to ‘win’ by participating in the black market – and that is where even the best control measures fall short.

It is also important to note that by fighting the black market with control mechanisms alone, we naturally give less consideration to the influence of taxation and regulation. Taxes are constantly being increased, regulations are being strengthened – but their by-products are left at the hands of control institutions.

How to fight it?

If we really wish to reduce the black market, we must employ a more varied approach to solving the problem. Reactive tools alone are not enough – we must use measures that could prevent the black market from emerging and tackle its roots. After all, each new tax and set of rules regulations only feed the black market – to think that we can fight the black market without questioning what conditions of legal activities cause it in the first place is shortsighted. Only when it is easy and convenient to participate in the legal market it will be easier to ask our citizens to act responsibly and refrain from buying illegal goods or receiving their pay ‘under the table’.

Lithuanian Shadow Economy No. 3 The shadow economy still makes up a quarter of the Lithuanian economy

DOWNLOAD THE REPORT (IN LITHUANIAN)│http://files.lrinka.lt/Seseline_ekonomika/LSE3.pdf

PRESS RELEASE │LFMI: The shadow economy still makes up a quarter of the Lithuanian economy

May 2014, Vilnius.In 2014, the shadow economy will account for 25 percent of the total economic activity in Lithuania, the Lithuanian Free Market Institute (LFMI) estimates. For the sixth consecutive year, the shadow economy will be significantly higher than before the economic crisis, when it was 18 per cent of GDP.

“A quarter of economic activity still takes place in the background. While the shadow economy declined slightly, it is mainly due to the country’s improved economic situation, rather than a decrease in taxes or a more favourable regulatory environment. The government is fighting under-the-table dealings, but as long as there are a significant number of low income earners, and there is high taxand regulation, the shadow economy will be significant,”says VytautasŽukauskas, senior policy analyst and research manager at LFMI.

Lithuania’s financial control and law enforcement agencies have provided 64 ways to combat the shadow economy between 2013 and 2014. Most of them are designed for tighter controls, or to enforce higher penalties.

The shadow economy occupies 27 per cent of the alcohol market, and 28 per cent of the cigarette and tobacco market.

The shadow economy is not only the problem of customs, tax authorities and other authorities. Law enforcement should not be asking,‘how do we better identify and punish perpetrators?’in fighting the shadow economy, but rather, “how can we make it easier for business to operate legally?’

Excessive restrictions only grow the shadow economy. In essence, the government is required to adopt such laws, taxes and regulation, so that it ensures individuals can pursue their own interests in a legal and profitable way,” V. Žukauskas remarked.

According to LFMI’s report on the shadow economy, half the price of gasoline now includes tax (value-added tax (VAT) and excise duties), with the price of diesel accounting for about 40 percent. Gasoline excise tax in Lithuania exceeds the minimum set by the EU. It is estimated that the reduction of gasoline tax to a minimum could reduce the price of fuel by about 30 cents.

26 percent of Lithuanian residents said that they purchased illegal fuel in 2013.

“High fuel taxes are an obvious cause of the shadow economy,” V. Žukauskas notes. “However, rather than reducing tax, it has been proposed to introduce new restrictions.”

At least 20 percent of Lithuanian residents worked illegally or received a part of their salary under-the-table. “The shadow labour market would diminishif we reduce labour taxes. Labour is taxed at aphenomenal40 percent. We also need to increase the amount of tax-exempt income (TFI), and modernise the Soviet era breathing labour code,”V. Žukauskas said.

The shadow economy grew rapidly between 2008 and 2010, and accounted for as much as 28 percent the country’s GDP.In 2013, it decreased to 26 percent of GDP.

SUMMARY:

The shadow economy has a big impact on the alcohol sector and accounts for 27 percent of the market.

The shadow economy’s influence is similarly high inthe Lithuanian cigarette and tobacco market. Since 2012, the illegal alcohol market has declined from 36 to 27 percent.

28 percent of the cigarette market is in the shadow economy

By the end of 2013, the illegal cigarette market in Lithuania amounted to 28 percent of the market. Absolutely the biggest part of the illegal market has been smuggled goods.

81 percent of non-Lithuanian smuggledtobacco products were indicated to be from Belarus, and 8 percent from Russia.

The largest share of illegal tobacco was found in Alytus (40 percent), Tauragė (38 percent), Ukmergė (38 percent), and Panevezys (36 percent).

One fifth of Lithuanians are still working in the shadow economy

In 2013, at least 20 percent of the Lithuanian population worked illegally or received a part of their salary under the table (data from January 2014 survey).In 2012, 22 per cent of the population was involved in the labour shadow.

Illegal fuel in the shadow economy

At the end of 2013, 29 percent of residents said that they, or their family members, had purchased illegal fuel during 2012. A survey in January 2014 noted that the number of Lithuanians engaged in illegal trade decreased to 26 per percent during 2013.

The survey revealed that the majority of black market fuel is acquired through nearby borders, namely Belarus and Russia. The cities most involved in sourcing illegal fuel includedAlytus, Taurage, Telsiai, and Marijampolė.

“The Lithuania Shadow Economy” is a periodicalLFMI research publicationthat examines the problems of the informal economy. The first edition was dedicated to the excise shadow in Lithuania; the second – to shadow in the labour market.The third issue addresses the effectiveness of counter action to the shadow economy. The publication uses the following assessment methods in its examination: surveys, statistical data analysis, andeconometric modelling.

V. Žukauskas. Limitations of cash will not curtail shadow economy

LFMI welcomes the Lithuanian Parliament’s decision to decline the proposals to limit cash settlements in excess of 10,000 litas. The Ministry of Finance argued that this restriction would help combat the shadow economy in Lithuania.

LFMI argued that cash settlement restrictions would impose additional costs on individuals and companies and would hardly help curtail the shadow economy as the restriction would not affect citizens who sell smuggled goods or pay “under the table” wages.

LFMI urged policy and decision makers to improve conditions for legitimate activities rather than focusing exclusively on prosecuting and punishing offenders.

LFMI: Cash payment restrictions will reduce people’s choice, not the shadow economy

4 December 2013, Vilnius. The proposal to restrict cash payments in excess of 10,000 litas that is being debated by the Seimas of Lithuania is not an effective way to fight the shadow economy, the Lithuanian Free Market Institute concludes based on a recent analysis of the shadow economy and trends in non-cash payments in the European Union. The proposed restriction would reduce people’s choice and competition among means of payments and would increase payment-related expenses for individuals and legitimate businesses.

„The experience of EU member states does not show that an increase in the amount of electronic payments leads to a decline in the shadow economy. It is important to eliminate the real causes of the shadow economy, including high taxes and a low standard of living, rather than the use of cash. Statistics show that EU countries where electronic payments have expanded the most rapidly over the past ten years have not recorded a faster reduction of the shadow economy,” Vytautas Žukaukas, senior policy analyst at LFMI, says.

From 2003 through 2012 the number of electronic transfers in Bulgaria, Lithuania, Poland, Hungary and Slovakia increased the most. The number of electronic payments per capita soared by as much as 373 percent, while the shadow economy decreased by a mere 3.3 percentage points during that same period. At the same time Portugal, Germany, Austria, Italy and France reported the lowest growth in the number of electronic payments but the shadow economy contracted more, by an average of 3.6 percentage points.

Statistical analysis shows a link between the size of the shadow economy and the volume of electronic payments, but this link is not that of cause and effect. According to Vytautas Žukauskas, the popularity of electronic payments and the spread of the shadow economy are determined by the level of a country’s economic development.

„In Scandinavia and Western European countries higher income means lower incentives to engage in shadow undertakings. A higher level of economic development also leads to a higher volume of non-cash payments. People have more trust in banks and use more diverse means of payment. So even though a shrinking shadow economy means lesser need for cash, an artificial, government-inflicted growth of electronic payments, as opposed to an increase brought about by people’s free choice, will not result in a reduction of the shadow economy,” Vytautas Žukauskas says.

According to LFMI, cash payment restrictions will deprive people of their right to make payments in the most acceptable ways and will force electronic payments that inflict additional costs. „If electronic payments are the cheapest, safest and most convenient way of payment, it is people’s choice, not coercion, that will prove this. Restrictions will increase people’s expenses as electronic services have their price. They will affect weekend payments. Many people in Lithuania make their living by selling second-hand cars to eastern countries. How will they be supposed to do it legitimately if cash payments become illegal?” Vytautas Žukauskas asks.

Cash payment restrictions will affect law-abiding citizens but will hardly influence those in the shadow economy. After all, the regulation will not inspire those who pay “envelope” wages, smuggle goods or underreport income to observe laws. It will not obstruct illegal sales of smuggled cigarettes, alcohol or fuel,” Žukauskas says. “Those who have been selling illegal cigarettes in the gateway will not install card scanners all of a sudden.”

LFMI report on shadow economy – in Bloomberg news

“In Lithuania, where one in every four consumers admits to having bought on the black market, fraudsters purchase lower-priced fuel from drivers of cars and trucks coming from Russia and Belarus and then sell it below local rates at a profit, according to the Vilnius-based Lithuanian Free Market Institute. The fuel is usually sold in parking lots, the institute said in a report,” BLOOMBERG journalists in their article on fuel fraud refer to LFMI report “Lithuanian Shadow Economy”.

Read more on shadow economy in Lithuania and Baltic States:

Lithuanian Shadow Economy No. 2 One fifth of Lithuanian labour market is undeclared

Population attitude survey towards smuggling and consumption of illegal goods Research: citizens of Baltic States justify and buy smuggled goods

Lithuanian Shadow Economy No. 1 LFMI releases a new publication on shadow economy in Lithuania

 

Lithuanian Shadow Economy No. 2. One fifth of Lithuanian labour market is undeclared

DOWNLOAD THE PUBLICATION: http://files.lrinka.lt/LSE2013_2/LSE_EN.pdf

According to Lithuanian Shadow Economy published by LFMI one fifth (22%) of Lithuanians have been involved in undeclared work.

Lithuanian citizens were asked if they or members of their family received any income through undeclared work – either working unofficially or working officially but getting a part of salary which was undeclared. 5% of respondents claimed that they have worked unofficially, while 8% stated that they have received a part of their salary which was not declared. 9% of Lithuanians indicated that they were using both types of undeclared work.

‘’LFMI research shows that shadow economy is formed not only of excisable goods segment but also undeclared work. It is likely that the real share of people having undeclared work is even higher as not all the respondents might have dared to admit it. The research has used surveys which are one of the main shadow economy measurement ways, statistic’s analysis and econometric simulation. The research has also reviewed and evaluated the factors which influence shadow economy such as economic state of the country, amount of income, taxes for workers, welfare, minimal wage rise and other’’, claimed LFMI senior expert Vytautas Zukauskas

According to Lithuanian citizens’ opinion, people choose undeclared work due to financial benefits. 62% of respondents claimed that the most important reason for choosing undeclared work is the higher amount of income they get. 52% of people had mentioned the difficulties of finding a legal job.

‘’Therefore, according to people of Lithuania, the most important reason of choosing undeclared work are high taxes for working people and the shortage of legal jobs. Labour taxation in Lithuania is more than 40% which is more than EU average. What is more, due to relatively lower productivity and remuneration even lower taxes in Lithuania compared with the ones with e.g. Germany, result in higher tax burden. Hence people experiencing higher tax burden are more likely to choose undeclared work’’, claimed V. Zukauskas.

Zukauskas adds, that this data shows that in order to increase people’s income and quality of living it is more important to think how to enhance productivity, while increasing greater business investments, than increasing taxes and wealth redistribution which strengthen shadow economy.

Lithuanian citizens also think than people choose undeclared work and salaries because they do not want to lose social welfare (43%). The amount for social welfare has been drastically increasing to more than 1 billion litas in 2010-2012 compared with 400 million litas in 2005-2008.

‘’The government support for unemployed people and low income households might encourage undeclared work. The higher the support is, the more it encourages people to look for illegal income, so they would not lose the benefits’’, said Vytautas Zukauskas

35% of Lithuanians believe that people do not see the benefit of taxes, so they chose shadow economy. 27% claim that people chose shadow economy to avoid the obligations they need to fulfil while working legally.

‘’Deficiency of control from the government institutions is often being blamed for the phenomenon of shadow economy. However, the economic and social state of the country, politics, taxes for workets, labour market regulation etc. are also very important. Minimal wage is one of the factors as well’’, explained V. Zukauskas.

According to the expert, enterprises which do not have enough financial resources to increase the salaries duo to heightened official minimal salaries solve the problem of increased tax burden by employing people illegally, or decreasing the official working hours and paying a part of the salary unofficially. Increasing official minimal salaries while Lithuania is in this economic situation only enhances incentives to exercise unofficial work.

In the beginning of 2013 LFMI surveyed market participants- economists, business owners, CEOs- who evaluated that in 2013 about a third (31%) of businesses operating in Lithuania have employees who get a part of their salaries which are undeclared. Market participants claimed that 11% business subjects have illegal workers.

‘’In order to lower undeclared work it is necessary to lower taxes for working people, modernize labour codex, not to increase official minimal salaries, not to create social support system, which increases the amount of unemployed or illegal workers, improve conditions for business, in that way attracting more investments and increasing the productivity of workforce’’, concluded V. Zukauskas

Lithuanian Shadow Economy is a periodical of LFMI which is designed to analyse the problem of shadow economy. The first issue was devoted to excisable goods shadow market in Lithuania. The second one – to undeclared work in shadow economy. The amount of undeclared work is measured by surveys, statistical data analysis and econometric simulation.

The first part analyses a general level of shadow economy in the Europe and shadow economy dynamics in Lithuania. The second part thoroughly explores what causes the increase of undeclared work. The third part presents the range of the unemployed work. Finally, up to date about excisable goods shadow market is presented.

Lithuanian Shadow Economy No. 1. LFMI releases a new publication on shadow economy in Lithuania

Download the publication:
http://files.lrinka.lt/Shadow_Economy_in_Lithuania_2012_1/Shadow_Economy_in_Lithuania_2012_1.pdf

Lithuanian Free Market Institute (LFMI) introduces the new periodical publication “Lithuanian Shadow Economy“. The publication provides data about shadow economy in Lithuania and more specific data and insights in alcohol, fuel and cigarette markets. Figures report growing trend of the Lithuanian shadow economy since 2008.

“In collaboration with state institutions and market participants we released a new publication, in which data about Lithuanian shadow economy is provided. We define the shadow economy as economic activity (i.e. goods manufactured or services provided) pursued without applying applicable laws or requirements which is not officially recorded with the purpose of evading taxes or regulations. It is important, that this publication provides an overview of the shadow in the markets of alcohol and fuel – there has been not much information on the topic before and it was very fragmented. Together with the partners we also created a new assessment methodology of illegal alcohol market,“ a senior expert of LFMI Vytautas Žukauskas says.

According to international studies, share of GDP of shadow economy in Lithuania 2010, was about 30 percent. According to the latter indicator, Lithuania holds the 4th place among 31 European countries. According to the findings from the Survey of the Lithuanian Economy conducted by LFMI in July 2012, the share of the shadow economy in relation to GDP was growing rapidly since 2008 and accounted for as much as 28 per cent of the country’s GDP in 2010 followed by a slight decrease down to 26 percent during 2011 and 2012.

Investigation and calculations carried out by LMFI, shows that in the market of fortified and strong drinks, illegal goods have 36 percent of total market in 2012. In the market of cigarettes, the shadow reaches 29 percent. Illegal market of fuel reaches about 18 percent. The assessments of LMFI are based on surveys of heads of wards (smallest administrative divisions of Lithuania), citizens, specialists of markets, previous investigations and the data from excised market participants.

Survey of heads of wards showed that in most of Lithuanian wards, it is possible to buy illegal alcohol beverages. 60 percent of them, who participated in the survey, said that in their wards it is possible to buy illegal produced alcohol. Only 17 percent argued that there is no illegal produced alcohol in their wards.

Investigation focuses on the reasons of shadow economy. The main reason of shadow economy is defined as the level of regulation and taxation.

“Taxation and regulation are legal inputs of activity. Therefore, the higher taxes and more compulsory regulation have those who are working legally, the greater incentive for market participants to avoid them and operate in the shadow,“ V.Žukauskas says.

The extent to which the level of taxation and regulation affects a country‘s shadow economy depends on the country‘s economic situation and on the income and standard of living. In countries with higher income and living standard, citizens can devote the greater share of income not for the first necessity goods and services. The situation is different in low-income and low living standard countries, where increasing taxes and decreasing income, force population to find alternative ways to purchase goods, as cheaper goods and services in shadow economy.

“Even the same size of tax tariff can have a different impact for the shadow economy in countries with different income and standard of living. For example, although excises in Lithuania compared with other EU countries are not the biggest, Lithuanian population excisable goods purchases hardly due to lower living standards,“ LMFI expert said.

Tolerance of Lithuanian population for the shadow economy also creates favorable conditions for the shadow. The shadow economy is neither often condemned, nor rejected as immoral activity in Lithuania. For example, from the data of population survey, 33 percent of population of the country entirely justifies or is tend to justify the illegal consumption of alcoholic beverages. Lower prices of fuel, cigarettes and alcohol in neighboring Belarus and Russia are conducive for contraband. High level of country‘s corruption reduces the risk and inputs of shadow activity – it is easy to bribe officers and evade in contravention of the law.

In the following publications, it is envisaged to overview not only markets of alcohol, cigarettes and fuel, but also other parts of shadow economy, as moonlighting and informal wage.

A stick instead of a carrot in the fight against the shadow

As far back as in early 2009, LFMI forecast a record increase of the shadow economy, which has been confirmed by the findings of the recent survey of the Lithuanian economy conducted by LFMI. Its data show that, in 2009, the share of the shadow economy in GDP increased by 5%, as compared to 2008.  In 2010, the share of the shadow economy is likely to comprise 27% of GDP. The size and the spread of the shadow forced the Government take action. In his comments published in the newspaper “15min“, Vytautas Žukauskas, LFMI Policy Analyst, analyses proposals for decreasing the volume of unofficial economy that were put forward by the working group established by the Prime Minister. Regrettably, 22 out of 25 measures included in the plan are targeted at the stricter controls, regulation and increased criminal penalties for shadow activities.