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’.