V. Žukauskas. Shadow economy is caused by bad government decisions, not “bad” people

Over the past year, the shadow economy in Lithuania has decreased from 27% to 26% of the GDP. This is not surprising as, according to the same calculations, the shadow economy has been contracting for five consecutive years. What is more curious is the fact that since its peak in 2010, the shadow economy has only shrunk by a little over 10 per cent, a relatively insignificant amount. The Lithuanian Free Market Institute and its partners in six countries (Lithuania, Latvia, Estonia, Poland, Sweden and Belarus) conducted a study on the involvement in and attitude towards the shadow economy. The study found that illegal goods still constitute one fifth of the cigarettes market, 22 per cent of the strong alcohols market and 15 per cent of the fuel market. A survey disclosed that almost one third of the population admits to have friends or relatives who receive “envelope wages”.

The research concluded that no lasting change can be expected until politicians come to terms with a few simple things:

First of all, the shadow economy is driven primarily by taxation and regulation rather than by “bad” people. It is no coincidence that the shadow economy is most widespread in those sectors which are subject to the highest taxes: excisable goods and labour. The more difficult it is to work legally and afford legal goods, the more people turn to illegal alternatives. It is false to believe that imposing a 40 per cent of tax rate on labour and 80 per cent on cigarettes will not lead to undesired outcomes and an increase in the shadow economy.

The above is obvious but, when the time comes to make decisions, politicians never fail to come up with reasons against decreasing the tax burden on labour and pretexts to increase the tax burden and regulations on alcohol. Not even the fact that illegal alcohol is easily accessible deters them: more than one third of the country’s eldership leaders claim that it is possible to acquire alcohol illegally in their areas. Every year the VAT, which was raised during the crisis, brings more money into the budget The fear of budgetary losses outweighs the desire to ensure lower prices and, by association, a smaller shadow economy.

Secondly, the country’s level of taxation is often evaluated inaccurately, as tax rates do not correspond to the taxes actually collected. The fact that the tax burden constitutes a comparably small portion of GDP compared to other countries does not mean that taxes are low, easy to pay and that they do not encourage the shadow economy.

Labour in Lithuania is subject to higher taxes than the European Union (EU) average. Due to high taxation (amounting to 50-80 per cent of the price) and relatively low income, the affordability of excisable goods is one of the lowest in the EU, while the VAT rate is one of the highest.

Thirdly, a large part of the population justifies the shadow economy because they do not trust the government and oppose its decisions. According to the representative survey data, as many as 43 per cent of respondents justify “envelope wages”. It is important to note that the shadow economy is perceived less negatively by those unsatisfied with the government, almost a third of whom excuse the smuggling, illegal production and sales of cigarettes, alcohol products and fuel. Whereas only 15 per cent of those who are satisfied with the government justify the aforementioned practices.

This shows that participation in shadow activities is a form of protest against the government. Close to 70 per cent of respondents claim that the shadow labour market is driven primarily by high taxation. Moreover, they believe that their taxes are put to wrong or inefficient uses.

Therefore, a meaningful decrease of the shadow economy in Lithuania requires measures that make legal work and purchases more practical and affordable. Labour and goods need to be taxed and regulated less. Only then will the shadow economy be successfully curbed. The extent of the shadow economy will always depend on people’s attitude towards the government. One can hardly expect enthusiasm and patriotism about paying taxes when trust in public authorities is as low as in Lithuania and when public services received do not reflect the high rates of taxes paid for them.

The Lithuanian Free Market Institute’s shadow economy study, “Shadow Economies in the Baltic Sea Region 2015”, can be found here.