The Shadow Economy: An International Survey

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The Shadow Economy An International Survey

Illicit work, social security fraud, economic crime, and other shadow economy activities are fast becoming an international problem. Friedrich Schneider and Dominik H. Enste use currency demand, physical input (electricity) method, and the model approach, to estimate the size of the shadow economy in seventy-six developing, transition, and OECD countries. They argue that during the 1990s the average size of a shadow economy varied from 12% of GDP for OECD, to 23% for transition, and to 39% for developing countries. They examine the causes and consequences of this development using an integrated approach explaining deviant behaviour, which combines the ﬁndings of economic, sociological, and psychological research. The authors suggest that increasing taxation, social security contributions, rising state regulatory activities, and the decline of the tax morale, are all driving forces behind this growth, especially in OECD countries. They propose a reform of state (public) institutions, in order to improve the dynamics of the ofﬁcial economy.                   is Professor of Economics and Vice-President for Foreign Affairs of the Johannes Kepler University of Linz, Austria. He is the European editor of Public Choice, and has written for various journals including The Quarterly Journal of Economics, The American Economic Review, The Economic Journal, and Kyklos.         .      studied Economics, Sociology, and Economic Psychology in Cologne, Dublin, and Fairfax, Virginia. He was Assistant Lecturer at the Department for Economic Policy at the University of Cologne and Lecturer at the University of Applied Science in Cologne, Germany. He has published several books and articles in a variety of journals including the Journal of Economic Literature, Perspectives of Economic Policy, and IMF-Working Papers. He is currently working as a Human Resources Manager for Gerling Insurance Company in Cologne.

The Shadow Economy An International Survey Friedrich Schneider Dominik H. Enste

          The Pitt Building, Trumpington Street, Cambridge, United Kingdom    The Edinburgh Building, Cambridge CB2 2RU, UK 40 West 20th Street, New York, NY 10011-4211, USA 477 Williamstown Road, Port Melbourne, VIC 3207, Australia Ruiz de Alarcón 13, 28014 Madrid, Spain Dock House, The Waterfront, Cape Town 8001, South Africa http://www.cambridge.org © Friedrich Schneider and Dominik H. Enste 2004 First published in printed format 2003 ISBN 0-511-03028-2 eBook (Adobe Reader) ISBN 0-521-81408-1 hardback

To Sabine and Julia

Contents

List of ﬁgures List of tables Foreword by Vito Tanzi

page ix x xiii

1 The shadow economy: a challenge for economic and social policy

1

2 Deﬁning the shadow economy

6

2.1 Informal economic activity and national income accounts 2.2 Shadow economy, tax evasion, and illicit work

7 10

3 Methods to estimate the size of the shadow economy

15

3.1 Direct approaches 3.2 Indirect approaches 3.3 The model approach 3.4 Summary of the methods used to estimate the size of the shadow economy

15 16 24

4 Size of shadow economies around the world 4.1 The results for seventy-six countries 4.2 The development of the shadow economy in the OECD countries from 1970 to 1999 4.3 Comparing the results for different estimation methods

5 The size of the shadow economy labour force 5.1 Illicit work and the shadow economy labour force 5.2 Developing countries 5.3 Transition countries 5.4 OECD countries

27

29 29 37 39

43 43 44 45 51

6 An integrated approach to explain deviant behaviour

54

6.1 Structure of the model 6.2 Criticising the neoclassical and welfare-theoretical considerations 6.3 Micro-economic foundation 6.4 Institutional and sociological aspects 6.5 Explanatory approaches in socio- and economic psychology

54 57 63 76 84

vii

viii

Contents 6.6 An integrative approach 6.7 An evolutionary theory of the shadow economy

7 Analysing the causes and measures of economic policy 7.1 7.2 7.3 7.4 7.5 7.6 7.7

Government failure – the main cause of illicit work Growing tax burden in the ofﬁcial sector Density of regulation Working hours agreements Empirical examination of the inﬂuence of main causes Control frequency and the level of punishment Tax morality and the supply of public goods

8 Effects of the increasing shadow economy

95 97

102 102 106 124 127 143 149 151

155

8.1 Allocation effects 8.2 Distribution effects 8.3 Stabilisation effects 8.4 Fiscal effects

157 166 169 171

9 The ‘two-pillar strategy’

178

9.1 9.2 9.3 9.4 9.5 9.6

On the necessity for a rational economic policy ‘Exit’ and ‘voice’ as behavioural options Decreasing the attractiveness of the ‘exit option’ Strengthening the ‘voice option’ Legalising illicit work? Combating illicit work: the perspective of public choice theory

178 179 181 183 185 185

10 Conclusion and outlook

190

List of references Index

194 215

Figures

2.1 2.2 2.3 2.4 3.1 3.2 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 6.11 6.12 6.13 6.14 6.15 6.16 7.1 7.2 8.1 9.1 9.2

The dual economy page 8 Categorisation of the underground economy 11 The structure of illicit work in Austria 13 The structure of illicit work in Germany 14 The basic monetary methods to measure the shadow economy 18 The basic idea of ‘soft modelling’ 25 The causal analysis 56 The integrative RREEMM human concept 59 Economic explanation for deviant behaviour 64 Economic factors inﬂuencing illicit labour supply 66 The basic model with optimal allocation of working and leisure time 70 Overtime, illicit work, and regular working hours 73 Reduction of working hours and illicit work 74 Sociological explanation based on Homo Sociologicus 76 Sociological and institutional determinants 78 Willingness to work illicitly, evade taxes, and abuse the system 80 Economic and socio-psychological explanation of deviant behaviour 85 Correlation between weight of tax burden, perception of tax burden, and tax evasion, and their determinants 90 A few psychological causes 92 Attitudes towards a choice of causes for illicit work 94 Integrative model for deviant behaviour 96 The correlation between tax yield, tax rate, and the development of the shadow economy 99 Economic causes for the shadow economy 104 Correlation of tax burden and size of the shadow economy 111 Systematisation of allocation effects 157 Behavioural options of households and ﬁrms 180 General economic policy recommendations 182 ix

Tables

3.1 A summary of all the approaches to estimate the extent of the shadow economy page 27 4.1 The size of the shadow economy in developing countries 31 4.2 The size of the shadow economies in transition 34 4.3 The share of the shadow economy of ofﬁcial GNP in the OECD countries: a comparison of estimation with different methods 35 4.4 The size of the shadow economies in OECD countries 36 4.5 The size of the shadow economies: summary and comparison 37 4.6 The development of the shadow economy in OECD countries from 1970–97 38 4.7 The extent of the shadow economies in German-speaking countries, 1998 and 1999 39 4.8 A comparison of the results of the estimations of the shadow economies of ﬁve OECD countries using nine different methods over the period 1970–90 40 4.9 Comparing estimations of the size of the shadow economy using different methods 41 5.1 Shadow economy labour force in Africa 46 5.2 Shadow economy labour force in Asia 48 5.3 Shadow economy labour force in Latin and South America 49 5.4 Shadow economy labour force in transition countries 50 5.5 Shadow economy labour force in OECD countries 52 7.1 The development of public expenditure and tax rates in OECD countries 108 7.2 Shadow economies, tax, and social security contributions in OECD countries in 1996 109 7.3 The density of regulation as an inﬂuencing factor for the size of the shadow economy 126 7.4 Regulation regarding working hours and overtime in OECD countries 128 7.5 Part-time employment in the OECD countries 1973–96 130 x

List of tables

7.6 The share of gainfully employed persons older than 55 years 7.7 ‘Atypical’ working hours of employees in the EU (1993) 7.8 The divergence between agreed and desired working hours in Germany (1997) 7.9 Estimation results for the cash demand function 7.10 Inﬂuence of changes to the taxation system on the development of the Austrian shadow economy 7.11 Dividing the development of shadow economic activities into its components by their respective inﬂuencing factors 7.12 The tax moral as an inﬂuencing factor for the rise of the shadow economy 8.1 Tax deﬁcits due to illicit work in Austria (1997)

xi

132 134 137 145 146 147 152 176

Foreword

More than two decades ago, economists discovered what they considered a rather strange phenomenon to which they gave many names including that of ‘underground economy’. This discovery was followed by attempts aimed at deﬁning it; measuring its size; assessing its implications for economic policy and its effects on the economy; and suggesting policies that would reduce or eliminate it. As one would have expected, there was inevitable controversy accompanying this work. Surprisingly, though, this early great interest was soon followed by a period of neglect. It seems that the economic profession, immersed as it was in its theories, could not cope or was unwilling to cope with the messy world of the underground economy. In more recent years, and for a variety of reasons, including the obvious one that the growth and large size of the underground economy made it progressively more difﬁcult for economists and statistical ofﬁces to keep ignoring it, interest in this phenomenon has revived with a vengeance. Friedrich Schneider was one of the few daring souls who entered this area early and who has kept a continuing interest in it. I was fortunate a few years ago, when I was director of the ﬁscal affairs department of the IMF, to have invited him to take up a visiting professorship to the Fund to continue his work on the underground economy. He produced a substantive paper that has grown into a book that represents a major contribution to this area. Economists and policymakers will learn much from this book. And they will learn much that is important and deserves attention. I hope that many will invest the time that it deserves.   State Secretary Ministry of Economy and Finance Rome

xiii

1

The shadow economy: a challenge for economic and social policy

In the eighties, the causes, effects, and problems generated by increasing shadow economic activities were extensively and controversially discussed in countries belonging to the Organization for Economic Cooperation and Development (OECD). Now, once again, attention is being drawn to the shadow economy because of dramatically rising unemployment (e.g., in the European Union) and the problems of ﬁnancing public expenditure, as well as the rising anxiety and disappointment about economic and social policies. Public discussion of illicit work, tax evasion, and all the other activities in the shadow economy has grown increasingly pointed. Broad initiatives on behalf of the EU Commission and EU Parliament, as well as at state-level, show that politicians have ﬁnally felt the need to act as well.1 Politicians are in a dilemma. While the fact that the wealthy are evading taxes leads to widespread public indignation, illicit workers are often much less criticised, although some politicians argue that they are behaving antisocially and are a source of growing unemployment and social injustice. This opinion is broadly shared in regard to social fraud, illegal employment, and extensive tax evasion. But what about part-time illicit work in the evening (‘moonlighting’) which, for example, about half of the population in Germany would tolerate, or even take advantage of, if they had the opportunity to make use of it?2 Can more sanctions and controls, combined with more regulation, be the ultimate solution to combat illicit work? What is the right way to deal with undeclared work? In the popular scientiﬁc media and daily newspapers, this discussion naturally does not go into detail. Here, judgement on the nature of the shadow economy ﬂuctuates between two extremes: either the shadow

1 2

All translations from German are by the authors. The publishers have used their best endeavours to ensure that the URLS for external websites referred to in this book are correct and active at the time of going to press. However, the publishers have no responsibility for the websites and can make no guarantee that a site will remain live or that the content is or will remain appropriate. See for example EU Commission (1998), EU Parliament (2000). See Enste (2001, pp.158f ).

1

2

The shadow economy

economy is blamed for many problems of economic policy, such as unemployment, high public debt, and the recession, or it is regarded as a legitimate free space in an economic system that is characterised by high taxes and too much regulation. New data on the size of the shadow economy are often used by certain pressure and interest groups who focus on only a few unilateral issues concerning illicit work. In the social sciences, articles and papers dealing with the shadow economy often focus on one single aspect only, mostly on the difﬁculties and challenges involved in measuring its size. In addition, the basis of the analysis of the causes and consequences of the increasing shadow economy is often quite narrow and does not take the results and insights of other social sciences into account. Therefore, a comprehensive overview and scientiﬁc analysis of this complex phenomenon is necessary. This book is an attempt to provide this analysis and ﬁll the gap. The main focus of interest in the shadow economy is concentrated on three areas, which will be analysed in more detail here:3 (a) In economic and social politics, the driving force for dealing with illicit work is the fact that these illegal and semi-legal activities are undesirable for ofﬁcial institutions. A growing shadow economy can be seen as the reaction of individuals who feel overburdened by the state and who choose the ‘exit option’ rather than the ‘voice option’.4 If the growth of the shadow economy is caused by a rise in the overall tax and social security burden, together with ‘institutional sclerosis’ (Olson 1985), then the ‘consecutive ﬂight’ into the underground may erode the tax and social security bases. The result can be a vicious circle of further increase in the budget deﬁcit or tax rates, additional growth of the shadow economy, and gradual weakening of the economic and social foundation of collective arrangements. In addition, the effects of the shadow economy on the ofﬁcial economy must be considered because illicit work can be a source of allocation distortions, since resources and production factors are not used in the most efﬁcient way. On the one hand, a growing shadow economy may attract (domestic and foreign) workers away from the ofﬁcial labour market and create competition for ofﬁcial ﬁrms. On the other hand, at least two-thirds of the income earned in the shadow economy is spent in the ofﬁcial economy, thereby having a positive and stimulating effect on the ofﬁcial economy.5 3 4 5

See also Weck, Pommerehne, and Frey (1984); Gaertner and Wenig (1985); Petry and Wied-Nebbeling (1987); Feige (1989); and Thomas (1992). See Chapter 9. This ﬁgure has been derived from polls of the German and Austrian population about the (effects of) the shadow economy. For further information see Schneider (1998b).

A challenge for economic and social policy

3

Furthermore, a prospering shadow economy may cause severe difﬁculties for politicians because ofﬁcial indicators, e.g., on unemployment, labour force, income, GDP, and consumption, are distorted. Policy based on erroneous indicators is likely to be ineffective, or worse. Therefore, the reciprocal effects between the shadow and the ofﬁcial economy have to be considered when planning measures of economic policy, especially ﬁscal policy. If underground activities occur in an economy, the tax revenue might reach the negatively sloped part of the Laffer-Curve, where higher tax rates result in a lower tax yield.6 (b) In social sciences, the shadow economy is ﬁrst and foremost a challenge for economic theory and economic policy. In economic and social science, answers have to be found for questions like: Why are people working illicitly? Why are transactions made in the shadow economy? What are the effects resulting from this behaviour? Currently, theoretical approaches in different social sciences exist that concentrate on single aspects of this complex phenomenon. But since a coherent, integrative, and interdisciplinary approach for the analysis of the causes is missing, the development of a systematic, basic ‘model’ is necessary. In empirical studies, the problems of measuring the size and development of the shadow economy by different methods have to be examined. The theoretically derived causes and consequences of shadow economic activities have to be investigated empirically. Feedback effects on the ofﬁcial economy, as well as interactions between the two sectors, have to be considered and measured.7 (c) The most difﬁcult task for economic policy researchers is to convey the often not very much appreciated results of scientiﬁc analysis to politicians, and then to convince them that the ﬁndings are relevant and correct. Here, we try to make suggestions for economic policy measures that are based on the analysis of the relationships between causes and effects of the shadow economy. They go far beyond the guidelines laid down by the EU Commission in their pan-European employment strategy for combating illicit work.8 The latter’s guidelines demand an exchange of ‘good practice models’ and coordination at the EU level to combat illicit work, e.g., by stricter controls and harsher sanctions. Unfortunately, these propositions are not new and they often do not go beyond trying to cure

6 7 8

Moreover, the results of these polls show that two-thirds of the value added produced in the shadow economy would not be produced in the ofﬁcial economy if the shadow economy did not exist. See Section 6.7. See Schneider and Enste (2000a,b); Cowell (1990); Thomas (1992); Pozo (1996); Spiro (1997); and Lippert and Walker (1997). In Europe, these occupations supposedly resemble 10–28 million regular employment positions. See the Commission’s publication: ‘Undeclared Employment’ of 11 June 1998.

4

The shadow economy

the symptoms. Instead, reforms of the tax system and the social security system are necessary, which could improve the dynamics of the ofﬁcial economy and make the ofﬁcial institutions more competitive within the (national and international) different institutional arrangements. The discussion about adequate economic policy is often inﬂuenced by ideologies. One comes across every position from a forced denial of the phenomenon of a ‘shadow economy’, to imaginative exaggerations of its size and impact. The starting point for debate is the fact that there are differences in estimates of the size of the shadow economy. Clearly, such estimates are vital for reliable analysis. Unfortunately, as a result, research efforts are concentrated on questions like: which is the best method to estimate the extent of the shadow economy? How large is the shadow economy labour force and how is it changing over time? The collection of information about underground (or criminal) activities and the frequencies with which these activities occur, as well as their magnitude, is crucial for making effective and efﬁcient decisions. But it is very difﬁcult to obtain accurate statistics about shadow economy activities, since the individuals engaged in these activities do not wish to be identiﬁed. Hence, the estimation of shadow economy activities can be seen as a scientiﬁc passion for knowing the unknown. An extensive literature on single aspects of the hidden economy exists, including a comprehensive survey.9 But there is still disagreement about the deﬁnition, the estimation methods, and the ‘right’ estimation of the shadow economy. Much controversy arises in discussion over these issues.10 Nevertheless, there are strong indications of a growth of the shadow economy on a global scale. The size, the causes, and the consequences vary in each country, but some comparisons can be made that are of interest to social scientists and the public in general, and helpful to politicians who will need to deal with this phenomenon sooner or later. Therefore, we will not restrict ourselves to only the documentation of the size of the shadow economy and its labour force in more than seventy countries from 1970 to 1998 (and to 2000 for some countries). An analysis of the 9

10

The literature on the ‘shadow’, ‘underground’, ‘informal’, ‘second’, ‘cash-’ or ‘parallel’, economy is increasing rapidly. Various topics on how to measure it, its causes, and its effect on the ofﬁcial economy are analysed. See, for example, the ﬁrst publications by Tanzi (1982); Frey and Pommerehne (1984); and Feige (1989); survey-type publications by Thomas (1992); Loayza (1996); Pozo (1996); Lippert and Walker (1997); Schneider (1994a,b, 1997b, 1998a); Johnson, Kaufmann, and Shleifer (1997); and Johnson, Kaufmann and Zoido-Lobaton ´ (1998a); and for an overall survey of the global evidence of its size Schneider and Enste (2000a,b). See e.g., Economic Journal 109, no. 456 (June 1999) the feature ‘Controversy: on the hidden economy’ including the different opinions of Tanzi (1999), Thomas (1999), and Giles (1999a,b).

A challenge for economic and social policy

5

cause and effects is also carried out. After deﬁning the shadow economy (chapter 2) and discussing the different estimation methods (chapter 3), we will present our extensive data on the shadow economy (chapter 4) and its labour force (chapter 5). After this empirical part of the book, the theoretical fundamentals are elaborated. Besides presenting the economic theory to analyse the relationships between the causes and effects of the shadow economy, we introduce a social sciences approach that adds sociopsychological and sociological components to the economic considerations (chapter 6). On this basis, the causes of the increase of the shadow economy will be analysed, and different economic policy measures will be discussed in the context of illicit work (chapter 7). The analysis of the effects of the shadow economy on the resource allocation, income distribution, and stabilisation policy, as well as on the ofﬁcial economy in general (chapter 8), provides the foundation for propositions of economic policy for the treatment of illicit work as an economic and social challenge (chapter 9). We will propose a ‘two-pillar strategy’ with two approaches for dealing with the phenomenon: (1) Reducing the attractiveness of evading taxes and regulations (‘exit option’), and (2) Improving the ways of voting and inﬂuencing the formal institutions (‘voice option’). The book concludes with a summary and an outlook (chapter 10).

2

Deﬁning the shadow economy

When examining the phenomenon of the ‘shadow economy’, the deﬁnition of the term is of the utmost importance. Many scientiﬁc controversies and political discussions arise because of differing or unsatisfactory deﬁnitions.1 To analyse the causes and, above all, to estimate and evaluate the consequences of the growing shadow economy, it is necessary to clarify what is meant by the latter in each context. Since the term ‘shadow economy’ comprises numerous economic activities, it is difﬁcult to provide a formal deﬁnition. For example, one has to distinguish between goods and services produced and consumed within the household, ‘soft’ forms of illicit work (‘moonlighting’), and illegal employment and social fraud, as well as criminal economic activities.2 In the context of the European Economic and Monetary Union, the deﬁnition has to be made comparable and more or less uniform. The shadow economy has been identiﬁed as a very problematic area within the European National Accounts. A harmonisation of terms is needed and should be attained by integrating the shadow economy into the gross national product (GNP). Although this is generally regarded as necessary,3 a global deﬁnition has not yet been found.4 An overview of different ways to deﬁne the shadow economy will be given here for general guidance.5 The objective is to make the deﬁnition transparent for the following analysis, without laying claim to a homogeneous deﬁnition. It has to be noted that considerable differences exist between developing, transitional, and OECD countries concerning the 1

2 3 4 5

6

The following is a small selection of the terms, which are either used synonymously or for different areas, according to the respective author: underground economy, illicit work, informal sector, irregular sector, leisure economy, alternative economy, black economy, hidden economy, unofﬁcial economy, parallel economy, shadow economy, unobserved economy, unrecorded economy. See amongst others Thomas (1992: 125). This chapter is partly taken from Enste (2002). See Strom, Hartmann, and Essing et al. (1999). See Bhattacharyya (1999); Dixon (1999); Giles (1999b); Tanzi (1999); and Thomas (1999). See also Cassel and Caspers (1984); Gretschmann (1983, 1984); Schrage (1984); and Thomas (1992).

Deﬁning the shadow economy

7

activities of their respective shadow economies. The following overview is a general approach, but concentrates particularly on those areas of the unofﬁcial economy that are important for OECD countries. 2.1

Informal economic activity and national income accounts

In general, the shadow economy can be seen as an ‘emigration from the established ways of working’ (Stutzel ¨ 1980: 453; own translation) or, as the German Council of Economic Experts (SVR 1980: 145, Tz.296) deﬁnes it, it is ‘a decision against the ofﬁcial norms and formal institutions for economic activity’. Cassel and Caspers (1984), as well as Muckl ¨ (1986), try to give a more systematic deﬁnition of the term which, by now, has gained broad acceptance in the literature,6 even though it omits the purely ﬁnancial transactions. The concept of National Income Accounts is taken as a systematisation criterion.7 The separation of the economy (Dual economy) into an ofﬁcial (First economy) and an unofﬁcial sector (Second economy; informal economic activities) offers an initial guide towards a categorisation of the shadow economy (see Figure 2.1). This classiﬁcation depends on the respective national propositions concerning the economic activity to be included. However, there is no unique set of propositions governing the construction of the accounts, since the principles of registration can vary over time and/or in different countries. Owing to this fact, the EU Commission initiated a standardisation on the European level that is being supported by extensive studies on the gross national product of EUROSTAT. But this discussion should start at an earlier point because, ﬁrst of all, it is crucial to decide which activity should be registered, taxed, and regulated, and then general rules should be set up. For example, should income or consumption be the basis for taxation? Should every market transaction be regulated? In addition to these theoretical considerations, the measurement of economic activity involves many practical problems. Here, the part of the economy that, apart from small statistical deviations, is encompassed by the national product is deﬁned as the ofﬁcial sector. It comprises the public sector (state activities) as well as the private economy (goods and services of private households and ﬁrms that are produced and sold through markets and that are regulated by law, publicly administered, and taxed). When turning to the underground economy, all private economic activities are implied that are not included in the calculation of the gross national product, even though they 6 7

See Feige (1989, 1994); Schneider (1994a); Frey and Pommerehne (1984); Lubell (1991); and Schneider and Enste (2000a). See Cassel and Caspers (1984: 1–7); Muckl ¨ (1986: 10f.); and Tuchtfeldt (1984: 17f.).

Not registerable

Private sector Private households and firms

Figure 2.1. The dual economy

Official (registered) GNP

Public sector Public institutions and public firms

Official sector (Formal sector, first economy)

Hidden GNP

Excluded from GNP

Not registerable

Household sector Self-sufficient economy

Underground economy (Informal economic activity; second economy)

Shadow economy Market transactions

National economy (Dual economy)

Deﬁning the shadow economy

9

contribute to added economic value. The underground economy can be deﬁned by: The term underground economy comprises all goods and services which normally should be added to the calculation of the national product but are not part of the latter for certain reasons. (Pommerehne and Kirchg¨assner 1994: 851)

Three reasons are mentioned as to why these activities are not registered: 1. According to international customs, one refrains from registering the activities in the context of the GNP (self-sufﬁciency economy), or 2. the transactions cannot be recorded in the national account statistics at all, or only partly, due to practical problems and insufﬁcient methods, or 3. the added value is not revealed, hence it cannot be recorded (shadow economy). Self-sufﬁcient activities are non-market transactions for individual needs. They imply voluntary activities of non-governmental organisations and, for example, neighbourhood assistance, whose activities are not recorded according to National Income Account conventions (NIAC). Thus, the self-sufﬁcient economy refers not only to the production of individual households, but also to all services that are not obtained on the market – i.e., efforts in social networks (‘network assistance’).8 Therefore, this sector of the underground economy is explicitly excluded from registration.9 By way of contrast, the shadow economy should be included in the added value, according to the convention of the National Income Accounts. Yet, evasive strategies of the private economy prevent such a recording. In general, these market activities are connected with the evasion of taxes and social security contributions, as well as the avoidance of regulations (ofﬁcial working time, safety regulations), and social security fraud. Regarding the analysis of causes and consequences, the taxonomy developed here would be of use if one deﬁnes the current ‘ﬂight from the ofﬁcial economy’ as a process, which is induced by the socio-economic conditions of the modern welfare state and which drives the individuals under ground (self-sufﬁcient and shadow economy). (Cassel and Caspers 1984: 6; emphasis taken from the original) 8 9

See also Glatzer and Berger-Schmitt (1986) as well as Meier (1999: 36f.). For help in social (or ‘informal’) networks see also Diewald (1986). See also Dohrn ¨ (1990: 23), as well as Strom et al. (1999: 272). The production of the agricultural household is often included as an estimated value. Yet, in this context, it is added to the shadow economy.

10

The shadow economy

2.2

Shadow economy, tax evasion, and illicit work

The analysis of the varying degrees of legality of activities, as well as their connection to tax evasion, is important for the evaluation of such activities in the shadow economy. Pure tax evasion via ﬁnancial transactions is excluded from our analysis as it does not render added value, and is usually not meant, when someone is talking about the shadow economy.10 The distinction between tax avoidance and tax evasion, mostly based on legal assessments, will not be discussed here. Moreover, the following analysis only broaches the problem of tax compliance, which has been intensively discussed in the literature in the last twenty years. This book is an attempt to transfer arguments from this discussion to the area of shadow economies and illicit work, i.e., areas that are usually excluded, for example by Andreoni, Erard, and Feinstein.11 Unfortunately, there are many important issues that we do not have room to discuss, most notably the vast literature on the underground economy which exists in part as a means of evading taxes. (Andreoni, Erard, and Feinstein 1998: 819)

The difference between ‘pure tax evasion’ and ‘underground economy’ is explained clearly in Lippert and Walker (1997). Shadow economic activities almost always imply the supply of goods and services, which are produced with resources such as work, managerial or industrial activities, and capital. In contrast to this, pure tax evasion usually results from ﬁnancial transactions carried out with the objective to conceal income, e.g., capital income. These aspects are especially important for ﬁscal policy and public ﬁnance and are elaborated upon in these areas. From the point of view of economic policy, those shadow economic activities related to the added value, as well as their inﬂuence on the allocation of resources, are particularly relevant. Concerning the evaluation of activities (in a context of economic order), one has to distinguish between, on the one hand, the output of illegal and legal activities and, on the other, legal and illegal production and distribution of these activities. Figure 2.2 clariﬁes this deﬁnition. Yet, the boundaries between the sectors 10

11

Schmolders, ¨ who invented the term in the 1980s, generally summarises under shadow economy tax evasion, and grey to black markets, which are the ‘expression and correction of the ofﬁcial market order’ (Schmolders ¨ 1980: 372). In his opinion, the main categorisation criterion is the secrecy of the ﬁnancial transactions. Hence, the shadow economy comprises the entire turnover, which is obtained in this economic system with its speciﬁc markets, competition rules, customs, marketing strategies, and investments. In this context, the survey-article by Schneider and Enste (2000b) and this book can be seen as a supplement. Both articles taken together give a broad overview on the shadow economy and tax evasion.

Deﬁning the shadow economy Sectors Household Informal sector sector

Criteria

11 Irregular sector

Criminal sector

Production/ distribution

legal

legal

illegal

illegal

Market transactions

no

yes

yes

yes

Output (goods/ services)

legal

legal

legal

illegal

NAC conventions

Self-sufficient economy (legal)

Examples

Do-ityourself, home office work; babysitting; exchange of goods

Neighbourhood help; counselling centres; self-help organisations; honorary activities; network help

Shadow economy (illegal) Illicit work; ⇒ because of violations of distributing handicraft and trade regulations.

Trade with stolen goods and drugs; prohibited gambling; fraud; smuggling; stolen goods

⇒ because of tax evasion ⇒ and abuse of public benefits.

Figure 2.2. Categorisation of the underground economy

are not clearly deﬁned and they change during the process of economic development.12 The underground economy can, in principle, be divided into four sectors. Informal economic activities may be deﬁned in terms of the two criteria of market transactions and legality. Hence, the underground economy can be separated logically into a legal and an illegal sector.13 The legal sector can then be deﬁned as the self-sufﬁcient economy and the illegal one as the shadow economy or hidden economy.14 The self-sufﬁcient economy can be differentiated according to whether market transactions take place (informal sector, alternative economy) or not (household sector). For example, the latter includes ‘Do-It-Yourself (DIY)’. The informal sector is predominant in developing and transforming countries where small ﬁrms produce a large share of the economic added value.15 The difference between the latter and the irregular sector 12 13 15

See also Asea (1996); Mirus and Smith (1997: 5); Smith (1997: 13); Petry and Wied-Nebbeling (1987: 14ff.); Thomas (1992: 6). 14 See also Fig. 2.1. See also Thomas (1992: 4, 6). De Soto (1989) describes this area very imaginatively using the example of Peru. He also clariﬁes the difﬁculties which often arise when the individual wishes to switch into the ofﬁcial sector.

12

The shadow economy

is that these informal activities are not prosecuted in many countries, even though certain regulations and administrative rules may be ignored, or people act on the border of illegality. Thomas (1992: 4, 87f.) introduces ‘law enforcement’ as a boundary criterion. Hence, it is not the existence of laws and regulation that is relevant, but rather their enforcement and supervision by the administration. The latter is hardly present in the informal sector, whereas there are intensive controls and investigations in the irregular sector. Thus, the activities in the informal sector are often not connected to tax evasion, and they are part of a mostly legalised ﬁeld which is tolerated by the state. In contrast to this, activities in the shadow economy are connected speciﬁcally to additional employment, accompanied by tax evasion or unlawful behaviour. The difference between the ‘criminal sector’ and the ‘irregular sector’ (Thomas 1992: 3f.) stems from the fact that production/ distribution and output of criminal activities are illegal (drug trafﬁcking, slave trade, prohibited gambling). On the other hand, the occupation in the irregular sector becomes part of the shadow economy only if the distribution and the production is illegal, since the output is legal! Most of these irregular activities can be summarised under the term ‘illicit work’. Irregular actions include producing goods or offering services while receiving social insurance without informing the labour ofﬁce (social security fraud); being self-employed and operating an industrial enterprise without complying with the regulations of the industrial code; or practising a trade without being registered. Offences against this legislation are prosecuted as irregularities and have been punished with a ﬁne of up to DM 200,000 since 1998 in Germany.16 In many OECD countries, however, economic activities resulting from favours, neighbourhood assistance, and small-scale activities are explicitly excluded from punishment. Therefore, in this case, these are part of the informal sector. The irregular sector will be analysed more closely in this book. It is characterised by market transactions. The production and distribution of these goods and services becomes unlawful either by illegal production or by prohibited trade or in combination with tax evasion. The produced goods or services themselves are not illegal. A paperhanger hanging wallpaper in Germany only works illicitly if he does this at the weekend and receives a cash payment without an invoice. Usually, a wide range of activities is summarised under the term ‘illicit work’, such as minor trade services after regular working hours, and organised illegal employment in combination with tax evasion. The bypassing of the laws of competition and of craftsmanship and social security fraud would be 16

See also §1 SchwArbG, BMA (1998b).

Deﬁning the shadow economy Building 12%

13 Private lessons 6% Servants 5% Baby-sitting 5%

Repairing electronic appliances 13%

Others 3%

Beautician/hairdresser 14%

Renovating 23%

Car repairs 19%

Figure 2.3. The structure of illicit work in Austria

further examples. The irregular sector also includes legal activities which are carried out legally, but which are still regarded as part of the shadow economy when combined with tax evasion, as this income is not recorded by the inland revenue ofﬁce (e.g., occasional freelancing, usually subject to income tax, as well as the non-declaration of tips and assessable gifts). With this speciﬁcation highlighted grey in Figure 2.2, the production of private households as well as voluntary work for charities is excluded from the analysis. Following Tanzi’s line of argumentation (1999: 338), activities that do not generate added value, but merely imply a ﬁnancial gain for the individual, are also ruled out (murder, kidnapping etc.). Neither is pure tax evasion included in the following analysis. Hence, the shadow economy (especially illicit work combined with tax evasion) is the subject of this study. Illicit work, carried out either on a part-time basis by individuals (‘moonlighting’) or as part of the activities of a ﬁrm (‘sole job’), constitutes the largest element of the shadow economy. To explain this further, Figure 2.3 shows the structure of illicit work. The arrangement according to economic and service industries contains data collected in Germany and Austria by opinion polls.17 17

See also Schneider and Enste (2000a: 9f.).

14

The shadow economy

Other jobs 25%

Building, renovating, repairing 44% Writing/translating 9% Chauffeuring 5% Manual trade 5% Private lessons 5%

Farming/ gardening 7%

Figure 2.4. The structure of illicit work in Germany

The results for Austria are also applicable to Switzerland, but cannot be compared directly since the way of questioning varies according to different polls. This also holds for different samples within a single country. Only summarised categories were polled in Germany (Figure 2.4), so that the largest share here is the area of building, renovating, and repairing. In other surveys, repairing car, painting apartments, as well as laying tiles, carpets, and parquet were frequently stated. Other activities include hairdressing services. Thus, the area of manual trade is popular for carrying out illicit work. This will be further elaborated upon in Chapter 7. In the following presentation of the different methods of measurement, the categorisation can be used as a guideline. Yet, differences in the deﬁnition of the shadow economy will result from the different methods used. For further analysis of causes and effects, it is important to state that solely soft forms of (part-time) illicit work are taken into account. Illegal activities such as drug-trafﬁcking and organised crime, as well as illegal employment and other forms of economic crime, are explicitly excluded from this study, unless otherwise stated.

3

Methods to estimate the size of the shadow economy

Attempting to measure the size of a shadow economy is a very difﬁcult and challenging task. This chapter is a comprehensive overview of the current data on the various measures used to estimate the shadow economy. The following three methods are especially useful to measure its size and development.1 3.1

Direct approaches

These are micro-economic approaches, employing either well-designed surveys and samples based on voluntary replies, or tax auditing and other compliance methods. Sample surveys designed to estimate the size of the shadow economy are widely used in a number of countries to measure underground activities.2 The major disadvantage of this type of method is commonplace: both average precision and results depend upon the cooperation of the individuals questioned. Direct questionnaires reveal little about increases in undeclared work because many interviewees are hesitant to confess fraudulent behaviour. The responses are, therefore, rarely reliable. Hence, it is difﬁcult to make a proper monetary estimation of the extent of illicit work. Nevertheless, surveys can provide detailed information about the structure of the shadow economy. The shadow economy can also be estimated by determining the discrepancy between income declared for tax purposes and actual earnings through the use of selective audits. In this regard, ﬁscal auditing programmes have been particularly effective. Such programmes, designed to measure the amount of undeclared taxable income, have been employed 1

2

This chapter closely follows Schneider and Enste (2000a,b). For a further discussion, see Frey and Pommerehne (1984); Feige (1989); Thomas (1992, 1999); and Schneider (1986, 1994a, and 1998a). The direct method of voluntary sample surveys has been employed extensively for Norway by Isachsen, Klovland, and Strom (1982), as well as Isachsen and Strom (1985). For Denmark, this method is used by Mogensen et al. (1995) in which they report ‘estimates’ of the shadow economy of 2.7% of GDP for 1989, 4.2% of GDP for 1991, 3.0% of GDP for 1993, and 3.1% of GDP for 1994.

15

16

The shadow economy

in several countries to estimate the shadow economy.3 This approach is beset with difﬁculties, for example, the use of tax compliance data is equivalent to using a (possibly biased) sample of the population. The choice of taxpayers for a tax audit is non-random and thus the sample is not representative of the whole population.4 This factor is likely to bias compliance-based estimates of the clandestine economy. Secondly, tax audit-based estimates reﬂect the portion of clandestine economic income that the authorities succeeded in discovering; probably only a fraction of the total clandestine income. Another disadvantage of the two direct methods (surveys and tax auditing) is that they do not capture all ‘shadow’ activities. Furthermore, they only result in point estimates; that is, they are unable to evaluate the development and growth of the shadow economy over a longer period of time (at least to date). Nevertheless, they have one considerable advantage – they can provide detailed information about shadow economic activities, and the structure and composition of illicit work. However, the formulation of the questionnaire greatly affects the results of these surveys.5 3.2

Indirect approaches

Indirect approaches, which are also called ‘indicator’ approaches, are mostly macro-economic. They use various economic and other indicators as information on the development of the shadow economy. Currently there are ﬁve indirect indicators: 3.2.1

The discrepancy between national expenditure and income statistics

This approach is based on discrepancies between income and expenditure statistics. In national accounting, the income measure of GNP should be equal to its expenditure measure. Thus, if an independent estimate of the expenditure side of the national accounts is available, the gap between the expenditure and the income measure can be used as an indicator of the extent of the hidden economy.6 National accounts statisticians are 3 4 5 6

See, for example, for the United States, IRS (1979, 1983); Clotefelter (1983); and Feige (1986). For a more detailed discussion, see Dallago (1990) and Thomas (1992). It is usually based on properties of submitted (tax) returns, which indicate a certain probability of (tax) fraud. The advantages and disadvantages of this method are extensively dealt with by Mogensen et al. (1995) in their excellent and very carefully performed investigation. See, for example, MacAfee (1980) and O’Higgins (1989) for Great Britain; Petersen (1982) and del Boca (1981) for Germany; Park (1979) for the United States. For a survey and critical remarks, see Thomas (1992).

Estimating the size of the shadow economy

17

anxious, however, to minimise this discrepancy and, therefore, the initial discrepancy, or ﬁrst estimate, should be used rather than the published discrepancy. If all of the expenditure-side components were measured without error, then this approach would yield a very good estimate of the scale of the shadow economy. Unfortunately, this is not the case and the discrepancy reﬂects all omissions and errors within the national accounts statistics as well as the shadow economic activity. Therefore these estimates may be crude and not very reliable.7

3.2.2

The discrepancy between the ofﬁcial and actual labour force

A decline in labour-force participation in the ofﬁcial economy can be seen as an indication of increased activity in the shadow economy. If total labour-force participation is assumed to be constant, a decreasing ofﬁcial rate of participation, ceteris paribus, can be seen as an indicator of an increase in illicit activities.8 The weakness of this method is that differences in the rate of participation may also have other causes. Moreover, people can work in the shadow economy and have an ‘ofﬁcial’ job at the same time. This is called ‘moonlighting’ whereas full-time illicit work is a ‘sole job’. Therefore, such estimates are weak indicators of the size and development of the shadow economy.

3.2.3

Monetary methods

Shadow economic activities are generally settled by paying cash so that as few traces as possible are left. Thus, if the demand for cash rises above the ‘normal’ relative or absolute value, one concludes that shadow economic activities are increasing. Figure 3.1 shows these considerations in a simpliﬁed manner. This basic idea has been developed further in different directions, according to the speciﬁc assumptions and context. There are three different techniques to measure the shadow economy and its development over time on the basis of monetary statistics.9 7

8

9

A related approach is pursued by Pissarides and Weber (1988), who use micro data from household budget surveys to estimate the extent of income understatement by selfemployed individuals. More or less the same difﬁculties arise in this micro-economic approach resulting in the calculation of crude values for the shadow economy. Such studies have been made for Italy, see, e.g., Contini (1981) and del Boca (1981). For the United States, see O’Neill (1983); for a survey and critical remarks, see Thomas (1992). See also Frey and Pommerehne (1984); Hofreither and Schneider (1987); Kirchg¨assner (1983; 1984); Schneider (1986); and Schneider and Poll ¨ (1999).

18

The shadow economy

Cash demand actual development of the cash demand

indicator for the extent of the shadow economy

‘normal’ development of the cash demand

0

Time

Figure 3.1. The basic monetary methods to measure the shadow economy (Schneider amd Enste 2000a: 15)

3.2.3.1 The transactions approach The transactions approach was developed by Feige.10 He assumes a constant relationship over time between the volume of transaction and ofﬁcial GNP. This approach starts, therefore, from Fisher’s quantity equation, M × V = p × T (with M = money, V = velocity, p = prices, and T = total transactions). Assumptions have to be made about the velocity of money and about the relationships between the value of total transactions ( p × T ) and total (= ofﬁcial + unofﬁcial) nominal GNP. Relating total nominal GNP to total transactions, the GNP of the shadow economy can be calculated by subtracting the ofﬁcial GNP from total nominal GNP. However, to derive ﬁgures for the shadow economy, Feige has to assume a base year in which there is no shadow economy and, therefore, the ratio of ( p × T )to total nominal (ofﬁcial = total) GNP is ‘normal’ and would be constant over time, in the absence of a shadow economy. This method, too, has several weaknesses: for instance, the assumption of a base year with no shadow economy, and the assumption of a constant ‘normal’ ratio of transactions. Moreover, to obtain reliable shadow economy estimates, precise ﬁgures of the total volume of transactions are needed. This may be especially difﬁcult to achieve for cash transactions as, among other factors, they depend on the durability of bank notes in terms of their paper quality. This approach also relies upon the additional assumption that all variations in the ratio between the total value of transaction and the ofﬁcially measured GNP are due to the shadow 10

For an extended description of this approach, see Feige (1979, 1989, and 1996); for a further application for the Netherlands, see Boeschoten and Fase (1984); and for Germany, Langfeldt (1984a,b).

Estimating the size of the shadow economy

19

economy. This implies that a considerable amount of data is required in order to eliminate ﬁnancial transactions from ‘pure’ cross payments, which are entirely legal and which have nothing to do with the shadow economy. In general, although this approach is theoretically attractive, the empirical requirements necessary to obtain reliable estimates are so difﬁcult to fulﬁl, that its application may lead to doubtful results.11 3.2.3.2 The currency demand approach The currency demand approach was ﬁrst used by Cagan (1958). He calculated a correlation of the currency demand and tax pressure (as one cause of the shadow economy) for the United States for the period between 1919 and 1955. Twenty years later, Gutmann (1977) employed a similar approach but without statistical procedures, examining only the ratio between currency and demand deposits over the years 1937 to 1976. Cagan’s approach was further developed by Tanzi (1980, 1983), who econometrically estimated a currency demand function to calculate the shadow economy in the United States from 1929 to 1980. He assumed that shadow (or hidden) transactions are cash payments, without observable traces for the authorities. An increase in the size of the shadow economy will therefore increase the demand for currency. To isolate the resulting ‘excess’ demand for currency, an equation for currency demand is econometrically estimated over time. All possible conventional factors such as the development of income, payment habits, interest rates, and so on, are accounted for. Additionally, the major factors causing people to work in the shadow economy are included in the estimation equation; namely, the direct and indirect tax burden, government regulation, and the complexity of the tax system. The basic regression equation for the currency demand, proposed by Tanzi (1983), is the following: WS C = β0 + β1 ln(1 + TW )t + β2 ln + β3 ln Rt ln M2 t Y t Y + β4 ln + ut N t with

β1 > 0, β2 > 0, β3 < 0, β4 > 0

where ln denotes natural logarithms, C is the ratio of cash holdings to current and deposit accounts, M2 11

For a detailed criticism of the transaction approach, see Boeschoten and Fase (1984); Frey and Pommerehne (1984); Kirchg¨assner (1984); Tanzi (1982, 1986); Dallago (1990); Thomas (1986, 1992, 1999); and Giles (1999a).

20

The shadow economy

TW is a weighted average tax rate (to proxy changes in the size of the shadow economy), WS is a proportion of wages and salaries in national income Y (to capture changing payment and money holding patterns), R is the interest paid on savings deposits (to capture the opportunity cost of holding cash) and Y is the per capita income.12 N The ‘excess’ increase in currency, which is the amount unexplained by the conventional or normal factors mentioned above, is then attributed to the rising tax burden and to the other reasons that lead people to work in the shadow economy. Figures for the size and development of the shadow economy can be calculated initially by comparing the difference between the development of the currency when the direct and indirect tax burden (and government regulations) is held at its lowest value, and the development of the currency with the current (much higher) burden of taxation and government regulations. Assuming that the same income velocity for currency is used in the shadow economy as for the legal amount of M1 in the ofﬁcial economy, then the size of the shadow can be computed and compared to the ofﬁcial GDP. The currency demand approach is one of the most commonly used methods. It has been applied to many OECD countries but has been criticised on various grounds. 13 The most frequently raised objections to this method are: 1. Not all transactions in the shadow economy are paid in cash. Isachsen and Strom (1980, 1985) used the survey method to ﬁnd out that in Norway, in 1980, roughly 80% of all transactions in the hidden sector were paid in cash. The size of the total shadow economy (including barter) may thus be even larger than previously estimated. 2. Most studies consider only one particular aspect, the tax burden, as a cause of shadow economic activity. But other factors (such as the impact of regulation, the taxpayers’ attitudes toward the state, ‘tax morality’, and so on) are not considered because reliable data for most 12

13

In Chapter 7, Table 7.9 shows the econometric estimation of such a currency demand function for Austria. There, more causes for the shadow economy (regulation, different tax rates, complexity of the tax system) are included. The estimation of such a currency demand equation has been criticised by Thomas (1999) but part of this criticism has been considered by the work of Giles (1999a,b) and Bhattacharyya (1999), who both use the latest econometric techniques. For applications, see Schneider (1997a,b, 1998a); Johnson, Kaufmann, and ZoidoLobaton ´ (1998a); and Williams and Windebank (1995). Thomas (1986, 1992, 1999), Feige (1986); and Pozo (1996) have criticised these.

Estimating the size of the shadow economy

3.

4.

5.

6. 14

15

16

21

countries are not available. If, as seems likely, these other factors also have an impact on the extent of the hidden economy, again it may be higher than that which is ascertained in most studies.14 A further weakness of this approach, at least when applied to the United States, is discussed by Garcia (1978), Park (1979), and Feige (1996) who point out that increases in currency demand deposits are due largely to a slow-down in demand deposits rather than to an increase in currency, caused by activities in the shadow economy. Blades (1982) and Feige (1986, 1997) state that Tanzi should have considered (and accounted for) US dollars which are used as an international currency and held in cash abroad.15 Frey and Pommerehne (1984) and Thomas (1986, 1992, 1999) also claim that Tanzi’s parameter estimates are not very stable.16 Another weak point in this procedure, as in most studies, is the assumption of the same velocity of money in both types of economies. As Hill and Kabir (1996) argue for Canada, and Klovland (1984) for the Scandinavian countries, there is already considerable uncertainty about the velocity of money in the ofﬁcial economy; the velocity of money in the hidden sector is even more difﬁcult to estimate. Without knowing the latter, one has to accept the assumption of an ‘equal’ money velocity in both sectors. Finally, the assumption of a non-existent shadow economy in a base year is open to criticism. Relaxing this assumption would again imply One (weak) justiﬁcation for the use of only the tax variable is that in the studies known to the authors this variable has by far the strongest impact on the size of the shadow economy. The only exception is the study by Frey and Weck-Hannemann (1984) where the variable ‘tax immorality’ has a quantitatively larger and statistically stronger inﬂuence than the direct tax share in the model approach. In the study by Pommerehne and Schneider (1985), for the USA, besides various tax measures, data for regulation, tax immorality, minimum wage rates are available, the tax variable has a dominating inﬂuence and contributes roughly 60–70% to the size of the shadow economy. See also Zilberfarb (1986). In another study by Tanzi (1982, esp. pp. 110–13) he explicitly deals with this criticism. A very careful investigation of the amount of US$ used abroad and US currency used in the shadow economy and for ‘classical’ crime activities has been undertaken by Rogoff (1998), who concludes that large denomination bills are a major driving force for the growth of the shadow economy and classical crime activities due to reduced transactions costs. However, in studies for European countries, Kirchg¨assner (1983, 1984) and Schneider (1986) reach the conclusion that the estimation results for Germany, Denmark, Norway, and Sweden are quite robust when using the currency demand method. Hill and Kabir (1996) show, for Canada, that the rise of the shadow economy varies with respect to the tax variable used; they conclude that ‘when the theoretically best tax rates are selected and a range of plausible velocity values is used, this method estimates underground economic growth between 1964 and 1995 at between 3 and 11% of GDP’ (Hill and Kabir 1996: 1553).

22

The shadow economy

an upward adjustment of the ﬁgures attained in the bulk of the previous studies. 3.2.4

The physical input (electricity consumption) method

3.2.4.1 The Kaufmann-Kaliberda method17 To measure overall (ofﬁcial and unofﬁcial) economic activity in an economy, Kaufmann and Kaliberda (1996) assume electric-power consumption to be the best physical indicator of overall economic activity. Overall (ofﬁcial and unofﬁcial) economic activity and electricity consumption have been empirically observed to move in unison on a global level, with an electricity/GDP elasticity usually close to one. By having a proxy measurement for the overall economy and subtracting it from estimates of ofﬁcial GDP, Kaufmann and Kaliberda derive an estimate of unofﬁcial GDP. This means that Kaufmann and Kaliberda suggest that the growth of total electricity consumption is an indicator of the growth of ofﬁcial and unofﬁcial GDP. According to this approach, the difference between the gross rate of registered (ofﬁcial) GDP and the gross rate of total electricity consumption can be attributed to the growth of the shadow economy. This method is very simple and appealing, however, it can also be criticised: 1. Not all shadow economy activities require a considerable amount of electricity (e.g., personal services), and other energy sources can be used (gas, oil, coal, etc.) so that, once again, only a part of the shadow economy will be captured. 2. Over the years, there has been considerable technical progress. Both the production and use of electricity are more efﬁcient than in the past, and that will apply in both ofﬁcial and unofﬁcial uses. 3. There may be considerable differences or changes in the elasticity of electricity/GDP across countries and over time.18 3.2.4.2 The Lack´o method Lacko´ (1996, 1997a,b) assumes that a certain part of the shadow economy is associated with household consumption of electricity. Among others, it comprises the so-called household production, do-it-yourself activities, and other unregistered production and services. She assumes that, in countries where the section of the shadow economy associated 17

18

This method was used earlier by Lizzeri (1979), del Boca and Forte (1982), and then employed much later by Portes (1996), Kaufmann and Kaliberda (1996), and Johnson, Kaufmann, and Shleifer (1997). For a critique see Lacko´ (1996, 1997a,b). Johnson, Kaufmann, and Shleifer (1997) make an attempt to adjust for changes in the elasticity of electricity/GDP.

Estimating the size of the shadow economy

23

with household electricity consumption is high, the rest of the hidden economy, the non-measurable part, will also be high. The author (1996: 19ff.) assumes that in each country a part of the household consumption of electricity is used in the shadow economy. Lacko’s ´ approach (1998: 133) can be described by the following two equations: ln Ei = α1 ln Ci + α2 ln PRi + α3 Gi + α4 Qi + α5 Hi + ui with

α1 > 0, α2 < 0, α3 > 0, α4 < 0, α5 > 0;

Hi = β1 Ti + β2 (Si − Ti ) + β3 Di with

(1)

and (2)

β1 > 0, β2 < 0, β3 > 0

where i : the number assigned to the country, Ei : per capita household electricity consumption in country i in Mtoe (unit million tons), Ci : per capita real consumption of households without the consumption of electricity in country i in US dollars (at purchasing power parity), PRi : the real price of consumption of 1 kWh of residential electricity in US dollars (at purchasing power parity), Gi : the relative frequency of months with the need of heating in houses in country i, Qi : the ratio of energy sources other than electricity energy to all energy sources in household energy consumption, Hi : the per capita output of the hidden economy, Ti : the ratio of the sum of paid personal income, corporate proﬁt, and taxes on goods and services to GDP, Si : the ratio of public social welfare expenditures to GDP, and Di : the sum of dependants over fourteen years and of inactive earners, both per 100 active earners. In an international econometric study, Lacko´ applies equation (1) substituting Hi with equation (2). The results can be employed to arrange the countries into an order according to their respective electricity use in the shadow economies. To calculate the actual size (added value) of the shadow economy, one should know how much GDP is produced by one unit of electricity in the shadow economy of each country. Since the author does not know, she takes the result of one of the known shadow economy estimations and applies it to the other countries.19 Lacko´ employed 19

Those estimations were carried out for a market economy with another approach for the early 1990s.

24

The shadow economy

the shadow economy of the United States as such a base (the shadow economy value of 10.5% of GDP taken from Morris (1993)), and then she calculates the size of the shadow economy for other countries. This method is also open to criticism: 1. Not all shadow economy activities require a considerable amount of electricity, and other energy sources can be used. 2. Shadow economic activities do not take place in the household sector only. 3. It is uncertain whether the ratio of social welfare expenditures can be used as the explanatory factor for the shadow economy, especially in transition and developing countries. 4. That which is the most reliable shadow economy base value, needed to calculate the size of the shadow economy for all other countries, is questionable. This is especially true for transition and developing countries. 3.3

The model approach20

All methods described so far are designed to estimate the size and development of the shadow economy and consider just one indicator that ‘must’ capture all the effects of the shadow economy. However, it is obvious that the effects appear simultaneously in production, labour, and money markets. An even more important criticism is that the factors that determine the size of the hidden economy are taken into account in certain monetary approach studies only. These usually consider only one: the burden of taxation. The model approach explicitly considers multiple causes that lead to the existence and growth of the shadow economy, and to its multiple effects over time. The empirical method that is applied is quite different from those used so far in that it is based on the statistical theory of unobserved variables, a theory which considers multiple causes and multiple indicators of the phenomenon to be measured. For the estimation, a factor-analytical approach is used to measure the hidden economy as an unobserved variable over time. The unknown coefﬁcients are estimated in a set of structural equations within which the ‘unobserved’ variable cannot be measured directly. Generally, the DYMIMIC model (dynamic multiple-indicators and multiple-causes) consists of two parts. 20

The pioneers of this approach are Weck (1983), and Frey and Weck-Hannemann (1984), who applied this approach to cross-section data from the 24 OECD countries for various years. Before turning to this approach they developed the concept of ‘soft modelling’ (Frey and Weck (1983a,b), an approach which has been used to provide a ranking of the relative size of the shadow economy in different countries, see, for example, Aigner, Schneider, and Ghosh (1988).

Estimating the size of the shadow economy Causes

25 Indicators

Tax burden Income rate Regulation density Development of the shadow economy

Working hours

Tax moral GNP Income

Figure 3.2. The basic idea of ‘soft modelling’

First, the measurement model links the unobserved variables to observed indicators. Secondly, the structural equations model speciﬁes causal relationships among the unobserved variables. In this case, there is one unobserved variable: the size of the shadow economy. Presumably, it is inﬂuenced by a set of indicators of the hidden economy’s size, thus capturing the structural dependence of the shadow economy on variables that may be useful in predicting its movement and size in the future. The interaction between the causes Zit (i = 1, 2, . . . , k) the size of the shadow economy Xt , and the indicators Yjt (j = 1, 2, . . . , p) is depicted in Figure 3.2. There is a large body of literature on the possible causes and indicators of the shadow economy in which the following types can be distinguished:21 Causes 1. The burden of direct and indirect taxation, both actual and perceived: a rising burden of taxation provides a strong incentive to work in the shadow economy. 2. The burden of regulation as a proxy for all other state activities: it is assumed that increasing regulation gives a strong incentive to enter the shadow economy. 21

See Thomas (1992); Schneider (1994a, 1997a,b); Pozo (1996); Johnson, Kaufmann, and Zoido-Lobaton ´ (1998a,b); and Giles (1999a,b).

26

The shadow economy

3. ‘Tax morality’ (citizens’ attitudes toward the state), which describes the readiness (at least in part) of individuals to leave their ofﬁcial occupations and to engage in shadow economic activities: it is assumed that a declining tax morality tends to increase the size of the shadow economy.22 A change in the size of the shadow economy may be reﬂected in the following: Indicators 1. Development of monetary indicators: if activities in the shadow economy rise, additional monetary transactions are required. 2. Development of the labour market: increasing participation of workers in the hidden sector results in a decrease in participation in the ofﬁcial economy. Similarly, increased activities in the hidden sector will probably be reﬂected in shorter working hours in the ofﬁcial economy. 3. Development of the production market: an increase in the shadow economy implies lower inputs (especially labour) in the ofﬁcial economy (at least partly); this displacement may have a depressing effect on the ofﬁcial growth rate of the economy. The studies by Giles (1999a,b) and Giles, Linsey, and Werkneh (1999) are the most recent applications of this approach. Basically, they assume a comprehensive (dynamic) MIMIC model to get a time-series index of the hidden/measured output of New Zealand or Canada, and then they estimate a separate ‘cash-demand model’ to obtain a benchmark to convert this index into percentage units. Unlike earlier authors of empirical studies of the hidden economy, they paid proper attention to the non-stationary and possible co-integration of time-series data in both models. Again, this model treats hidden output as a latent variable, and uses several (measurable) causal and indicator variables. The former include measures of the average and marginal tax rates, inﬂation, real income, and the degree of regulation in the economy. The latter include changes in the (male) labour-force participation rate and in the cash/money supply ratio. In their cash–demand equation, Giles et al. allow different velocities of currency circulation in the hidden and recorded economies. Their equation is not used as an input to determine the variation in the hidden economy over time – it is only employed 22

When applying this approach for European countries, Frey and Weck-Hannemann (1984) had difﬁculty in obtaining reliable data for the cause series, as well as for the direct and indirect tax burden. Hence, their study was criticised by Helberger and Knepel (1988), who argue that the results were unstable with respect to both changing variables in the model and over the years.

Estimating the size of the shadow economy

27

Table 3.1. A summary of all the approaches to estimate the extent of the shadow economy Method

Approach

Direct methods Indirect methods Approach via national accounting

Monetary approaches

Physical input method Causal methods

(1) Surveys (2) Inquiries on tax evasion (3) Discrepancy between the national accounting of distribution and application (macro-economic approach) (4) Discrepancy between income and expenditure of the households (micro-economic approach) (5) Difference between the ofﬁcial and the actual income rate (6) Cash velocity (7) Cash velocity of major bills (8) Transaction method (9) Cash demand (10) Electricity consumption approach (11) Approach of ‘soft modelling’ (12) Model approach (LISREL Technique)

to obtain the long-run average value of hidden/measured output so that the index for this ratio, predicted by the MIMIC model, can be used to calculate a level and percentage units of the shadow economy. Giles’ latest combination of the currency demand and MIMIC approach shows clearly that some progress has been achieved in the estimation technique of the shadow economy and that a number of weaknesses have been overcome. 3.4

Summary of the methods used to estimate the size of the shadow economy

The different methods used to estimate the shadow economy are summarised again in Table 3.1. Even though the techniques mentioned above may not be able to give an exact result, they can render a few clues. Some approaches – such as the cash approach – allow an estimation of the development of the shadow economy over time. The measurement techniques all have their pros and cons and the speciﬁc problems of the investigations show different results for a variety of reasons. Thus, it seems sensible to summarise and compare the results. As the bases of the different approaches vary, there are clear differences with regard to the estimation of the size of the shadow economy. Yet, they can give a hint as to whether or not the estimations are plausible.

28

The shadow economy

If entirely different approaches lead to similar outcomes or if the ensuing disparities can be explained by a theoretical speciﬁcation of the method, then more reliable results can be derived by combining the various methods. The availability of the relevant data is such that, in Chapter 4, we will present the results derived by using the approaches of estimating a currency demand and an electricity demand function and the model approach for many countries. For some countries, we will also present the speciﬁc survey results.

4

Size of shadow economies around the world

4.1

The results for seventy-six countries

There are numerous empirical surveys on the extent of the shadow economy in single countries (e.g., OECD or Eastern European countries). Various methods have been employed and the results concerning the size and development of this phenomenon differ strongly over time.1 Until now, these have not been compared properly. Therefore, in the following tables, the shadow economies of seventy-six countries (developing, transition, and OECD countries) are analysed for the years 1989–90 and 1990–3 with the ‘electricity consumption method’ as well as both the ‘cash’ and the ‘model’ approach. Naturally, restrictions also apply here. Yet, since at least two of the methods were applied to the majority of the countries, the different countries and approaches can be made comparable to a certain extent because of the corresponding periods of time.2 In the tables, the countries are divided into developing, transition, and OECD countries as well as according to continents. The ‘physical input (electricity consumption) method’ has been applied not only to the majority of the developing and transition countries, but to the OECD countries also. This approach thus provides results for almost every country. The size of the Latin American shadow economy was calculated with the additional help of the model approach. Regarding the development of an economy, one can assume that in the early stages the greater part of economic activity is hidden, as the added value is not yet seized ofﬁcially and most of it is used for self-sufﬁciency. 1 2

For more recent studies see also among others Lippert and Walker (1997); Loayza (1996); Pozo (1996); Portes (1996); Schneider and Enste (2000c); Schneider (2000). We explicitly point to the fact that this comparison merely draws a very crude picture of the order regarding the sizes of the shadow economy of single countries. This is not only because the methods have their weaknesses (see Chapter 3) but also possibly because different speciﬁcations and calculation methods were applied to each country and the extent of the available data differed. In this respect, see also Thomas (1992) and Schneider and Enste (2000c). A positive aspect of the comparison is that all countries were surveyed during the same period of time (either 1989–90 or 1990–93) and that, depending on the availability of the data, the average was calculated.

29

30

The shadow economy

This provides a possible explanation for the large black markets in developing countries, besides that of corrupt administration.3 In centrally planned (command) economies, a large part of economic activity is on grey and black markets, which are gradually integrated in the ofﬁcial added value after transformation. However, ofﬁcial economic growth is also impeded here by corruption and the insecurity of property rights.4 At least theoretically, one can still expect a normal economic development and a reduction of the hidden economy, if institutional change is sustainable and broadly tolerated or even supported by the people. In developed countries, however, the exact opposite can be observed. Starting from a high ofﬁcial rate of added value, there is an increasing shift towards hidden economic activities. The reasons for this are manifold and will be analysed further in Chapter 7. 4.1.1

Developing countries

The situation regarding the informal sector in developing countries is dramatically different from that in the industrial nations. This applies to its causes and consequences as well as to its size and development.5 Current estimations are shown in Table 4.1, revealing that the black and grey markets may be the most important economic factors in these countries. In order to analyse developing countries, one can often refer to data from the cities only, as the major part of the added value is produced here. In rural areas, it is rare to see ofﬁcial, statistically recorded, economic activity. Thus, the taxation system seldom functions in these regions. Furthermore, the main part of the activities is based on self-sufﬁcient and household production.6 Detailed surveys on the problems and consequences of shadow economic activities in Latin America focus on Peru. Here, President Fujimori carried out necessary reforms in the 1990s, as the state’s increasing inﬂuence on the economic process had no positive effect and led to the rise of one of the largest black markets in Central and South America. The necessity of drastic reforms has been illustrated very vividly by de Soto (1989), in particular, with examples of the cost of formalisation and registration for small ﬁrms. The main causes for secrecy are corruption, 3 4 5

6

See, among others, Brockmeier (1997); Johnson, Kaufmann, and Zoido-Lobaton ´ (1998, b); Loayza (1996); Tanzi (1998). See, e.g., Cassel (1986); Lacko´ (1997a,b); Johnson, Kaufmann, and Shleifer (1997); Rose-Ackermann (1999). Since this book focuses on the OECD nations, in particular the German-speaking ones, we would like to refer to literature which concentrates on the problem of the developing countries: see Thomas (1992) and the literature he refers to. See, among others, Portes, Castells, and Benton (1989); Chickering and Salahdine (1991).

Size of shadow economies around the world

31

Table 4.1. The size of the shadow economy in developing countries Size of the shadow economy in % of GNP

Developing countries

Electricity consumption approach average 1989–90

Africa 1. Nigeria 2. Egypt 3. Tunisia 4. Morocco 5. Tanzaniaa 6. Botswana 7. Mauritius

76.0 68.0 45.0 39.0 31.5 27.0 20.0

— — — — — — —

Latin America 1. Bolivia 2. Panama 3. Peru 4. Guatemala 5. Honduras 6. Brazil 7. Uruguay 8. Colombia 9. Ecuador 10. Venezuela 11. Mexicob 12. Paraguay 13. Costa Rica 14. Argentina 15. Chile

— 40.0 44.0 61.0 — 29.0 35.2 25.0 — 30.0 49.0 27.0 34.0 — 37.0

65.6 62.1 57.4 50.4 46.7 37.8 — 35.1 31.2 30.8 27.1 — 23.2 21.8 18.2

Asia 1. Thailand 2. Philippines 3. Sri Lanka 4. Malaysia 5. South Korea 6. Israel 7. Cyprus 8. Hong Kong 9. Singapore

71.0 50.0 40.0 39.0 38.0 29.0 21.0 13.0 13.0

— — — — — — — — —

a For

Model approach average 1990–93

Tanzania, see Bagachwa and Nasho (1995: 1394), who have applied the Cash Approach. b For Mexico, Pozo (1996) calculates the following ﬁgures: 33% (1989–90) and 35.1% (1990–93). Sources: Own calculations for Africa and Asia on the basis of records taken from Lacko´ (1996). Results for Latin America are taken from Loayza (1996).

32

The shadow economy

inefﬁcient administrations, incompetence, and the arbitrariness of the authorities. Therefore, the reforms in Peru comprise the privatisation of state-owned companies, and the reform and simpliﬁcation of the system and administration of taxation and the land register. This should secure property rights. The reforms could be a ﬁrst step towards reducing the shadow economies in developing countries, and making this very important economic sector part of the ofﬁcial added value.7 Table 4.1 summarises the outcomes for some developing countries. Commencing with those for Africa, one can ﬁnd results for seven nations. The largest shadow economies in the period 1989–90 are in Nigeria with a rate of 76%, followed by Egypt and Tunisia with 68% and 45%. Botswana and Mauritius have the smallest black markets, with 27% and 20% respectively. In Latin America, the largest hidden economies are located in Bolivia, Panama, and Peru with approximately 66%, 62%, and 57% respectively; on the lower part of the scale, one discovers Costa Rica, Argentina, and Chile with 23%, 22%, and 18% of the ofﬁcial GNP. When comparing these results derived from the model approach to those obtained by applying the physical input (electricity consumption) method, only some countries (Venezuela, Brazil) display similar outcomes. In most of the latter, the variations are considerable, e.g., the difference in Panama is 12 percentage points; in Chile 19. Regarding the ﬁgures for Asia, Thailand has by far the largest shadow economy of 71%, followed by the Philippines with 50%, and Sri Lanka and Malaysia with 40% and 39%. The smallest black market records exist in Singapore and Hong Kong with 13% both. A detailed analysis of the consequences of the Asian Crisis, with regard to the development of the hidden economy, is an interesting subject but one which cannot be elaborated in this context. 4.1.2

Transition countries

In the transition countries, an ofﬁcial, and more or less free, market economy has barely begun to develop. There are immense changes underway in the Eastern European countries, which vary greatly in the different economies. The shadow economies in these previously socialist countries are also changing.8 Yet, they are no less important, as they are expanding. The transition process of the socialist shadow economy (which used to be necessary for market economy activities and production) towards a system 7 8

For detailed descriptions of the informal sector in developing countries, see, e.g., Brockmeier (1997); de Soto (1989); Lubell (1991); Tokman (1992); and Ghersi (1997). For a comparison of socialist and capitalist shadow economies, see Cassel (1986); Dallago (1990).

Size of shadow economies around the world

33

which offers a portal to an ofﬁcial opening of the markets, requires complete structural upheaval. This makes consistent predictions impossible. Nevertheless, a few estimations will be presented, which apply, in part, to these countries until the mid-1990s. Primary statistical surveys on the basis of polls clarify a few reasons for the differing sizes of the shadow economies. The key causes are a high actual tax burden (for management staff ), strong corruption in the administration, organised crime (Maﬁa), and a lack of trust in the law. Implementing and securing property rights is of the utmost importance. These causes partly explain the large variations in the size of the shadow economies in Russia and the Ukraine, on the one hand, (41% and 47.3% respectively of GNP in 1994/95), and Poland, Slovakia, and Rumania, on the other, with relatively small black markets (between 7% and 18% of GNP from 1989 to 1995).9 The causes and consequences, as well as the shift in illicit activities in transition countries, will not be discussed further here as the focus of the book is on the analysis of the shadow economies in OECD nations.10 The ﬁgures for the transition countries for 1989–90, 1990–3, and 1994/95 were derived by applying the electricity consumption method. The following conclusions can be made: of those countries that followed the former Soviet Union, Georgia, and Azerbaijan have the largest shadow economy with 44% and 34% (in the period 1990–3) and White Russia and Uzbekistan have the smallest with 14% and 10% respectively. Regarding the former Eastern bloc, Hungary has the largest black economy with 31%, followed by Bulgaria with 26%, whereas the Slovakian and the Czech Republic have the smallest with 14% and 13% respectively. In all the transition countries, the shadow economies have grown in the past years. The summary of current data conﬁrms this trend. The average size of the shadow economy has risen from 17% in the years 1989–90, to nearly 30% in the years 1994–5. The countries that followed the former Soviet Union record an even greater increase from 16.6% to 35%. A country-speciﬁc analysis offers numerous starting points for a differentiated analysis of the causes, which has already been carried out by various authors.11 4.1.3

OECD countries

This book focuses on analysing the causes and the meaning of the shadow economies in the OECD countries. The importance of hidden activities 9 10

11

For these results, see also Johnson, Kaufmann, McMillan, and Woodruff (1999). For more detailed considerations and economic policy recommendations for transition countries, which vary from those for the OECD nations due to their entirely different situation, see also, e.g., Lacko´ (1996, 1997a,b). See, e.g., Allesandrini and Dallago (1987).

34

The shadow economy

Table 4.2. The size of the shadow economies in transition Size of the shadow economy as % of the GNP (electricity consumption method) Transition countriesa

Average 1989–90

Average 1990–93

Average 1994–95

Former Soviet Unionb 1. Georgia 2. Azerbaijan 3. Ukraine 4. Russia 5. Moldavia 6. Latvia 7. Kazakhstan 8. Latvia 9. Belarus 10. Estonia 11. Uzbekistan

24.9 21.9 16.3 14.7 18.1 12.8 17.0 11.3 15.4 19.9 11.4

43.6 33.8 28.4 27.0 29.1 24.3 22.2 26.0 14.0 23.9 10.3

63.0 59.3 47.3 41.0 37.7 34.8 34.2 25.2 19.1 18.5 8.0

Middle and Eastern Europe 1. Bulgaria 2. Croatiac 3. Hungary 4. Rumania 5. Czech Rep. 6. Poland 7. Slovakia

24.0 22.8 27.5 18.0 6.4 17.7 6.9

26.3 23.5 30.7 16.0 13.4 20.3 14.2

32.7 28.5 28.4 18.3 14.5 13.9 10.2

a Sorted

by the estimations for 1994–5 respectively. the countries of the former Soviet Union, only ﬁgures for 1990 could be used in the column for, 1989–90. c For Croatia, see Madzarevic and Mikulic (1997: Table 9, p. 17) who applied the discrepancy approach. Sources: Own calculations with ﬁgures by Johnson, Kaufmann, and Shleifer (1997: Table 1, p. 182) derived by applying the electricity consumption method, and Johnson, Kaufmann, and Zoida-Lobaton (1998a: 351). b For

can be illustrated with the following estimations regarding their extent. Even if the countries and the different methods can hardly be compared, we can at least state tendencies. There are more data available for the OECD countries than for developing countries. Here, either the cash approach or the physical input method was applied. The former was calculated either by the authors of this book, or taken from Johnson, Kaufman, and Zoido-Lobaton ´ (1998a,b). In Table 4.3, the results from three different methods for OECD countries are compared. In 1990–3, Johnson et al. estimate that the southern

Size of shadow economies around the world

35

Table 4.3. The share of the shadow economy of ofﬁcial GNP in the OECD countries: a comparison of estimation with different methods The share of the shadow economy of ofﬁcial GNP calculated with the:

OECD countries

Cash approach (Johnson et al.)a 1990/93

1989/90

1990/93

Electricity consumption method 1989–90

1. Greece 2. Italy 3. Spainb 4. Portugal 5. Belgium 6. USA 7. Australia 8. Netherlands 9. Sweden 10. Germanyc 11. France 12. Canada 13. Denmark 14. New Zealandd 15. Japan 16. Ireland 17. Great Britain 18. Switzerland 19. Norway 20. Austria 21. Finland

27.2 20.4 16.1 15.6 15.3 13.9 13.1 11.8 10.6 10.5 10.4 10.0 9.4 9.0 8.5 7.8 7.2 6.9 5.9 5.8 —

— 22.8 16.1 — 19.3 6.7 10.1 11.9 15.8 11.8 9.0 12.8 10.8 9.2 — 11.0 9.6 6.7 14.8 5.1 —

— 24.0 17.3 — 20.8 8.2 13.0 12.7 17.0 12.5 13.8 13.5 15.0 9.0 — 14.2 11.2 6.9 16.7 6.1 —

21.2 19.6 23.9 16.8 22.0 10.5 15.3 13.5 10.8 15.2 12.5 11.7 17.8 — 13.7 20.7 13.6 10.2 9.0 15.0 13.3

Cash approach (Schneider)

a Order

according to the size of the average shadow economy 1990/93 following Johnson, Kaufmann, Shleifer (1997). b These ﬁgures were calculated by Mauleon (1997), personal correspondence. c After 1990 uniﬁed Germany. d The results were derived by applying the Model Approach and the Cash Method. Sources: Electricity consumption approach by Lacko´ (1996, 1997a,b); cash demand approach by Schneider (1994a, 1998a), Johnson, Kaufmann, and Zoido-Lobaton ´ (1998a,b), Giles (1999a), and Williams and Windebank (1995).

European countries have the largest black markets: Greece has 27.2%, Italy 20.4%, Spain 16.1%, and Portugal 15.6% of GNP. The authors of this book come to similar conclusions, as does Lacko´ (1997b), who applied the physical input method. Following Johnson et al., the smallest shadow economies exist in Switzerland with 6.9%, Norway with 5.9%, and Austria with 5.8% of GNP. However, we ﬁnd the smallest hidden

36

The shadow economy

Table 4.4. The size of the shadow economies in OECD countries Share of the shadow economy as % of GNP (cash approach by Schneider) OECD countries

Average 1994–5

Average 1996–7

1. Greece 2. Italy 3. Spain 4. Portugal 5. Belgium 6. Sweden 7. Norway 8. Denmark 9. Ireland 10. Canada 11. France 12. Netherlands 13. Germany 14. Australia 15. Great Britain 16. Japan 17. USA 18. Austria 19. Switzerland

29.6 26.0 22.4 22.1 21.5 18.6 18.2 17.8 15.4 14.8 14.5 13.7 13.5 13.0 12.5 10.6 9.2 7.0 6.7

— 27.2 23.0 — 22.2 19.5 19.4 18.2 16.0 14.9 14.8 13.8 14.75 — 13.0 — 8.8 8.6 7.8

Sources: Schneider (1998a) and Schneider and Poll ¨ (1999).

economy in the USA having a rate of 8.2% (Johnson et al. calculated 14%), as well as in Switzerland (6.9%) and Austria (6.1%). To sum up, the results concerning the size, as well as the development, of shadow economies are conﬁrmed by other surveys.12 Yet it is not surprising that the results vary immensely because of the different estimation methods and statistical techniques. Current data on the OECD countries, which Schneider has derived by applying the cash approach, conﬁrm the trend towards a rise in shadow economic activity (Table 4.4). There are numerous surveys and results on Italy, which traditionally has a large shadow economy, especially in the south. Ongoing reforms, carried out to comply with the Maastricht Treaty, are a step in the right direction. Whether or not, in future, Italy will continue to top the index (behind Greece) remains to be seen and is considered with scepticism by 12

For the 1980s, see Frey and Pommerehne (1984), and Frey and Weck-Hannemann (1984). For the 1990s, see Williams and Windebank (1995); Thomas (1992); and Lippert and Walker (1997).

Size of shadow economies around the world

37

Table 4.5. The size of the shadow economies: summary and comparison

Countries/continents

Share of the shadow economy as % of GNP 1989–93 (physical input method)

Africa Latin America Asia Former Soviet Union Middle and Eastern Europe OECD countries

44 39 35 25 20 12

Source: Schneider and Enste (2000b).

many authors. The north and the south diverge too signiﬁcantly and the networks of illicit work are too strong.13 Altogether, one can ascertain that the average size of the shadow economies in the OECD countries was 12% in the years 1989–90 and 16% in the period between 1996 and 1997. A similar tendency can be detected for single countries. This goes hand in hand with a general rise in illicit work. 4.1.4

Summary and comparison

Table 4.5 compares the continents and different groups of countries in the early 1990s. This comparison, which, for the reasons outlined above, does not, in fact, have particular validity, shows that Africa has the largest shadow economy with 44% of GNP, followed by Latin America with 39%, and Asia with 35%. Regarding transition economies, the nations of the former Soviet Union have a somewhat larger rate (with 25%) than the former Eastern bloc countries with 20%. The OECD countries lie at the bottom end of the scale with 12%. Although these ﬁgures should not be overrated, nevertheless, they render an order concerning the extent of shadow economic activities. This was to be expected on the basis of the theoretical considerations. 4.2

The development of the shadow economy in the OECD countries from 1970 to 1999

Table 4.6 illustrates the results for single OECD nations during 1970–97. The calculations show a signiﬁcant rise in hidden activities in these 13

For current literature, see Bovi and Castelluci (1999).

38

The shadow economy

Table 4.6. The development of the shadow economy in OECD countries from 1970–97 Size of the shadow economy as % of ‘ofﬁcial’ GNP (cash approach) Country

1970

1980

1994

1995

1996

1997

1. Greece 2. Italy 3. Spain 4. Portugal 5. Belgium 6. Sweden 7. Norway 8. Denmark 9. Ireland 10. Canada 11. France 12. Netherlands 13. Germany 14. Australia 15. Great Britain 16. USA 17. Austria 18. Switzerland

— 10.7 — — 10.4 6.8–7.8 6.2–6.9 5.3–7.4 4.3 — 3.9 4.8 2.7–3.0 — 2.0 2.6–4.6 1.8 4.1

— 16.7 18.0a — 16.4 11.9–12.4 10.2–10.9 6.9–10.2 8.0 10.1–11.2 6.9 9.1 10.3–11.2 — 8.4 3.9–6.1 3.0 6.5

26.0 25.8 22.3 21.2 21.4 18.3 17.9 17.6 15.3 14.6 14.3 13.6 13.1 13.0 12.4 9.4 6.7 6.6

26.6 26.2 22.6 21.9 21.6 18.9 18.5 18.1 15.6 15.0 14.8 14.1 13.9 13.2 12.6 9.0 7.3 6.9

28.5 27.0 22.9 22.3 21.9 19.2 18.9 18.3 15.9 15.1 14.9 14.0 14.5 14.0 13.1 8.8 8.3 7.5

— 27.3 23.1 22.9 22.4 19.8 19.4 18.1 16.1 14.8 14.7 13.5 15.0 13.9 13.0 8.8 8.9 8.1

a Data

from 1978. Source: Own calculations. For 1970 and 1980 sources of the different surveys see Schneider and Enste (1998).

countries for that time.14 The order in which the economies are listed has scarcely changed over the years. Current estimations for Germany, Austria, and Switzerland were also made for the years 1998 and 1999. They conﬁrm a rise in shadow economic activity in these years as well (Table 4.7). Comparisons between the different countries are very restricted, but are similar compared to many other surveys (e.g., by the OECD). A limited comparability can be based on the following factors: 1. The different countries were analysed by employing diverse independent variables (e.g., tax burden, regulation intensity, tax morality). 2. The speciﬁcations of the dependent variables and the estimation equations vary, according to the author and method. 3. In parts, the assumptions differ (e.g., concerning the velocity of cash). Thus, a comparison seems especially sensible for single countries, possibly over a period of several decades, as long as consistent data are 14

They were done by applying the cash approach.

Size of shadow economies around the world

39

Table 4.7. The extent of the shadow economies in German-speaking countries, 1998 and 1999 Rate of the Shadow Economy as % of ‘ofﬁcial’ GNP Countries

1998

1999

Germany Austria Switzerland

14.7 9.1 8.0

16 9.6 8.3

Source: Own calculations.

available. This is possible, with the help of the cash demand approach, as shown in Table 4.6. According to one’s own interests, the reader may choose a country and follow the development over the given period of time. General hints concerning the causes for this development can be found in Chapters 7 and 8. 4.3

Comparing the results for different estimation methods

Since determining the size of the shadow economies is not simple and the different methods often render varying results, it seems sensible to compare these to ﬁnd possible explanations.15 For this, the collection of extensive data over a longer period of time, using various methods, is necessary. These data must then be made comparable regarding the periods and the reference ﬁgures. Table 4.8 shows a comparison between the different shadow economies in ﬁve countries (Canada, Germany, Great Britain, Italy, and the USA). The calculations for four periods are presented (1970–5, 1976–80, 1981–5, and 1986–90). The data were extracted by employing nine different methods and, for all countries, at least ﬁve of these were used for one or more periods. One survey approach, which was used for four countries and most certainly rendered lower estimations, yields results of 1.5% to 5.6% of GNP. The polls regarding tax evasion led to estimations between 3% and 10% for three countries. When comparing the three monetary approaches (‘currency demand method’, Gutmann’s ‘cash/deposit method’, and Feige’s ‘transactions approach’) one can detect a clear pattern. The largest shadow economy in all ﬁve countries is calculated by using the transactions approach, where the results range between 12.6% and 34.3% of the ofﬁcial GNP (average value: 21.9%). Slightly lower values were derived with the Gutmann 15

See Chapter 3.

Great Britain Average over

Italy Average over

United States Average over

2

—

—

8.8

11.2

15.4

—

—

—

6.3

15.9

26.5

8.7

5

2.9 —

— —

4

1.3

—

5

—

21.2

18.4

12.0

11.2

—

— —

1.4

6

5.8

17.2

—

4.5

—

23.0

— 11.0

3.6

5

6.1

22.3

—

7.8

—

38.5

— 10.2

—

5

8.2

29.3

—

9.2

—

34.0

— 13.4

—

3

—

31.4

—

11.3

14.5

—

— —

—

5

—

17.2

14.0

4.3

—

—

— 2.5

1.5

5

8.0

12.6

7.2

7.9

—

—

— 3.6

—

4

—

15.9

6.2

8.5

—

—

— 4.2

—

2

—

—

—

9.7

13.2

—

— —

—

5

—

19.5

23.4

11.3

—

—

3.0 3.2

—

7

10.5

26.4

27.2

13.2

—

18.4

3.9 4.3

—

—

—

—

3

—

34.3

29.3

17.5

–

—

4

—

—

—

21.3

19.3

—

10.0 9.3

—

6

—

17.3

8.8

3.5

—

—

4.9 3.2

3.7

7

8.2

24.9

11.2

4.6

—

—

6.3 4.9

4.5

7

—

21.2

14.6

5.3

7.8

—

8.2 6.1

5.6

5

—

19.4

—

6.2

9.9

—

10.0 10.2

—

Notes: The value were grouped (when possible, averaged) in the time periods 1970–75, 1976–80, 1981–85, 1986–90 in order to undertake a rough comparison. The sources of the values are given by country. Sources: Own calculations by using the following sources: 1. For Canada: Lippert and Walker (1997), Thomas (1992), Hill and Kabir (1996), Schneider (1997), and Jacques Bendelac and Pierre-Maurice Clair (1993). 2. For Germany: Lippert and Walker (1997), Schneider (1994a,b) and Schneider (1997). 3. For Great Britain: Thomas (1992), Lippert and Walker (1997), Schneider (1994a,b, 1997), Pozo (1996). 4. For Italy: Thomas (1992), Lippert and Walker (1997), Pozo (1996), Schneider (1994a,b, 1997), Bendelac and Clair (1993). 5. For the United States: Thomas (1992), Lippert and Walker (1997), Pozo (1996), Schneider (1994a,b, 1997), Bendelac and Clair (1993), Tanzi (1986), Feige (1986), Thomas (1986).

Number of methods used

Germany Average over

1970–5 1976–80 1981–5 1986–90 1970–5 1976–80 1981–5 1986–90 1970–5 1976–80 1981–5 1986–90 1970–5 1976–80 1981–5 1986–90 1970–5 1976–80 1981–5 1986–90

Surveys of — households Tax auditing — Discrepancy between — expenditure and income Discrepancy between — actual and ofﬁcial employment Physical input — method Currency demand 5.1 (Tanzi) Cash deposit 13.8 ratio (Gutmann) Transactions — approach (Feige) MIMIC method — (Frey/Weck-H.)

Method

Canada Average over

Table 4.8. A comparison of the results of the estimations of the shadow economies of ﬁve OECD countries using nine different methods over the period 1970–90

Size of shadow economies around the world

41

Table 4.9. Comparing estimations of the size of the shadow economy using different methods

Methods to calculate the size of the shadow economy Discrepancy between actual and ofﬁcial income rate Transactions approach (Feige) Cash/deposit approach (Gutmann) Electricity consumption method (physical input) Currency demand approach (Tanzi) Model method (LISREL approach) Discrepancy between income and expenditure Polls on tax evasion Surveys

Size of the shadow economy as % of GNP – average values for 5 countries from 1970–90a 24.4 21.9 15.5 12.7 8.9 7.9 6.4 6.1 3.1

a Germany,

Great Britain, Canada, Italy, USA. Source: Own calculations. See Schneider and Enste 1998.

technique, where the results lie between 6.2% and 29.3% for all ﬁve countries during the considered periods. The rates obtained via the currency demand method were considerably lower with an average size of the shadow economy of 8.9% for the ﬁve countries. Comparing the periods within the different countries is also interesting, e.g., for Germany. Here, one recognises that illicit work made up 3.6% of the GNP during 1970–5 when the survey approach is employed. When considering the discrepancy between ofﬁcial and actual employment, one obtains a rate of 23%. The transactions approach results in 17%. As opposed to this, when the model or cash demand approach is used, this results in 5.8% and 4.5% respectively. Similar outcomes can be obtained for the USA, where a large number of estimations have been made. Here, one obtains the clearly highest results by applying the transactions method (17% and 25% of the ofﬁcial GNP), followed by the Gutmann and physical input approach. To conclude, Table 4.8 illustrates once again how difﬁcult it is to measure the size and the development of the shadow economy over time and how the results of the various methods can differ. Yet, these methods measure different facts and the deﬁnition of the shadow economy varies, so that only a restricted comparison is possible. The order of the estimations resulting from the different methods, documented in Table 4.9, is mostly conﬁrmed by theory. The direct methods

42

The shadow economy

probably register only a minor part of the actual hidden activities, because of the secrecy of the individuals interviewed. The indirect methods also consider economic self-sufﬁciency, housework, and neighbourhood help but, in the context of this book, they are not speciﬁcally part of the shadow economy. Since the results offer similar tendencies for the different countries and methods, the list can give an indication of which techniques over- and which underestimate it.

5

The size of the shadow economy labour force

5.1

Illicit work and the shadow economy labour force

After an extensive examination of the size and rise of the shadow economy in terms of added value, this section analyses the black labour market. In the ofﬁcial labour market, there is a particularly tight relationship and ‘social network’ between people who are active in the shadow economy.1 Moreover, by deﬁnition, every activity in the shadow economy involves illicit work to some extent. Hence, this market includes all cases where the employees, the employers, or both, occupy a ‘shadow economy position’. Why do people work in the shadow economy? In the ofﬁcial labour market, the costs ﬁrms (and individuals) have to pay when ‘ofﬁcially’ hiring someone are increased tremendously by the tax burden and social contributions on wages, as well as by the legal administrative regulations that control economic activity.2 In various OECD countries, in effect, these costs are greater than the wage earned by the worker – providing a strong incentive to work in the shadow economy. Lemieux, Fortin, and Fr´echette (1994) analyse the labour supply decision in the underground economy by using micro data from a survey conducted in Quebec City (Canada). In particular, their study provides some economic insight regarding the distortion caused by income taxation and the welfare system. The authors conclude that hours worked in the shadow economy are quite responsive to changes in the net wage in the regular (ofﬁcial) sector. Their empirical results attribute this to a misallocation of work from the ofﬁcial to the informal sector, where it is not taxed. In this case, the substitution between labour-market activities in the two sectors is quite high. These empirical ﬁndings clearly point to the fact that ‘participation rates and hours worked in the underground sector also tend to be inversely related to the number of hours worked in the regular sector’ (Lemieux, Fortin, 1 2

Pioneering work in this area has been done by Cappiello (1986); Lubell (1991); Pozo (1996); and Tanzi (1999). This is especially true in Europe (e.g., in Germany and Austria), where the total tax and social security burden adds up to 100% on top of the wage effectively earned; see also Section 7.2.

43

44

The shadow economy

and Fr´echette 1994: 235). These ﬁndings demonstrate a large negative elasticity of hours worked in the shadow economy with respect both to the wage rate in the regular sector, as well as to a high mobility between the sectors. Illicit work can take many forms. For example, the underground use of labour may consist of a second job after (or even during) regular working hours. A second form is illicit work by individuals who do not participate in the ofﬁcial labour market. A third is the employment of people who are not allowed to work in the ofﬁcial economy (e.g., clandestine or illegal immigrants). Empirical research on the shadow economy labour market is extremely difﬁcult, since there is very little evidence for how many hours an average ‘shadow economy worker’ works (from full time to a few hours, only); hence, it is not easy to provide statistical data.3 The following results of the shadow economy labour force are based on the World Bank database on informal employment in major cities worldwide, as well as on other sources mentioned in the footnotes of this chapter. The values of the shadow economy labour force are calculated in absolute terms, and as a percentage of the ofﬁcial labour force, under the assumption that the shadow economy in rural areas is at least as high as in the cities. This is a conservative assumption, since in reality it is likely to be even larger.4 Survey techniques and, for some countries, the MIMIC-method and the method of the discrepancy between the ofﬁcial and actual labour force are used for estimation. The following results are preliminary and should be treated as a ﬁrst attempt to calculate the shadow economy labour force. 5.2

Developing countries

Table 5.1 shows the results of countries in Africa. Gambia has the largest shadow economy labour force with 80% of the ofﬁcial one, followed by Guinea with 79%, Benin with 76.9%, Rwanda with 75%, and the Republic of Congo with 50%.5 Zimbabwe has the lowest rate of illicit 3

4

5

For developing countries, some literature about the shadow labour market exists, e.g., the latest works by Dallago (1990); Pozo (1996); Loayza (1996); and especially Chickering and Salahdine (1991). The assumption that the shadow economy labour force is at least as high in rural areas as in major cities, is a very modest one and is supported by Lubell (1991). Some authors (e.g., Lubell (1991), Pozo (1996), and Chickering and Salahdine (1991)) argue that the illicit labour force is nearly twice as high in the countryside as in urban areas. But since no (precise) data exists on this ratio, the assumption of an equal size may be justiﬁed arguing that such a calculation provides at least minimal ﬁgures. These high values strongly indicate that a considerable number of these illicit workers also have (at least part-time) jobs in the ofﬁcial economy. Yet, the number of these ‘doublejob-holders’ (ofﬁcial and unofﬁcial at the same time) is unknown and may differ from country to country. The ratio of the shadow economy labour force as a percentage of the

The size of the shadow economy labour force

45

work with 33.9% of the ofﬁcial labour force. For African countries, the ﬁgures show considerable variation and should really be seen as ﬁrst and preliminary results. Under the assumption that this informal or shadow economy labour force is as productive as the ofﬁcial economy and contributes per capita a similar added value, the shadow economy GNP can be calculated, which is also shown in Table 5.1. Gambia has the largest shadow economy as a percentage of ofﬁcial GNP with 41.2%, followed by Guinea with 36.9%, and Rwanda with 38.7%. On average, the supply of illicit work in these 33 African countries is 54.2% (of the ofﬁcial labour force) and 24.6% of the population. Table 5.2 illustrates the results for some Asian countries. Here, China, India, and Indonesia have to be examined more closely, as they are the three largest countries in Asia (regarding population). In China, it is estimated that 160 million people work in the shadow economy – 21.9% of the ofﬁcial labour force.6 In India, 217 million people work illicitly – 50% of the ofﬁcial labour force. In Indonesia, 36.7 million people engage in shadow economic activities, this corresponds to 37.4% of the ofﬁcial labour force. In Pakistan, 29.4 million people or 60% work in the shadow economy. One realises that in Asia the shadow economy labour force is quite high, but these values are also preliminary and have to be reevaluated. On the whole, the shadow economy labour force in these Asian countries makes up 46.5% of the ofﬁcial labour force and 19.6% of the population. In Table 5.3, some Latin and South American states are shown. In absolute terms, Brazil has the highest shadow economy labour force with 37.4 million (49.2% of the ofﬁcial labour force), followed by Colombia with 9.7 million or 53.8%. Both Ecuador with 58.8%, and Peru with 54.6%, have a quite high rate of illicit work. Chile has the lowest rate, with 40%, as well as Paraguay with 41%, and El Salvador with 47.3% of the ofﬁcial labour force. Overall, the shadow economy labour force in these nine countries is 49.6% of the ofﬁcial labour force and 20.3% of the population. 5.3

Transition countries

Nine transition countries were analysed (see Table 5.4.). Armenia has the highest rate with an illicit labour force of 75.5% of the ofﬁcial labour

6

ofﬁcial one should be interpreted very cautiously, since it is unclear what this ratio actually stands for. Hence, an interpretation is very difﬁcult. In addition, making comparisons between different countries is very complicated and such comparisons provide only a very crude picture. Maybe the rate of the shadow economy labour force as a percentage of the population is a somewhat better gauge. The ﬁgure for China should be interpreted with great care as this country still has a communist regime with some regions under a capitalist system.

Millions

1.90 2.00 0.30 3.40 3.50 1.30 0.60 3.40 15.70 15.70 0.30 0.50 6.10 2.60 6.00 0.31 0.40 3.90 2.50

Country

Angola Benin Botswana Burkina Faso Cameroon Chad Congo Cote ˆ d’lvoire Dem. Rep. of Congo Ethiopia Gabon Gambia Ghana Guinea Kenya Lesotho Liberia Madagascar Malawi

35.7 76.9 45.0 65.0 61.7 38.0 50.3 60.3 80.0 61.0 58.0 80.0 72.3 79.0 40.8 38.8 35.0 57.5 51.7

As % of ofﬁcial labour force 16.3 34.5 19.6 32.5 25.1 18.2 22.1 23.9 33.6 26.3 26.1 42.4 33.9 37.6 21.0 15.4 13.8 27.6 24.3

In % of population

Informal employment (1998)

Table 5.1. Shadow economy labour force in Africa

11.66 5.80 1.53 10.47 13.94 7.15 2.71 14.21 46.71 59.75 1.15 1.18 17.98 6.92 28.61 2.01 2.89 14.15 10.28

Population (1997) millions 5.3 2.6 0.7 5.2 5.7 3.4 1.1 5.7 19.6 25.7 0.5 0.6 8.5 3.3 14.6 0.8 1.2 6.7 4.9

Millions 45.45 44.83 45.75 49.67 40.89 47.55 40.59 40.11 41.96 43.01 43.48 50.85 47.27 47.69 51.03 39.80 41.52 47.35 47.67

As % of population

Labour force (1997)

646 758 1,080 816 2,135 299 414 2,380 1,727 1,570 1,251 170 2,379 1,404 2,100 185 — 1,014 500

Shad. ec. GNP in billion $, 1998

4,000 2,200 5,600 2,600 8,700 — 1,900 10,100 5,400 6,200 — 413 7,200 3,800 9,800 1,200 — 3,700 2,100

Ofﬁcial GNP in billion $, 1998

16.2 34.5 19.3 31.4 24.5 — 21.8 23.6 32.0 25.3 — 41.2 33.0 36.9 21.4 15.4 — 27.4 23.8

Shad. ec. GNP as % of ofﬁcial GNP

3.9

Average over 33 countries

54.2

36.0 41.0 47.1 51.0 48.9 75.0 62.4 70.0 42.6 42.2 38.9 57.1 56.4 33.9 24.6

17.5 20.3 20.4 23.5 19.8 40.5 28.4 27.4 16.3 21.7 16.1 21.5 28.5 15.7

10.29 2.46 1.62 9.80 117.90 7.90 8.79 4.75 28.30 31.32 4.34 9.30 20.32 11.47

5.0 1.1 0.7 4.6 47.9 4.2 4.0 1.8 10.8 16.1 1.8 3.5 10.2 5.3 44.9

48.59 44.72 43.21 46.94 40.63 53.16 45.51 37.89 38.16 51.40 41.47 37.63 50.20 46.21

450 205 652 437 17,780 736 1,325 182 1,333 1,476 226 4,272 1,798 1,082

2,600 1,000 3,200 — 36,400 1,900 4,800 702 8,200 6,800 1,400 19,400 — 6,900

Source: Own calculations based on World Bank, Africa Region Live Database, http://www.worldbank.org/html/extdr/regions.htm.

1.80 0.50 0.33 2.30 23.40 3.20 2.50 1.30 4.60 6.80 0.70 2.00 5.80 1.80

Mali Mauritania Namibia Niger Nigeria Rwanda Senegal Sierra Leone Sudan Tanzania Togo Tunisia Uganda Zimbabwe 25.7

17.3 20.5 20.4 — 48.8 38.7 27.6 25.9 16.3 21.7 16.1 21.5 — 15.7

46.5

21.9 50.4 37.4 44.0 78.1 60.0 30.6 31.3 65.0

As % of labour force

19.5

13.1 22.2 18.0 16.2 37.6 22.3 13.0 13.3 19.9

As % of population 1,238.60 979.70 203.70 2.60 22.90 131.60 75.20 18.80 16.60

Population (1998) millions 743.0 431.0 98.0 1.0 11.0 49.0 32.0 8.0 5.0

Millions

43.4

59.99 43.99 48.11 38.46 48.03 37.23 42.55 42.55 30.12

As % of population

Labour force (1998)

138,327 95,568 24,956 169 1,803 — 11,520 — 990

Informal GNP in billion $, 1998

1,055,000 427,400 221,500 1,000 4,800 — 88,400 — 4,400

Ofﬁcial GNP in billion $, 1998

Source: Own calculations based on World Bank, World Development Indicators, http://www.worldbank.org/html/extdr/regions.htm.

52.3

162.40 217.20 36.70 0.42 8.60 29.40 9.80 2.50 3.30

China India Indonesia Mongolia Nepal Pakistan Philippines Sri Lanka Yemen

Average of 9 countries

Millions

Country

Informal employment (1998)

Table 5.2. Shadow economy labour force in Asia

19.5

13.1 22.4 11.3 16.9 37.6 — 13.1 — 22.5

Informal GNP as % of ofﬁcial GNP

1.54 37.40 2.40 9.70 2.94 1.40 2.01 0.80 4.91

7.0

Bolivia Brazil Chile Colombia Ecuador El Salvador Guatemala Paraguay Peru

Average of 9 countries

49.6

51.3 49.2 40.0 53.8 58.8 47.3 50.3 41.0 54.6

As % of labour force

20.3

19.5 22.5 16.2 23.8 24.1 23.0 18.6 15.4 19.8

As % of population 7.90 165.90 14.80 40.80 12.20 6.10 10.80 5.20 24.80

Population (1998) millions 3.0 76.0 6.0 18.0 5.0 3.0 4.0 2.0 9.0

Millions

41.2

37.97 45.81 40.54 44.12 40.98 49.18 37.04 38.46 36.29

As % of population

Labour force (1998)

1,540 — 11,544 25,220 4,482 2,590 3,296 1,408 12,079

Informal GNP in billion $, 1998

7,400 — 73,400 106,100 18,600 11,200 16,800 9,200 61,100

Ofﬁcial GNP in billion $, 1998

Source: Own calculations based on World Bank, World Development Indicators, http://www.worldbank.org/html/extdr/regions.htm.

Millions

Country

Informal employment (1998)

Table 5.3. Shadow economy labour force in Latin and South America

20.3

20.8 — 15.7 23.8 24.1 23.1 19.6 15.3 19.8

Informal GNP as % of ofﬁcial GNP

49.0

75.5 63.0 70.0 36.7 40.0 40.0 42.7 42.2 31.0

As % of labour force

23.9

39.7 30.4 31.1 20.4 17.9 17.0 20.9 22.4 15.5

As % of population 3.80 8.30 4.50 5.40 15.60 4.70 22.50 146.90 2.00

Population (1998) millions 2.0 4.0 2.0 3.0 7.0 2.0 11.0 78.0 1.0

Millions

48.9

52.63 48.19 44.44 55.56 44.87 42.55 48.89 53.10 50.00

As % of population

Labour force (1998)

725 3,100 6,328 1,023 3,668 280 6,533 75,670 3,026

Informal GNP in billion $, 1998

1,800 10,100 20,700 5,100 19,400 1,600 31,300 337,900 19,400

Ofﬁcial GNP in billion $, 1998

Source: Own calculations based on World Bank, World Development Indicators, http://www.worldbank.org/html/extdr/regions.htm.

5.3

1.51 2.52 1.40 1.10 2.80 0.80 4.70 32.90 0.31

Armenia Bulgaria Croatia Georgia Kazakhstan Kyrgyzstan Rumania Russian Federation Slovenia

Average of 9 countries

Millions

Country

Informal employment (1998)

Table 5.4. Shadow economy labour force in transition countries

24.1

40.3 30.7 30.6 20.1 18.9 17.5 20.9 22.4 15.6

Informal GNP as % of ofﬁcial GNP

The size of the shadow economy labour force

51

force, followed by Croatia with 70%, and Bulgaria with 63%. In absolute ﬁgures, Russia has by far the largest shadow economy labour force among the transition countries with 32.9 million illegal workers, followed by Rumania with 4.7 million, and Kazakhstan with 2.8 million. Slovenia has the lowest black labour force with 31%.7 Generally, the shadow economy labour force in these nine countries is 49% of the ofﬁcial labour force and 23.9% of the population. 5.4

OECD countries

Table 5.5 summarises the estimates for the shadow economy labour force in seven OECD countries (Austria, Denmark, France, Germany, Italy, Spain, and Sweden). In Austria, the number of illicit workers has risen from 500,000 in 1997 to 750,000 in 1998 (16% of the ofﬁcial labour force; average value). In Denmark, the development in the 1980s and 90s shows that the part of the Danish population engaged in shadow economic activities ranged from 8.3% of the total labour force in 1980 to 15.4% in 1994 – quite a remarkable increase in illicit work; it almost doubled in those ﬁfteen years. In France, the shadow economy labour force reached a size of between 6% and 12% of the ofﬁcial labour force or in absolute ﬁgures between 1.4 and 3.2 million. In Germany, this ﬁgure rose from 8% in 1974 to 12% in 1982, and to 22% in the years 1997/98. For both countries, this again is a very strong escalation in the shadow economy labour force. In other countries, the size of the shadow economy labour force is also relatively large: in Italy 30–48%, Spain 11.5–32%, and Sweden 19.8%.8 In the European Union, approximately 20 million people were engaged in shadow economic activities in the years 1997–8, and in all European OECD countries 35 million work illicitly. These ﬁgures demonstrate that the shadow economy labour market is active and, for example, may provide an explanation as to why one can observe such high and persistent unemployment in Germany. In Table 5.5, the ofﬁcial GNP per capita and the shadow economy GDP per capita (in US$) were calculated. On taking a closer look, one realises immediately that in all the countries investigated, the shadow economy GDP per capita is much higher – on average approximately 40%. Clearly, this shows that the productivity of the shadow economy is considerably higher than that of the ofﬁcial one – a clear indication that work incentives are stronger in the black market. In general, these very preliminary results demonstrate that the shadow economy labour force has also reached a remarkable size in the developed OECD countries, 7

Of the ofﬁcial labour force.

8

All these rates are valid for the years 1997/98.

8,040 20,361 5,640 13,791 15,107 25,685 9,930 22,179 9,576 22,880

20,636 25,874 13,233 18,496 25,946 34,441 12,539 24,363 11,940 26,080

11,736 29,425 7,868 19,927 21,981 37,331 14,458 32,226 14,162 33,176

25,382 29,630 18,658 26,356 36,558 48,562 17,542 34,379 17,911 39,634

Shadow economy GDP in US$ per capita

16.7 27.3 19.0 23.1 13.0 19.8 14.5 19.6 15.0 20.2

5.47 8.93 8.6 9.8 11.2 17.6 6.9 14.9 10.6 14.7

Size of the shadow economy (as % of ofﬁcial GDP) currency demand approachb

4000–7000 6600–11400 1250–3500 1500–4200 750 1150 10,000 20,000 16,000 35,000

300–380 500–750 250 390 410 420 800–1500 1400–3200 3000–4000 7000–9000

Shadow economy labour force per 1000 peoplec

b

Source: OECD, Paris, various years. Source of size of shadow economy: Schneider (1994a, 1998b, 1999). c Estimated full-time jobs, including unregistered workers, illegal immigrants, and second jobs. d Percentage of the population aged 20–69, survey method.

a

European Union OECD (Europe)

Sweden

Spain

Italy

Germany

France

1979 1997–98 1979–80 1997–98 1978 1997–98 1978 1997–98 1978 1997–98

90–91 97–98 1980 1986 1991 1994 1975–82 1997–98 1974–82 1997–98

Austria

Denmark

Year

Countries

Ofﬁcial GDP per capita in US$a

20.0–35.0 30.0–48.0 9.6–26.5 11.5–32.3 13.0–14.0 19.8 — 11.9 —

9.6 16.0 8.3 13.0 14.3 15.4 3.0–6.0 6.0–12.0 8.0–12.0 22.0

Shadow economy participants as % of ofﬁcial labour forced

De Grazia (1983) and own calculations De Grazia (1983), Schneider (1998b) and own calculations Gaetani d’Aragona (1979) and own calculations Ruesga (1984) and own calculations De Grazia (1983) and own calculations De Grazia (1983) and own calculations De Grazia (1983) and own calculations

Schneider (1998a) and own calculations Mogensen, et al. (1995) and own calculations

Sources of shadow economy labour force

Table 5.5. Shadow economy labour force in OECD countries and ofﬁcial and shadow economy productivity in some OECD countries 1974–98

The size of the shadow economy labour force

53

even if many calculation errors remain. Again, the picture illustrates that the illicit labour market has reached a substantial size in most countries. The results for the different countries, derived from the application of diverse methods, were elaborately illustrated in this chapter. They should give a crude idea of the size and development of the shadow economy. The following chapters concentrate on the problem of illicit work in Germany and public attitudes towards it.

6

An integrated approach to explain deviant behaviour

6.1

Structure of the model

Discussions about the shadow economy often focus on single aspects of its development. Economists base their analysis primarily on neoclassical theory, whereas in the social sciences different unilateral theories compete with one another. Furthermore, one frequently discovers purely descriptive approaches that neglect the analytical aspects. In addition, authors tend to focus on their own scientiﬁc ﬁeld, which does not do justice to the complexity of the phenomenon.1 As the shadow economy cannot be explained by economic theory alone, an integrative approach will be introduced in the following chapters, allowing a thorough and differentiated analysis of causes.2 6.1.1

Synergy effects of an integrative approach

The studies by Bernard de Mandelville (1670–1733), Adam Smith (1723–90), Jeremy Bentham (1748–1832), and James Mill (1773–1826), as well as by the Austrians (e.g., Menger; Bohm-Bawerk), ¨ are not restricted to a unilateral approach. Smith had already thoroughly analysed the socio-psychological correlations (Theory of the moral sentiments, 1759) long before publishing An enquiry into the nature and causes of the wealth of nations (1776). Similarly to Mandelville (1732), the author investigated human behaviour as such (preferences and egoism), and did not conﬁne himself to merely observing exchange on markets (the famous ‘invisible hand’). Hayek (1969) points to this tradition and emphasises Methodological Individualism, which forms the basis for a stronger integration of economic and social sciences. On the one hand, the disintegration in this ﬁeld results from divergences in the different branches of social sciences (socio-psychology, psychology, and sociology) whilst, on the other, it emanates from the extremely analytical approach with the very restrictive, 1 2

See Frey (1990, 1997b); Kirchg¨assner (1991); W¨arneryd (1994). This chapter is taken from Enste (2002) and translated.

54

An integrated approach to explain deviant behaviour

55

and often unrealistic, assumptions in economics.3 These two ﬁelds have recently been merged once again, as theories in socio-psychology and sociology become increasingly based on ‘methodological individualism’ and ‘rational choice theory’. Here, the goal is to explain social processes and institutional change by applying theories that are based upon individual behaviour. The analysis of macro-economic phenomena is founded on micro-economic and micro-sociological theories. For example, the correlation between higher public expenditure and a rise in shadow economic activity can be explained on an individual level. Shadow economic activity has for the most part been analysed with macro-economic approaches that show differing results, due to very restrictive assumptions. However, many authors ﬁnd it necessary to add more detailed micro-analysis of the structures and causes.4 These approaches are developed by economists and psychologists in ‘economic psychology’ and ‘behavioural economics’. Frey (1990, 1997b) shows that applying economic models in social sciences is useful to analyse certain reactions. Thus, an interdisciplinary analysis of the shadow economy could render possibilities for further integration of the social sciences. 6.1.2

Developing a model

In the following sections, elements of the different social sciences will be integrated into the neoclassical ‘income-leisure model’. The division of the relevant factors into economic, sociological, socio-psychological, and ﬁnance-psychological ones illustrate the role of the different branches. However, a strict separation is not possible; thus the relevant factors of all disciplines have to be considered. Figure 6.1 shows the link between the macro- and the micro-level on which the analysis is based.5 The correlations observed on the macrolevel are caused by individual actions. This micro-foundation is important to derive policy implications. Normative considerations are also based on methodological individualism, since the consequences of a reform can only be explained on an individual level.6 The (normative) Ordnungstheorie (as part of institutional economics) can be linked to the positive 3 4

5

For an overview, see Andreoni, Erard, and Feinstein (1998); Pommerehne and WeckHannemann (1992); Juster and Stafford (1991). See, e.g., the empirical survey on the basis of an endogenous growth model, by Loayza (1996), which analyses the development of the shadow economy; see also Neck, Schneider, Hofreither (1989); Quirk (1996); and Andreoni, Erard, and Feinstein (1998). 6 See Suchanek (1997: 99f.). See Esser (1999a: 91f.), and Coleman (1990: 10f.).

56

The shadow economy Macro-Level (Indirect research methods)

Causes: e.g. Tax burden

Consequences: Increase of illicit work

Economic policy implications

Shadow economy (illicit work, household work) Individual decision process Official sector (reduction of work time) Individual preferences Micro-Level (Direct research methods)

Figure 6.1. The causal analysis

analysis due to the integrated approach, i.e., the common methodological approach with the help of the rational choice theory (RCT).7 With aggregate, macro-level data, correlations between possible causes (e.g., a rise in taxation) and the consequences (e.g., increased shadow economic activity) can be found on the macro-level. However, one has to be cautious when making economic policy decisions on the basis of these results without considering the individual decision process. Macroeconomic correlations, such as the Phillips- or the Laffer-Curve, have to be examined on a micro-level before policy implications can be derived. The micro-economic, micro-sociological, and psychological analysis of causes investigates the presumptions and decision structures of the individual who opts for illicit work. The individual preferences are the starting point of the analysis. They are often taken as stable by economists to avoid tautological results. Economic theory examines those factors in place (e.g., high taxation) that act as restrictions. Psychology and micro-sociology emphasise the analysis of the development of preferences and norms. These scientiﬁc areas are combined to explain deviant and 7

The rational choice theory is no uniform theory but includes various concepts of the Homo Oeconomicus, which are all based on the utilitarian theory. Instead of emphasising the incompatibility of the theoretic and methodic components in economics, sociology, and social psychology, IRCT offers the possibility of combining the different areas of research.

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antisocial behaviour (e.g., tax evasion). In this chapter, a few of these approaches are applied to the analysis of illicit work and then integrated into the rational choice theory, in so far as they render additional explanations. This section concludes with an illustration of the integrated model, including the variables that inﬂuence the individual decision process. This approach is then put into a broader context. 6.2

Criticising the neoclassical and welfare-theoretical considerations

6.2.1

Criticising the concept of Homo Oeconomicus

The micro-economic analysis of decision-making has been criticised on numerous occasions on the grounds of its unrealistic and very restrictive assumptions. In some cases, there are deviations in human behaviour that do not coincide with the economic statements.8 In particular, the following assumptions are criticised: 1. The strict application of the postulate of rationality and the rule of maximization. 2. The employment of objective probabilities. 3. The transitivity, consistency, and stability of preferences. In experiments, Kahneman and Tversky (1990) have been able to prove that individuals systematically behave differently from that which is predicted by (‘original’) economic theory (anomalies of decision theory). In surveys on tax evasion, it is shown that, under ceteris paribus conditions, more taxes are evaded by the concealment of income, when extra tax is due, than when one expects a rebate of taxes already paid.9 This conﬁrms the ‘prospect theory’ by Kahneman and Tversky concerning the inﬂuence of given conditions, i.e., in this case, the assessment of the tax payments either as gains (payback) or as losses (extra payments). The theory presents some more points of criticism regarding the neoclassical Homo Oeconomicus, which are discussed further in Enste (2002). One political implication could be to tax people more highly in the ﬁrst place, so that they get a payback of taxes rather than an additional payment. This holds for a short time only, since the taxpayers will get used to paybacks and adjust their expectations (threshold level). The neoclassical model can be extended by integrating the 8

9

For this, see Kahneman and Tversky (1990) and the literature given there, as well as Badelt (1987); Frey and Eichenberger (1989); Kirchg¨assner (1991); Schweers Cook and Levi (1990); Wiswede (1987); for an overview on the controversy, see Arni (1989). See also Fetchenhauer (1998: 74ff.); Robben, Webley and Weigel et al. (1990).

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ﬁndings from related disciplines. RCT can serve as a starting point for this integration. 6.2.1.1 An integrated human concept In the past, there were two independent concepts of the human being. On the one hand, there was the neoclassical Homo Oeconomicus who is fully informed, acts on perfect markets without institutional regulations or barriers, and who tries to maximise his utility according to the neoclassical theory without risk. Relative prices are important to indicate degrees of scarcity. The individual weighs the pros and cons, the costs, and the utility of the different options and chooses the alternative that promises the highest net utility (rational choice).10 The basis for this decision is the assumption of self-interest. This economic explanation is very general ‘due to the reference to scarce resources and competing objectives’ (Becker 1993: 2). This has been applied to sociological topics by Becker (1993), Frey (1990), Kirchg¨assner (1991), and McKenzie and Tullock (1984). On the other hand, there was Homo Sociologicus, who is restricted by norms, expectations, institutions, and the expected role-model behaviour.11 The behaviour of the individual is inﬂuenced by the expectations of society and the anticipated sanctions. These norms are internalised in the course of socialisation and affect conduct. Ultimately relevant for the latter are expectations, sanctions, and internalised expectations. Nevertheless, this theoretical approach can be integrated into rational choice theory, as norms can be regarded as preferences and restrictions.12 These two concepts can be linked. In a situation of scarcity, the individual chooses according to his preferences as not all desires can be satisﬁed. Costs and utility of the consequences of the different alternatives have to be weighed up. Then, the individual chooses the alternative with the highest expected subjective net utility, considering the subjective probabilities.13 Social psychology and sociology offer further sensible options to extending the basic model; a topic that will be elaborated on in the ensuing subsection. However, a complete analysis is not possible in this context.14 10 12 13

14

11 See also Dahrendorf (1959). See Enste (1995: 4f.). See, e.g., Opp (1986: 7f.). For an exhaustive presentation of the general theoretic foundation of the rational choice theory (RCT) and the subjective-expected-utility (SEU) theory, see Becker (1993); Esser (1990, 1991); Kirchg¨assner (1991); Lindenberg and Frey (1993); and Little (1991). For attempts at integrating psychological elements into the economic theory, see, e.g., Lewis, Webley, and Furnham (1995); Elster (1998); Lewin (1996). For examples, see Bayer and Reichl (1997); Enste (1995, 1998); Fetchenhauer (1998).

An integrated approach to explain deviant behaviour

components

(neoclassical) Homo Homo (Social-) Sociologicus Oeconomicus psychology

Resourceful

X X

Restricted

RREEMM human concept X X

Evaluating

X

X

Expecting

X

X

Maximising Man

59

X

X X

X

Figure 6.2. The integrative RREEMM human concept

The neoclassical model can be modiﬁed by incorporating ﬁndings of related disciplines on the basis of the RCT.15 The RREEMM model is a combination of Homo Oeconomicus, Homo Sociologicus, and elements of social psychology, and is based on Scottish moral philosophy.16 The crosses in the simpliﬁed Figure 6.2 signify which components have to be considered in the different disciplines.17 Sociologists stress the importance of norms and values in combination with individual expectations and evaluations of a situation, whereas neoclassical theory is based on utility maximisation with certainty, according to objective probabilities. Furthermore, one has to consider the human ability to act creatively, with innovation, and thoughtfully, i.e., ‘resourcefully’. This results in the fact that ‘deviant’ behaviour can always occur, (Esser 1991: 52). The individual can generate options and choose between these (resourceful), while at the same time being subject to restrictions (restricted). To select an alternative, he forms ‘expectations’ and ‘evaluates’ the consequences before choosing the alternative that maximises his utility. Motivations and attitudes, as well as their inﬂuences, can also be considered, summarised under the ‘Man’ component.18 This model is broad enough to be used as a foundation for socio-scientiﬁc 15 16 17

18

On RCT and subjective-expected-utility (SEU) theory, see Becker (1993); Esser (1990, 1991); Kirchg¨assner (1991); Lindenberg and Frey (1993) and Little (1991). See Esser (1991, 1999a,b). See also Esser (1991: 61f.; 1999a: 237f.), who also explains the single components in detail. The model was derived by Lindenberg (1985: 100f.) in the context of the ‘new political economics’. See Enste (1995: 15f.). Besides motivation, a decision is also strongly inﬂuenced by emotions, as, e.g., Elster (1998) stresses. To reduce the complexity, this aspect has been omitted. See also, e.g., Koch (1996), who shows a correlation with evolutionary economic policy.

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studies of human behaviour. At the same time, it is detailed enough to be applied to single areas. 6.2.2

Modiﬁcations

6.2.2.1 Satisﬁcing and bounded rationality Certain modiﬁcations, developed by Simon, have been accepted in economic theory for a long time;19 these comprise the concepts of ‘satisﬁcing’ and ‘bounded rationality’ which show a more relaxed approach than the strict neoclassical theory.20 Instead of presuming utility maximisation, it is assumed that the individual strives for a satisfactory alternative, according to his demands (satisﬁcing). Such a choice is rational when considering the information and transaction costs.21 The postulate of ‘bounded rationality’ reﬂects the limited human ability to process information.22 The individual is not able to take in all the available information, but instead concentrates on certain important problematical areas. The decision-making process can be divided into three steps: ﬁrst, the individual focuses on the most pressing problem or area of interest.23 Second, depending on the ability to solve problems and process information, the individual uses the available information for the cognition of the situation. Third, if the internal information is insufﬁcient, a rational and limited external search ensues, resulting in the evaluation of the alternatives. The selection of one alternative follows the satisﬁcing-concept, i.e., without utility maximisation. The decision process can be simpliﬁed further by scripts and schemes (standardised concepts of certain persons or facts), as well as frames (goals) and habits, which have been integrated into the RREEMM model and tested empirically by, e.g., Esser (1990, 1991), Lindenberg and Frey (1993), and Enste (1995, 1998). 6.2.2.2 Frames Frames can explain why, in a similar situation, the same individual chooses different alternatives, depending on the way the situation is presented. A dominating frame inﬂuences the evaluation process of the alternatives. These results contradict the traditional theory of decision-making and conﬁrm the inﬂuence of individual deﬁnitions of situations. As has been 19 20 21 22 23

For an application on private investment, see Enste (1995, 1998). For an extensive overview and further literature, see Becker (1993). See Esser (1990: 236). Hayek ﬁnds the limited ability to process information, i.e., his ‘sensory order’ to be an important element of human behaviour. See also Streit (1999). In psychology, the rationale behind this is known as relative deprivation. The maxim of declining marginal utility describes the effect of decreasing relative deprivation in economic terms.

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empirically tested by Kahneman and Tversky (1990), the presentation and formulation of the problem can strongly inﬂuence the deﬁnition of the situation. To make successful economic policy outcomes, it could be useful to consider the different personal characteristics of the individuals involved. Depending on the motivation and perception of the situation, the decision for or against illicit work can differ. Koch (1996) points to the importance of information selection and processing and the way in which it is conveyed and presented, especially by the mass media, which inﬂuences frames and leads to differing perceptions of the same facts.24 As a consequence, ‘the management of public opinion is an important task for economic policy’ (Koch 1996: 112). Economic topics can be enforced more easily, when presented in the media and brought forward in an understandable manner, and if the relevant effects are carefully explained. These results can be applied to the shadow economy. To achieve a different perception of, for example, tax evasion and illicit work, it could be helpful to point out to the public just how many people abide by the rules rather than those who do not. This might lead to more support for public institutions and rules.25 6.2.2.3 Habits In connection with shadow economic activity, habits can explain why reducing such activity is so difﬁcult and why it would be better for politicians to try to prevent it. The decision process is simpliﬁed by continuing with a successful alternative (habit), because it reduces cognitive effort considerably. A new alternative has to be much more attractive before it is sought after and selected. For example, if the alternative of ‘illicit work’ is not known and its utility is uncertain (e.g., due to the possibility of being detected, the amount of the ﬁne, the potential customers, etc.), the hesitation in choosing this alternative is greater. These considerations justify preventive action that will impede further expansion of the shadow economy. The difﬁculties of a reduction can be based on econometric ﬁndings and can be proven psychologically.26 The same holds for the perception of illicit work being a peccadillo. Due to this, the latter is now an alternative for the individual, as former habits are no longer viable, e.g., because of the new law concerning ‘work on the side’ in Germany.27 Even though the alternative illicit work was 24 25 26 27

For an overview on the vast ﬁeld of research on the effects of the media, see Schenk (1987). From the point of view of economic theory, the negligible number of tax evaders is surprising, as it stands in contrast to the utility theoretic result. See Section 4.3. See Spiro (1993) and, for the decision processes, Enste (1995, 1998). For similar considerations, see Frey (1990); Frey and Eichenberger (1986).

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attractive before, the individual only changes his behaviour as a result of the modiﬁcation of the institutional framework, e.g., a servant can no longer be employed ofﬁcially at low cost and without bureaucratic obligations on the part of the employer. Whereas a satisfactory alternative used to exist, and searching was unnecessary, higher costs now make other options more interesting despite possible risks and search costs. Thus, habits are a reason why illicit work has not yet spread even further. In addition, they throw light on the reasons why even marginal changes in the institutional framework lead to a considerable response, once a certain threshold is crossed.28 Habits can also help to explain the development of path dependencies and evolutionary blocks on the macro-economic level in a microeconomic context. Institutional change is blocked when individuals stick to their customs and are sceptical about structural changes and the risks that these entail.29 6.2.2.4 The man component of the RREEMM-model The aforementioned modiﬁcations are commonly cited in economics. However, there are more radical demands to extend the concept of the Homo Oeconomicus using psychological considerations, summarised here under the component ‘Man’. The majority of the extensions deal with motivational structure and its inﬂuence on behaviour. Scitovsky (1976, 1981) stresses the importance of the ‘desire for stimulation’; Hirschman (1989) investigates entrepreneurship and the desire to innovate; Frank (1988) and Elster (1998) illustrate the important signalling function of emotions, which cannot easily be imitated. Frey (1997b) demands the integration of extrinsic and intrinsic motivation into the analysis, as this can explain seemingly irrational behaviour. In certain situations, the correlation between price and quantity can be reversed, i.e., a higher price does not lead to an increased supply, as the extrinsic motivation displaces intrinsic motivation (‘crowding-out effect’). This effect, however, does not contradict economic theory; it only underlines the signiﬁcance of personal and circumstantial characteristics. We have to clarify the conditions under which the price effect inﬂuences human behaviour, and to understand why a ‘crowding-out effect’ is to be expected.30 28

29 30

The considerations to take the search for information into account can be found in institutional economics, where the topic of institutions to reduce transaction costs is a focal point. See, e.g., Richter and Furubotn (1996). See, for an evolutionary theory of the shadow economy, Enste (2002). For an attempt at integrating psychological elements into economic theory, see, e.g., Lewis, Webley, and Furnham (1995); Elster (1998); Lewin (1996). For examples, see Bayer and Reichl (1997); Enste (1995, 1998); Fetchenhauer (1998).

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One example of the ‘crowding-out effect’ in German economic policy is the case of obligatory health care insurance.31 Family members, who until now had cared for their elderly parents (or relatives) for personal reasons, now receive a payment. This is often regarded as inadequate and cannot fully replace people’s intrinsic motivation. Setting a price destroys the immaterial basis for health care. In certain cases, this results in a decrease in both intrinsic motivation and the supply. A voluntary health insurance would have given the individuals room to choose and therefore avoided the ‘crowding-out effect’. The negative consequences of unnecessary state pressure will be analysed further in Section 6.5 with the help of the control motive. 6.3

Micro-economic foundation

Despite the critique stated above, economic theory offers a solid foundation for the causal analysis, as it renders a stringent model from which conditions for an efﬁcient resource allocation can be derived. The starting point for the analysis is the neoclassical income-leisure model, which will be extended by illicit work and other inﬂuencing factors. After introducing the scientiﬁc contribution, the basic model is presented and then extended. The inﬂuence of economic causes is explained through the example of the forced reduction of working hours. Finally, certain problematic areas are elaborated upon, resulting in the extension of the model. 6.3.1

The explanatory contribution of economics

The contribution of neoclassical theory to the integrative model is easily illustrated. In principle, both the characteristics of the situation and the individual can be determined as inﬂuencing factors. According to economic theory, these can be categorised into preferences and restrictions. The preferences are taken as constant and exogenously given, so they are not considered here. The restrictions are the focal point of economic analyses, and in the current context they are deﬁned as economic causes. Homo Oeconomicus is the theoretical foundation for this analysis. He weighs costs against utility and acts rationally. Illicit work is supplied and demanded if the expected net utility is higher than when working regularly. The expected value is calculated while considering the following given characteristics (restrictions), which can be reasons for deviant behaviour:32 31 32

For similar results, see Meier (1999). See Schneider/ Enste (2000a,b) for further literature.

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The shadow economy

(Objective) situative conditions

Weighing expected costs and utility

Behaviour

Figure 6.3. Economic explanation for deviant behaviour

1. 2. 3. 4. 5. 6. 7. 8.

the possible options to act deviantly, marginal tax and social security contribution burden, regulations on the labour market (e.g., working hours), general density of regulation (on the macro-economic level), transfer payments (e.g., social security), ﬁnes, the probability of being detected and prosecuted and additional income.

Figure 6.3 depicts the economic explanation for deviant behaviour in a simpliﬁed manner. 6.3.2

Basic assumptions and aspects

The following analysis is based on micro-economic theory. Without elaborating on theoretical details, a few assumptions will be made to develop the model. These will prove to be important for the subsequent analysis. 33 Prior to a sensible model-theoretical approach to studying individual behaviour, certain assumptions have to be made regarding preferences and restrictions. Preferences are deﬁned as the disinclination towards a choice of desired objects, which satisfy individual needs more or less. As for the order of preferences, certain axioms are taken as given: 1. Completeness, i.e., all the alternatives can be made comparable, 2. Reﬂexivity, i.e., identical alternatives or combinations of alternatives have the same value, 3. Transitivity, i.e., if alternative A is better than B, and B is better than C, then A must also be superior to C. The last axiom on transitivity seems especially problematical, since one can imagine situations in which this does not hold.34 Yet, the assumption is necessary for the model. Indifference curves are employed to illustrate preferences in a diagram. They provide certain combinations of preferences (i.e., goods), 33

34

For the fundamentals of micro-economics and the income-leisure model, see also, e.g., Varian (1995: 34f.); Moritz (1993: 13f.); Petersen (1984b, 1989: 71f.); Trockel (1987: 124f.); and Riebel (1983: 33f.). For a discussion, see, e.g., Kirchg¨assner (1991).

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which are equally attractive for the individual, i.e., the individual is indifferent towards choosing a certain combination or bundle of goods. A number of postulates has to be made to further specify indifference curves: 1. Non-saturation: In the following analysis, the normal case of a conventional slope of the utility curve is assumed. This implies that either a larger amount of the good or a higher income is more desirable. 2. Decreasing marginal rate of substitution: The indifference curves must run strictly convex to their origin. This implies that the more units of an alternative an individual already owns, the less he values possessing an additional unit of that alternative. The slope of the curve in a certain point deﬁnes the marginal rate of substitution. It states how many units the individual is willing to exchange for additional units of the other alternative without leaving the path of the indifference curve. Thus, the relation between these (marginal) changes is the (marginal) rate of substitution. 3. Utility maximisation: Furthermore, the individuals are presumed to behave rationally according to the economic principle and have a desire to maximise their utility. 35 Applying this to the decision between working and leisure time indicates that the individual eventually reaches an optimal allocation of time, i.e., a utility-maximising distribution of time between the different applications, according to preferences. 36 Varian (1995: 50f.) elaborates on how far the individual preferences can be described by utility functions. With the help of the term ‘utility’, certain utility values can be assigned to the indifference curves. The further the indifference curve lies from the origin, the higher the utility will be for the individual (ordinal utility theory).37 The utility function can be employed to calculate the marginal rate of substitution (MRS) that in turn yields the slope of the indifference curve. Consequently, the MRS gives the relationship between the marginal utilities. According to the assumption of rationality, the household has the primary objective to maximise its utility under the given restrictions. These are exogenous institutional regulations restricting the freedom of action, which result from the scarcity of resources (e.g., time and income). They can vary over time, yet the individual is unable to exert any inﬂuence on them at short notice. In micro-economic theory, the budget restriction is 35 36 37

The economic principle says that the individual either strives for the largest possible success with given means, or for a given success with the least means possible. See Becker (1965). For an illustration of the differences between cardinal and ordinal utility theory see, e.g., Moritz (1993: 28f.).

if the unemployment rate is high

if labour market regulations are dense

if the probability of being detected is low

if the probability of prosecution decreases

Figure 6.4. Economic factors inﬂuencing illicit labour supply

if official work time is reduced

Labour market situation

if the tax burden increases

Tax burden

if the fines drop

Prosecution and risk

if the wage rate on the black market increases

if the official wage rate decreases

Wage rate

Economic influence factors The volume of illicit work increases

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illustrated graphically by a budget line, yielding the maximum consumption possibilities. The slope of the budget line measures the opportunity costs of choosing alternative (good) 1 by dispensing with a certain number of units of alternative (good) 2. The question here is: how many units of the latter do I have to give up in order to consume additional units of good 1? The hourly wage rate realised by the individual yields the opportunity costs of leisure time or, put in a more general way, the lost utility from the next best alternative. In economics, behavioural changes are explained by variations in the restrictions, whereas the order of preferences is taken as being constant and stable. This is necessary to avoid tautological statements. The following example illustrates this problem: the price of one good (e.g., butter) is lowered and consequently the consumption of this good rises. This rise is not explained by a sudden modiﬁcation of individual preferences (e.g., butter now tastes better), but by changing restrictions. Besides the lower price itself, the reduction in the relative prices, i.e., the good has become cheaper compared to others (e.g., margarine), has resulted in a higher demand. If one does not presuppose stability at least for certain situations, any change in behaviour can be attributed to an alteration in preferences. The theoretical models would then be very limited in their explanatory function. 6.3.3

Models of taxation and punishment

6.3.3.1 Models of time allocation In the traditional theory of labour supply, individuals can merely spend their time at work and pursue leisure activities, according to their personal preference. In these models, there is no differentiation between regular and illicit work. Becker (1965) extends the problem of efﬁcient time allocation by the problem of deciding between different occupations. Thus, time is a scarce good that has to be distributed optimally between work and leisure by the individual. The author divides work into that carried out in the ofﬁcial economy and that in the household. This is not yet a differentiation into ofﬁcial and unofﬁcial sectors. However, Becker at least distinguishes between the ofﬁcial sector and the self-sufﬁciency economy (part of the underground economy). Other adaptations of the model explicitly consider illicit labour supply. An example here is the model by de Gijsel (1984), which is based on the theory of multiple occupations. Starting from a micro-economic decision problem, de Gijsel investigates the inﬂuence of various economic factors on illicit labour supply (see Figure 6.4.). However, these hypotheses have

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not yet been proven either in theory or empirically.38 A few of the statements seem questionable. The thesis, that illicit labour supply decreases when the ofﬁcial rates of pay increase, only considers individual utility. The decline of employment on the macro-economic level due to higher wages, and the increasing demand for illicit work resulting from higher costs in the ofﬁcial economy, are ignored. Therefore, it may seem sensible to take secondary effects into account.39 In de Gijsel’s model, the increased rate of unemployment is a cause for the rise in illicit work as, in the ofﬁcial economy, a higher employment risk is positively correlated with a higher income risk. This induces the individuals to engage in shadow economic activities. If there is extensive unemployment insurance, the income risk is negligible; indeed, the inﬂuence of the rate of unemployment is negligible too.40 This supply-side reaction contradicts the demand for illicit work that arises, especially in times of full employment and production with long waiting and delivery periods. 6.3.3.2 Models of tax evasion Another way to model deviant behaviour is via the theory of tax evasion. If this theory is combined with labour supply models, the decision to evade taxes depends on whether to opt for the ofﬁcial or the unofﬁcial sector.41 In the founding approach by Allingham and Sandmo (1972), the decision to evade taxes results from the individual utility maximisation. Under the assumption of insecurity, the authors analyse the decision on which part of the income should be concealed. Those involved have to pay the highest tax rate if they declare their whole income. As an alternative, they can reveal part of their income, with the risk of possibly being detected and prosecuted. In this model, the whole income is exogenously given and the declared income is the decision variable. The individuals maximise their ‘Neumann-Morgenstern utility function’ by 38

39

40 41

The hypotheses are not proven analytically here. Numerous models exist, which, under different presumptions, come to contradictory conclusions. See Trockel (1987); Werner (1990). For an extensive overview on model variations, empirical results, and further literature, see Andreoni, Erard, and Feinstein (1998). These correlations are illustrated by Neck, Schneider, and Hofreither (1989). They stress the problems of making policy implications with these models, as one has to consider numerous restrictions when applying these models to reality. See the omnibus volume by Sch¨afer (1984); Carlberg (1984); Wiegard (1984). However, there are incentives for unemployed individuals to abuse the system, depending on the kind of transfer payments. See also, e.g., Allingham and Sandmo (1972); Andreoni, Erard, and Feinstein (1998); Mettelsiefen (1984); Petersen (1984a: 132ff.); Sandmo (1981); Shishko and Rostker (1976). In crime theory, Becker (1968) additionally considers the probability of being detected as well as the severity of the punishment.

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choosing the optimal taxable income. Allingham and Sandmo come to the – expected – conclusion that the higher the risk of being detected and the greater the punishment, the higher is the taxable part of the income. However, this model cannot clarify completely the correlation between tax rate and declared income. Andersen (1977) tries to eradicate this deﬁcit and combines the theory of tax evasion with the neoclassical theory of labour supply. The individuals maximise their Neumann-Morgenstern-utility function by selecting the taxable income and the labour supply. As the latter is variable, the total income is now determined endogenously. Anderson shows that a rise in the tax burden has a negative effect on the labour supply and the declarable income. Isachsen and Strom (1980) try to model explicitly the shadow economy by combining the theory of tax evasion with the model of time allocation. In contrast to Andersen, individuals here can divide their time between ofﬁcial and unofﬁcial work as well as leisure. Thus, these now become the decision variables. Whereas the income gained in the ofﬁcial economy is taxed directly, illicit work is not. Therefore, tax evasion results from unofﬁcial work. Isachsen and Strom conclude that a higher marginal tax rate leads to a lower supply of ofﬁcial labour. In this model, the marginal tax burden causes a rise in shadow economic activity. However, one has to differentiate between income and substitution effects of the tax burden regarding the labour supply. Nevertheless, the survey results are ambiguous. Sandmo (1981) illustrates that the results rely strongly on the model’s speciﬁcations.42 Depending on the structure of the model and its assumptions or the data, the results differ considerably. In some models, higher taxation leads to an increase in illicit work, whereas in others that consider the probability of being detected and severity of punishment, it decreases. It is assumed that higher taxation results in a higher undeclared share of income and thus a higher ﬁne. Under the assumption of risk aversion, the costs of the expected punishment outweigh the utility from illicit work, in this case. 6.3.4

The extended income-leisure model

6.3.4.1 Graphical treatment of the basic neoclassical model The individual labour supply is now analysed within the neoclassical income-leisure model in which the optimal allocation of time for each person is the given objective. The most favourable combination of income 42

See also Bos ¨ and Felderer (1989); Cowell (1989, 1990); Hackmann (1984).

70

The shadow economy Yr

I0 I1

I2

wn

N

YN

α

TF0

TAmax

TN

TFmax

TF

TA0

Figure 6.5. The basic model with optimal allocation of working and leisure time

and leisure time, when working hours are chosen independently, is used as an orientation. The reference model is illustrated in Figure 6.5.43 The individual system of preferences is illustrated by a (theoretically inﬁnite) number of indifference curves in an income-leisure diagram (Y,TF ).44 The budget line is described by wn , showing the attainable income when working and leisure time varies relative to a given wage rate. The axis intercept TF0 TFmax on the horizontal axis denotes the maximum leisure time of the individual. Working time is illustrated by the intercept on the horizontal axis in the reverse direction. The axis intercept T A0 T Amax illustrates the maximum time span during which the individual can derive an income. The indifference curves are 43

44

Shisko and Rostker (1976: 298–308) have applied this to the problem of illicit work. These considerations have been picked up by various authors, such as Isachsen and Strom (1980); Sandmo (1981); de Gijsel (1984); Lemieux, Fortin, and Fr´echette (1994), who in part have employed empirical tests to verify their models. Because of the chosen utility function, the indifference curves run convex to the origin of the graph. The further they are away from the latter, the higher is the utility.

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restricted from the right by the realisation of the maximum time budget T F0 T Fmax . At T Fmax , where the individual uses all the available time for leisure, no income is attained. The tangent of α denotes the wage rate w. The optimal allocation of time is derived in N as the tangent point of the indifference curve I1 and the budget line, since here the marginal rate of substitution between income and leisure is identical to the wage rate. This implies that in N the slope of the indifference curve equals that of the wage, i.e., budget line. Thus, the individual reaches his utility maximum in N, with an income of YN, working hours of T A0 T N and leisure time of T F0 T N. For further analysis of how the possibility of taking up illicit work inﬂuences the allocation of time, one has to consider especially that the regular income is taxed, whereas the illicit income is not declared and thus cannot be registered. 6.3.4.2 Illicit work and regulated working time In basic models, further options (overtime, illicit work) are ignored. At the starting point of these considerations are individuals who have one single occupation and who do not work in the shadow economy. Now this premise no longer holds. The individual labour supply will be analysed, allowing for the possibility of attaining a higher income by working overtime or by taking up illicit work during leisure time. Depending on individual preferences, a combination of both is also conceivable. An obvious possibility for attaining more income is working overtime. This becomes especially relevant when illicit work is not possible at all or only to a certain degree. The following additional, restrictive assumptions hold for the extended model. They will be considered critically in the context of the integrated model (see Section 6.5.2). The individual: 1. is risk-neutral towards illicit work (this implies that the illicit wage rate does not have to be higher than the ofﬁcial one), 2. does not ﬁnd illicit work morally reprehensible, 3. has freedom of choice between the alternatives work and leisure, 4. can carry out the desired occupation up to the maximum of the time T Fmax and in the ofﬁcial profession in the amount of the regular working hours, 5. wishes to maximise his utility. Furthermore it is assumed that: 1. the standard net wage wn is lower than the wage rate for illicit work ws , as ascertained empirically, 2. the illicit wage rate ws is higher than for overtime wu,

72

The shadow economy

3. the tax progression is only relevant for the income from overtime, which is taxed so heavily that the wage rate wu¨ is lower than the net wage rate for regular work, and 4. the individual earns no capital income. In Figure 6.6, one can distinguish four possible options. Under the given assumptions, the individual would always choose the alternative that lies on the highest indifference curve. Assuming that the wage rate of illicit work lies above that for regular and for overtime work, one can conclude that full-time illicit work yields the highest utility, as also stated by Isachsen and Strom (1980: 307f.). Yet all alternatives should be mentioned: 45 1. Part-time illicit work: (S) The utility maximum is S if, on the one hand, the individual has a regular occupation during T Fmax T R with the ofﬁcial wage rate (denoted by the slope of the wage line wn ) and, on the other hand, works illicitly during the time T RT S1 for the illicit wage rate (slope of the line ws1 ).46 Here, the individual realises an income of Y S. Consequently, the resulting budget line for regular and illicit work is ws1 . This multiple occupation (‘moonlighting’) is presumed throughout the following analysis, as it is especially relevant in reality.47 2. Overtime (U): Another alternative is working overtime at the corresponding wage rate (slope of the line wu¨ ). U gives the utility maximum of this occupation. The level of the income and thus the utility is lower when compared to case 1. In this situation, the resulting budget line for regular work and overtime is denoted wu¨ . The kinked course results from the progressive taxation on overtime income. 3. Ofﬁcial occupation, overtime, and illicit work (K): This is a combination of cases 1 and 2. The individual attends to his legitimate job during regular working hours, submits T RTU¨ –units of overtime for the corresponding wage rate (slope of the wu¨ ) and, in addition, offers illicit labour to the wage rate of the latter (slope of the ws 0 ). Here, the income Y K lies between scenarios one (Y S) and two (YU ). The ensuing budget constraint is denoted by ws 0 .48 4. Full-time illicit work (V): The ﬁnal and optimal option, according to the given assumptions about the individual preferences, is to offer 45 46 47

48

On the critique, see de Gijsel (1984: 93ff.); for an explanation, see Shishko and Rostker (1976: 299); and for the diagram, see Trockel (1987: 126ff.). The slope of the illicit wage line, and hence the illicit wage rate, stays constant; the terms ws0, ws1, and ws2 only point to the different possible combinations. With the exception of de Gijsel (1984), who prefers his more general model of multiple occupation, Shishko and Rostker (1976); Alden (1980); Riebel (1983, 1984); Trockel (1987); and Werner (1990) look at the part-time illicit worker, who dominates in reality. See Alden (1980).

An integrated approach to explain deviant behaviour

73

Yr ws2

I4

I3

ws1

TR ws0 YV YS

wn I1

YK YU

I2

V S K

w

U

YR

TF0

R

TS = K

TV T

TR

TFmax

TF

Figure 6.6. Overtime, illicit work, and regular working hours

exclusively illicit labour at the corresponding wage. Here, regular working hours are ignored. In this scenario, the individual is no moonlighter but instead practises a so-called ‘sole job’. The resulting utility maximum is V and the income is YV , when the time represented by the axis intercept T Fmax TV is worked illicitly. This subsection can provide a general overview on the alternative for the individual. The complete renunciation of an ofﬁcial occupation is highly unlikely for several reasons. First, complementarities may exist between the two activities, e.g., the car mechanic uses the garage /tools of his employer on the weekends for illicit work. Furthermore, illicit work provides no security with regard to income or social insurance. And ﬁnally, no social network exists. Therefore, the focus of the analysis is on the ‘moonlighter’, who is a part-time illicit worker. 6.3.4.3 Effects of a reduction in working hours Varying the factors that inﬂuence the labour supply is particularly interesting, when examining the causes for illicit work. As shown in the preceding chapter, the different options (overtime, illicit work) of an employee can be presented graphically, when regular working hours are introduced. In the following section, we see the causes and effects of

74

The shadow economy Yr

I2 ws3

I3

ws2

I1

TR40

TR35

Q

YQ P

YP wn = ws1

N

YN

R TF0

TP TQ

TN

TR40

TR35

TFmax

TF

Figure 6.7. Reduction of working hours and illicit work

reducing the weekly working time (as opposed to the daily work time presumed hitherto) on the individual supply of part-time illicit work. The income-leisure model can be used for the analysis. It is assumed that the illicit worker complies with the legal regulations concerning working time for reasons such as social security or lacking opportunities for part-time work. This implies that he is not a full-time illicit worker (which, as illustrated in Figure 6.6, would yield the highest utility on account of the given preferences). Figure 6.7 illustrates the labour supply of one who prefers income when working hours are reduced continuously without a wage compensation. The working time constraint T R40 is lowered further by a standard wage agreement or legal regulations from 40 hours weekly to 35. The effects can be demonstrated by shifting the time constraint T R40 to T R35 . The assumption that the wage rate for illicit work is higher than the ofﬁcial net wage still holds. This yields the following result, which is analytically derived by Riebel (1984: 525f.). The reduction of working hours implies an increase in the utility of the illicit worker under the presumption that he has no moral doubts about engaging in the latter. He can realise Q on indifference curve I3 instead of P. Owing to the higher illicit work rate, (slope of the line ws 3 ), he obtains a higher income by increasingly working

An integrated approach to explain deviant behaviour

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in the shadow economy. Nevertheless, this result also implies growing incentives to engage in the shadow economy via an (involuntary) expansion of individual leisure time. In addition, one can read from the graph that when the wage rates in the unofﬁcial (ws1 ) and the ofﬁcial sector (wn ) are identical, this does not result in changing utility levels as regards total income or working time. Again, N is reached on indifference curve I1 . Yet, the distribution of working hours shifts towards illicit work. The ofﬁcial working hours are now denoted by the axis intercept T Fmax – T R35 and activities in the shadow economy take up the time T R35 T N. In this case, the shadow economy also grows, due to the reduction in working hours. 6.3.5

Limitations of the income-leisure model

As has already been illustrated above, development and empirical testing of a model for tax evasion is problematic. Despite the speciﬁcation with restrictive assumptions, the results are rarely clear. As both the income and the substitution effect of income taxation have contrary consequences on the labour supply, one cannot come to a ﬁnal conclusion. When considering the possibility of engaging in shadow economic activities, one may react to taxation even more strongly than in the basic model. Losses are overcome, as income can be gained in the shadow economy (illicit work) or costs saved (self-sufﬁcient sector). The dimension of the respective effects is investigated in empirical surveys. However, these are often contradictory, and this does not render satisfactory results. The empirical results concerning the inﬂuence of the probability of being detected and the severity of punishment are similarly ambiguous. Neoclassical theory by itself cannot explain why tax compliance is so large. The objective probability of being detected and the risk of being prosecuted are very low, relative to the possible utility from tax evasion. Taking a rational decision process as well as economic causes into account, one cannot explain why this deviant behaviour is so rare. Only when assuming extreme risk aversion, which cannot be proven empirically, can one see that this behaviour would be rational. Furthermore, the explained variance of the behaviour of illicit workers is negligible when economic factors are considered on their own. For example, this has been illustrated by Weck, Pommerehne, and Frey (1984). A multitude of reasons is responsible for deviant behaviour and illicit work so the analysis has to be extended. It seems sensible to consider sociological, as well as socio- and ﬁnance psychological factors.49 49

This was ﬁrst pointed out by Schmolders ¨ (1951, 1960, 1975, 1980).

76

The shadow economy

Social expectations Sanctions of society

Internalised norms (personal characteristics)

External norms (situative characteristics)

Behaviour

Demographic data and personal situation (general personal characteristics)

Figure 6.8. Sociological explanation based on Homo Sociologicus

6.4

Institutional and sociological aspects

6.4.1

The sociological explanatory contribution

The concept of Homo Sociologicus provides one approach to explain human behaviour. Man is seen to be restricted by social norms and expectations as well as sanctions that he internalises. Sociologists often try to explain human behaviour with the help of demographic data and personal situations. However, they tend to neglect the underlying personal characteristics that are examined in psychology. Figure 6.8 shows how the sociological approach can be illustrated in a simpliﬁed manner.50 Examples of external norms (established characteristics) include informal institutions (customs, habits, and values). They can be perceived as restrictions. Hence, offences against these can be deﬁned as costs, which are part of the decision process. Internalised norms, e.g., conscience, (tax) morals, and religion are preferences (personal characteristics). This interpretation combines the economic and sociological approaches.51 6.4.2

Descriptive variables, demography, and changing values

The sociological variables illustrated in Figure 6.9 contribute to the analysis of the behaviour of illicit workers.52 As other empirical surveys prove, the socio-demographic variables (e.g., age, network) have an indirect inﬂuence on the individual decision process.53 They can act as indicators for individual values and attitudes which, themselves, can hardly be tested. 50 52

53

51 See, e.g., Myles and Naylor (1995). See Opp (1986). Due to the close relation between micro-sociology and socio-, i.e., ﬁnance psychology, socio-psychological factors could also be mentioned in the current context. See, e.g., Merz (1997); Niessen and Ollmann (1987); Schwarze (1990); Wolff (1991: 78ff.); Lamnek, Olbrich, and Sch¨afer (2000); Lamnek and Luedtke (1999). See, e.g., Jessen et al. (1988); Evers (1987); Offe and Heinz (1992).

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Illicit workers can be characterised by speciﬁc (descriptive) criteria (e.g., age, occupation, number of children), which can be employed to deﬁne types. These can be divided according to their motivation to engage in shadow economic activities. If there are groups with a certain afﬁnity towards illicit work, one can ﬁnd superior methods of restricting incentives to take up this type of occupation. Besides the individual attitudes, the structure of opportunities is an important factor inﬂuencing the supply and demand of illicit work. Some areas are especially prone to the latter, e.g., building, retail, hotels, and restaurants. This illustrates that the branch or industry is relevant when investigating this phenomenon. The model also differentiates between personal and given social characteristics. Examples of the latter include the rate of debt and the living situation. Individuals owning real estate have a higher demand for illicit work, as their ﬁnancial situation is less relaxed.54 The subjective conditions for illicit work, such as ability, knowledge, and social network also have to be considered.55 Besides qualiﬁcation, real capital, i.e., the availability of machines and premises, is vital for illicit labour supply. In sociology, the inﬂuence of the shift in standards and the erosion of norms on the shadow economy is discussed controversially. Here, there is no consensus regarding the shift in standards, although it is agreed that the shadow economy is expanding. For some, it is a form of alternative economy, which expands due to the reﬂection on old standards (postmaterial standards) and renunciation of the ‘taylorised working world’, i.e., a too specialised economy.56 Others assume an increased individualisation and ﬁxation on material standards. Instead of maximising leisure time, income maximisation is sought and working (illicitly) becomes increasingly important to obtain additional income. Only differentiated analyses, which consider diverse demographic groups of various ages, can explain the numerous directions of inﬂuence as well as the contradicting assertions about the shift in standards.57 In a current experimental survey, Alm, McClelland, and Schulze (1989, 1999) show the importance of social norms with regard to tax honesty. However, this can only be grasped on a micro-economic level. Restricting the analysis to the macro-economic level does not sufﬁce, as it merely 54 55 56 57

For a theoretic sociological foundation, which stands in close relation to the economic analysis of the restrictions, see Cloward and Ohlin (1960). For an overview on sociological causes, see Portes and Sassen-Koob (1987). See Wiswede (1995: 192ff.). For an elaborate description of the discussion of the shift in standards, see, e.g., Beck (1986); Inglehart (1990; 1997); Klages (1993); Klages, Hippler, and Herbert (1991).

Figure 6.9. Sociological and institutional determinants

Degree of urbanity

Living situation

Education/occupation

Personal real estate

Political system

Social network

Marital status

Income

Human and real capital

Debit situation

Sex

Economic system

Societal values and norms

Institutional framework

Family/size of household

Personal situation

Age

Demographic data

Sociological and institutional determinants

An integrated approach to explain deviant behaviour

79

considers norms and sanctions. The authors rightly demand an integrated approach on the basis of the RREEMM-model, which not only considers the basic (economic) assumption of self-interest but also social norms and standards.58 In short, individual behaviour is likely to be motivated by a variety of factors, including adherence to a social norm and individual optimisation, and these factors need to be considered in explaining behaviour. (Alm, McClelland, and Schulze 1999: 165)

6.4.3

Institutions and restrictions

Both the framework (e.g., the economic and the political system) and restrictions inﬂuence formal and informal economic activities. Conﬁdence in the government, political parties, and the representation of individual interests depend strongly on this framework. How the economic system affects the shadow economy cannot be discussed further in this book, even though this is an interesting subject, especially in the context of transformation in Eastern Europe.59 The inﬂuence of the political system will play an important role in the discussion of the voice option.60 The relevance of a liberal market economy and the possibilities to correct formal institutions are the focal point of the causal analysis which follows. 6.4.4

Some empirical investigation on social deviance in Germany

The inﬂuence of theoretically derived variables is examined empirically in social sciences with direct polls and multivariate data analysis methods. The polls on deviant behaviour are very problematical, due to the common tendency towards secrecy. Hence, the following data have to be treated with care and seen merely as an attempt to illustrate the rising acceptance of illicit work. One major problem is deﬁning the term ‘shadow economy’. Differing deﬁnitions lead to further divergences in surveys.61 6.4.4.1 Attitudes towards illicit work, tax evasion, and social security fraud in Germany In a representative survey in 1998, 22% of the interviewed persons (with 16% male) admitted to working illicitly to a considerable extent (for more 58 59 60 61

See also Alm (1996). See Cassel (1986); de Gijsel and Seifert-Vogt (1984); and Feige (1989), who illustrate the relation between shadow economic activity, economic systems, and the political system. See Neck, Schneider, and Hofreither (1989); Schneider (1998a); Pommerehne and Kirchg¨assner (1994). As, e.g., Lamnek, Olbrich, and Sch¨afer (2000: 25).

% of people polled

0

10

20

30

40

50

60

5

17.5

Social security fraud

All people

Tax evasion

13.2

‘Good’ people

Demand for illicit work

15.3

36.9

2.5

12.7

Abuse of social welfare

Figure 6.10. Willingness to work illicitly, evade taxes, and abuse the system

Illicit work

16

47.4

53.9

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81

than 3,600 euros per year). 60% demanded illicit work. As a relatively reliable result, it can be said that 50% of the population were willing to engage in shadow economic activities.62 The reasons for demanding illicit work are manifold.63 More than 90% of the individuals questioned stated the lower costs. 70% voiced a certain dissatisfaction with the government, especially the high tax burden. 60% admitted that illicit work was easily obtained due to the active supply by ﬁrms. Other important arguments for the demand for illicit work are greater ﬂexibility and the high quality of the goods and services (stated by 28% of the population). The price is usually only a third or even a quarter of the ofﬁcial price, whereas the quality is often regarded as equal.64 Figure 6.10 shows that illicit work is the most common form of deviant behaviour. It displays the inﬂuence of social norms and morality on attitudes towards deviant behaviour. One side depicts the norm-conforming individuals (well-behaved) and the other shows the total number of polled persons. The well-behaved are those who do not have to admit to having abused social security or unemployment and other insurances, to having evaded taxes or having worked illicitly, or stolen goods from work, etc. This group comprises more than a third of the population. The great differences between these two groups can be seen in this ﬁgure. In principle, if the car repair shop asks: ‘Do you require an invoice?’, more than half the people asked would not expect one, and would thus save at least the value-added tax. More than half would at least think about hiring an illicit worker to renovate their house. However, of the ‘well-behaved’ group, less than 16% would demand illicit work, whereas 47% of the total survey would be willing to do so. The actual demand or supply of illicit work requires the opportunity. Therefore, it should be interesting to investigate those who actually become active. According to the ‘Focus Poll’ and the survey of 2,700 persons by Lamnek, Olbrich, and Sch¨afer (2000), 25% admitted to having already worked illicitly. Compared to this, the considerably lower demand of 24% (in the ‘Focus Poll’ it was 60%) is rather questionable, as the authors themselves admit.65 It seems plausible that more individuals have the opportunity to demand illicit work than to supply it. The latter are prone to numerous restrictions, such as the industry, the qualiﬁcations, and the skills required. 62 63 64 65

See also Schneider and Enste (2000a) and the poll of ‘Focus Magazine’. For results in Canada, see Flexman (1997). Multiple entries were possible. For respective surveys, see Schneider and Enste (2000a). See Lamnek, Olbrich, and Sch¨afer (2000: 143). They state ambiguities of the questionnaire, interview effects, and the tendency for socially desired answers as reasons for the results.

82

The shadow economy

The widespread acceptance of illicit work is also evident when examining the efforts made to counter deviant behaviour.66 Lamnek, Olbrich, and Sch¨afer come to the conclusion that willingness to counteract the shadow economic activities of a friend is non-evident for 40% of the population. A further 40% would at least request the friend to stop. Readiness to actually sanction such behaviour is very low (7.6%). 6.4.4.2 Personal characteristics and sociological factors The following sociological factors are apt to describe and categorise illicit workers. A few of these are integrated into the model, as they complete the economic explanation. Shift in values. The evaluation of the demographic data shows that younger persons are more willing to supply and demand illicit labour. However, it is questionable as to whether the shift in values and individualisation result in increased deviance.67 One can only say that, in general, older individuals tend to adhere more strongly to norms and values.68 Therefore, this aspect is neglected when investigating the development of the shadow economy. However, the changing individual norms and their inﬂuence on cultural evolution are analysed. Sex, education, occupation. Whereas males tend to work illicitly more often than females (64% compared to 36%), the latter have a higher demand (54% compared to 46%). The reasons for this are industry and labour-market speciﬁc, as well as the family situation and the different abilities of females and males.69 School education has no inﬂuence on the supply or demand of illicit work. Regarding vocational training, an apprenticeship is the highest qualiﬁcation stated by 60% of the illicit workers. The concentration of illicit work in the manual trade sector is unusually high for both sexes. The intensive demand for illicit work can be explained by the close social network that simpliﬁes the exchange of these services. Furthermore, part-time illicit work is immensely popular and the opportunity to take up such an activity depends strongly on the individual’s occupation and qualiﬁcation (‘moonlighting’).70 Only 6% of illicit workers are unemployed; pensioners make up 20%. Hence, their share of illicit work is similar to their share in the ofﬁcial economy. Unemployed individuals not only lack the qualiﬁcations but also the social network.71 66 67 69 70 71

For the data see Schneider and Enste (2000a: 50). 68 See Section 6.4.2. See Lamnek, Olbrich, and Sch¨afer (2000: 165). See Lamnek, Olbrich, and Sch¨afer (2000: 177). See Niessen and Ollmann (1987: 176). See, e.g., Glatzer and Berger-Schmitt (1986); Gross and Friedrich (1988).

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83

The structure of opportunities and the given social characteristics determine considerably whether or not deviant behaviour is demonstrated. The integrative approach has to analyse this. Income and real estate. The inﬂuence of income is analysed frequently. Illicit work is supplied and demanded by all classes. There is no correlation between the latter and deviant behaviour. Merton’s (1968) hypothesis, that it is especially common among the lower income classes, does not hold. A rise in income and utility maximisation are much more important reasons for illicit work. The effect of one’s living situation has been insufﬁciently tested by Lamnek, Olbrich, and Sch¨afer (2000), so that no satisfactory predictions can be made. Other studies show that owning real estate and a low degree of urbanisation lead to an increase in illicit work. This can be explained by extensive opportunities and a tighter social network.72 General willingness to act and inﬂuence of personal circumstances. Accepting social norms by individuals depends heavily on the perception of whether these are common or whether there is a general willingness to engage in shadow economic activities. Lamnek, Olbrich, and Sch¨afer (2000) prove a high positive correlation (r = 0.29 to r = 0.39) between the overall and the individual willingness to demand or supply illicit work. These results conﬁrm the inﬂuence of norms and expectations. Deviant behaviour is imitated, and possibly becomes the norm. The general motivation can also be integrated into multiple regression equations to explain social deviance. The activities, which are perceived as peccadillos, like part-time illicit work, can best be explained by the general motivation to act (21% as regards supply and 23% concerning demand) as well as by the individuals’ circumstances (15% for supply and 19% for demand). The more intensive the contact is with like-minded individuals, the easier it is to justify personal willingness to engage in shadow economy activities. Accordingly, less weight will be attached to the costs resulting from breaking ofﬁcial rules.73 The process of institutional change is fuelled by such mechanisms and will continue, as long as the existing institutions are not more readily accepted. These concepts are promising in the long run as, only then, can the free-rider problem of public goods be overcome. Those who do not evade taxes or work illicitly feel exploited to a certain extent. Solidarity becomes more costly, so that new methods are tested. A greater severity of ﬁnes and increased controls, however, will not be successful. Lamnek, Olbrich, 72 73

See Jessen et al. (1988); Evers (1987); and Offe and Heinz (1992). See the ‘theory of social comparison’ by Festinger (1954); for more current developments, see Frey et al. (1993).

84

The shadow economy

and Sch¨afer (2000: 338) conclude that to merely intensify regulations will not be enough to stop the trend of ‘disappearing loyalty towards the state and society, which also comprises a decreasing acceptance of government regulations’. The personally perceived risk of being prosecuted contributes to the explanation of this variable with a mere 5% (supply), i.e., 8% (demand). 6.5

Explanatory approaches in socio- and economic psychology

When explaining human behaviour, economists concentrate on analysing and altering restrictions and maybe integrating the institutional framework. Psychologists, on the other hand, focus on preferences and motivation, which are taken as constant by the former. Combining these two aspects gives an holistic picture of human behaviour.74 Socio-psychological factors are integrated into economic theory by psychologists in particular. In the face of numerous, and in parts contradictory, theories, the commonly accepted and uniform economic ‘utility theory’ provides an attractive basis, which can be extended by certain psychological ﬁndings without making it too complicated. However, other economists, such as Frank (1988) and Frey (1990, 1997b), are willing to counteract the trend towards formal analysis and formulate the economic model so as to reach a higher degree of generality of its conclusions. 6.5.1

The explanatory contribution of socio- and economic psychology

‘Reactance theory’ in particular, analyses the inﬂuence of personal characteristics on deviant behaviour. The motivational structure (e.g., the control motive, involvement, intrinsic motivation), as well as the basic orientations (e.g., risk preference, tax moral) are particularly interesting in the analysis of the behaviour of illicit workers. Depending on personal characteristics, the perception of the situation varies, as well as the evaluation and selection of an alternative. The established, social characteristics only have an indirect inﬂuence, as they are interpreted individually by the individual.75 Figure 6.11 summarises these considerations. Behaviour is not directly determined by objective restrictions. The factors are ﬁltered by the subjective deﬁnition of the situation and evaluated 74 75

We cannot elaborate on the single surveys and experiments which conﬁrm this. For an overview, see Bayer and Reichl (1997); Elster (1998); Fetchenhauer (1998). The economic explanatory contribution concentrates on the examination of the situative characteristics, whereas socio-psychology analyses the personal characteristics and the subjective perception of the situation, while ignoring the former. Since they are integrated in ﬁnance psychology, they are still relevant.

An integrated approach to explain deviant behaviour Situative characteristics

Personal characteristics • Motivation • Basic orientation

Subjective definition of the situation • Weighing moral inhibitions and utility • Perception of burden • Restriction of freedom

85

Behaviour

Figure 6.11. Economic and socio-psychological explanation of deviant behaviour

individually, depending on the latter. For example, this deﬁnition is inﬂuenced by the basic orientation or a guiding motive and distorted in parts by the simpliﬁed perception. The decision process itself can entail either a long search process, being extremely short or habitual.76 It consists of weighing costs (which include moral inhibitions) against utility. The individual utility-maximising alternative is chosen under consideration of the information costs and bounded rationality. This decision can be distorted by various factors. The behaviour of illicit workers is heavily inﬂuenced by the individual perception of restricted personal freedom or individual burden. The latter, affected by the duration and weight of the burden as well as by the possibilities of evasion, can be explained by reactance theory. The perception of a burden is determined by comparing one’s individual situation with that of others. Further inﬂuences are the perceived ‘fairness’ of the taxation system and contact with ﬁnancial institutions, as well as tax morality.

6.5.2

Control and reactance theory

To analyse the shadow economy from a socio-psychological point of view, it seems appropriate to introduce the control motive into the analysis. In particular, reactance theory can give supplementary explanatory approaches. This is a special form of control theory, i.e., the theory of an imminent or occurred loss of control. 6.5.2.1 Control theory Strictly speaking, control is deﬁned as the subjective perception of the possibility of inﬂuencing certain events or conditions by an action. In a 76

A detailed analysis of the decision process can be found in Enste (1995: 81f.).

86

The shadow economy

broader sense, control is the conviction of a person to be able to exert cognitive domination. In this context, Thompson (1981) differentiates four types of cognitive control: 1. Behavioural Control: subjective perception that an event or condition can be inﬂuenced by changes in behaviour: e.g., reducing the tax burden by tax evasion (exit-option) or the possibility to participate in the decision process (voice-option).77 2. Information Control: the person has access at least to information on a future/expected event: e.g., by long-term announcements in the context of medium-term ﬁscal planning or by transitional regulations, which guarantee the safety of planning. 3. Cognitive Control: the individual has cognitive strategies to reinterpret the result: e.g., the reduced attraction of a possibility that can no longer be chosen. 4. Retrospective Control: this is the option to determine the causes of an event, ex post facto, to help the explanation of that event. The efﬁciency of control decreases from scenario one to four. Therefore, the perception of being in a dominant position is higher with behavioural control than in the more defensive strategy of retrospective control. This implies a very broad deﬁnition of the term ‘control’ that not only includes the possibility of exerting inﬂuence but also taking cognitive action. The basic statements of this theory can be summarised as follows: 1. Individuals wish to control certain conditions, events, and actions.78 2. Thus, the perception of a loss of control can either be interpreted as an impaired perception/experience or behaviour, or as a punishment (aversive stimulus). In perceiving control possibilities, the individual can eliminate or, at least, reduce this stress, i.e., the stimulus. 3. The form of reaction (e.g., passivity/activity, intensity, stability, and generality) varies, depending upon the subjective importance of the event, the perception of the probability of the loss of control, and the individual analysis of the causes. In its various facets (e.g., concerning the attribution of control or the loss of control to a person or a situation), control theory has been successfully applied to economic behaviour.79 Yet, reactance theory is able to examine illicit work or tax evasion. 77 78

79

Decision control can be included here, i.e., the choice between two or more alternatives, implying individual freedom of choice. Wiswede (1995) points to the fact that this assumption can be interpreted both in the context of motivational theory and of adaption theory, a fact which underlines the broad applicability of the theory. See Wiswede (1995: 89f.).

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87

6.5.2.2 Reactance theory and the shadow economy Brehm (1966, 1972) has developed the reactance theory as a theory of an imminent or occurred loss of control.80 The following deﬁnition can be derived from the general considerations on control theory: A loss of control exists if a person can exert no control at all (i.e. the event can neither be inﬂuenced nor predicted nor explained nor cognitively controlled) or when in the opinion of the person it does not have the appropriate extent. (Frey, Osnabrugge, ¨ and Stahlberg 1985: 129.)

The main aspects of the theory can be summed up as follows: 1. Individuals have the freedom to carry out certain actions and are motivated to do this. 2. As assumed in control theory, when the individual perceives his freedom of action or of choice to be impaired by external inﬂuences, he responds with a psychological/cognitive reaction. 3. Reactance is a motivational condition of tension, in which the individual wants to avoid being impaired in his actions and wants to regain his original freedom. 4. The intensity of reactance depends on (1) the importance of the impaired freedom for the individual, (2) the extent of the threatened freedom, and (3) the force of the reduction of freedom. Here, the degree of severity, the expected duration and the tendencies towards generality of the loss of control all need to be considered. 5. The restriction of the freedom of choice has to be seen as not being legitimate, i.e., ‘the existence of social norms can prevent reactance’ (Wiswede 1995: 91). 6. The reactions are either aimed at a direct or indirect or implicit restoration of freedom (e.g., by engaging in the activity in a different area) or at resisting external control. This can be done by cognitive strategies (e.g., social comparisons, social norms) or behavioural strategies (e.g., aggression, tax evasion and avoidance, declaration of solidarity). Since they have the reputation of being ‘anti-social’, ‘public’ reactions are generally not accepted, (Dickenberger, Gniech, and Grabitz 1993: 247). Cognitive strategies or ‘secret’ ones are the rule. Concerning ‘slight’ illicit work and tax evasion, this behaviour is no longer sanctioned in public, whereby the whole range of reactance effects is displayed. The determining components of reactance theory have been examined in numerous experiments and areas.81 Nevertheless, the application 80 81

Dickenberger, Gniech, and Grabitz (1993: 243–73) give an overview on the different modiﬁcations and speciﬁcations of the theory. See Herkner (1991: 99ff.).

88

The shadow economy

of this to the analysis of tax resistance, for instance, may be sensible in Wiswede’s (1995: 91) opinion, but it has not yet been done. Current interpretations of the theory point out that reactance can only be expected if the reduction of freedom is regarded as being variable, i.e., the socalled ‘Canadian tax rule’ that ‘old taxes are good taxes’ can be based on reactance theory.82 The tendency to generalise leads to the individual perception that other, originally unimpaired areas are being harmed. This is possibly one cause for the increasing vexation of the public in their concern over governmental actions and taxation. This also applies especially to social contributions that originally have not been understood as forced payments (taxes) but rather as a contribution (e.g., to the pension system). The increasing public use of resources is seen as an illegitimate restriction of freedom that is opposed in almost every area (cognitive, concealed, and open) to decrease the motivational condition of tension. The increasing shadow economy is possibly a further step in the process of responding to the loss of control via too high taxation and too extensive public regulations. Reactance theory can easily be integrated into economic utility theory, e.g., via the problem of scarcity. In the context of reactance, this central theoretical element can threaten freedom of choice. Hence, reactance inﬂuences motivation regarding the attractiveness of the relatively scarce alternative. A little more light can be brought into the ‘black box’ between an effect and its causes, which can be analysed in a more differentiated manner. The inﬂuencing factors, examined in the control or reactance theory, are, among others: 1. the anticipated duration of the tax burden (e.g., the introduction of a temporary tax),83 2. the existing possibilities of tax evasion (e.g., illegally transferring investments, loop-holes in taxation, illicit work), 3. the perceptibility of the tax burden (e.g., direct vs. indirect taxation), and 4. the generalisation of the loss of control if there is a lack of possibilities to take inﬂuence. This can e.g. be counter-acted with direct-democratic elements.84 To reduce reactance, the individual can actively take part in the constitution of the political will. If the impairing institution (the state) does not relax the restriction, the person can independently restore his liberty of 82 83

84

See Pelzmann (1985: 45). When the surtax of solidarity was introduced in Germany, an attempt was made to weaken the reactance by: 1). the time-limit, 2). the term ‘solidarity’, as well as 3). servicableness. For this argument, see also Petersen (1984a: 141), who does not make this theoretical reference. See also Chapter 9.

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action by, for example, engaging in shadow economic activities in accordance with the motto: ‘What tax avoidance or evasion is to the wealthy and self-employed, illicit work or extended neighbourly help is to employed individuals.’ Control-theoretic considerations are important to analyse tax reform recommendations (e.g., reducing tax rates and simultaneously broadening the tax base and cutting tax abatements). Simplifying the tax system and making it more transparent, which is desirable from the point of view of economic order and systematic taxation, can lead to an increase in reactance. The lack of an opportunity to inﬂuence the tax burden by one’s own activities, as well as the increased transparency, causes a stronger perception of the burden and diminishing perception of control. Thereby, the positive effect triggered by reducing the tax rates – the reduction of incentives to work illicitly – is weakened. The burden becomes obvious and thus reactance increases. An empirical study on the Austrian shadow economy by Schneider proves this effect.85 The growing simpliﬁcation of the taxation system implies an increasing reactance and thus the perception of the burden (personal awareness of the burden) becomes an important reason to work illicitly. In the context of economic order and the Theory of Evolutionary Taxation, the enhanced transparency can be judged positively as the sovereignty of the voter is strengthened. He is no longer deceived about the extent of the governmental share. The government can be controlled more efﬁciently. The components mentioned above are all discussed in the context of ‘economic psychology’, where connections between economic theory and psychological concepts are sought.86 Investigating taxation and its effects in the context of tax psychology has a long tradition in interdisciplinary research. 6.5.3

Economic psychology

“Taxation” psychology has been rediscovered as a ﬁeld of research within the framework of Anglo-Saxon ‘economic psychology’. Schmolders ¨ (1975) founded this branch as the ‘Cologne School of Fiscal Psychology’. He tried very early to connect public ﬁnance and socio- and economicpsychological research, with a view to avoiding a divergence of the two directions.87 To explain tax compliance and tax evasion, he examined the perception of burden and tax morality, in particular. 85 86 87

See Section 7.5.2. See the Journal of Economic Psychology, e.g., the special edition on taxation psychology ( Journal of Economic Psychology, 1992). See Smekal and Theurl (1994) for a survey.

90

The shadow economy

Tax mentality and tax morality

Weight of burden

Perception of burden

• • • • • •

Distribution of the tax burden Transfer payments Efficiency of state activity Contact with financial institutions Perceptibility Durability

Tax evasion

Illicit work

Figure 6.12. Correlation between weight of tax burden, perception of tax burden, and tax evasion, and their determinants

These are intervening variables, i.e., they inﬂuence behaviour but cannot be directly perceived by researchers. Tax morality is important, as it has helped to give a proper explanation of tax evasion in various surveys.88 These approaches will now be applied to illicit work. When explaining human behaviour, subjective expectations and evaluations are of the utmost importance. The latter can be found in considerations regarding the ‘subjective perception of burden’. Generally, taxes are perceived as coercive rather than contributive, as contributions are seen to bring future compensation.89 According to control and reactance theory, this results in conﬂict. The extent of the burden, which will be analysed further in the context of the economic causes, determines the subjective perception of burden and thus tax evasion.90 The following factors inﬂuence the personal perception of burden: 1. Distribution of the tax burden and transfer payments: The amount of the personal burden relative to that of others, and in comparison with one’s 88 89

90

E.g., by polls or experiments; see Fetchenhauer (1998). One has to consider that by now an increasing opposition against contribution, e.g., pension system, can be detected, as the equivalency of payment and pay-back is no longer perceived. This conﬁrms the necessity to reform social security systems. See Mackscheidt (1993, 1994); Pelzmann (1985); and Wiswede (1995: 166).

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personal situation before and after the change, has a strong inﬂuence, as does the perceived distributive equality of the taxation system. A further component is the perceived balance of public expenditure and transfer payments, which is usually distorted.91 These inﬂuences can be examined further by applying the ‘theory of social comparison’ by Festinger (1954).92 Depending on the comparisons between persons or situations, a certain tax burden is perceived differently. This becomes problematical if all groups in society feel exploited, when comparing themselves to others, as it can lead to increased deviance. Regarding the interaction between the state and taxpayers, the ‘exchange theory’ by Thibaut and Kelley (1959) offers further interesting approaches, e.g., for increasing dissatisfaction with the taxation system. Economic internationalisation offers new and fresh possibilities that are more attractive than the status quo. Depending on the level of tax demands, this can result in vexation and/or an unstable situation that again results in increased shadow economic activity or emigration. Psychology conﬁrms the economic considerations regarding the exit option. 2. Efﬁciency of governmental activity and contact with ﬁnancial institutions: In polls, the efﬁcient or inefﬁcient use and administration of the Inland Revenue is important with reference to tax honesty. Here, one can differentiate speciﬁc equality of distribution and public expenditure in general, within the group. The former is usually perceived as distorted, and the perception of being exploited is common.93 Furthermore, contact with ﬁnancial and other public institutions plays a role, as this inﬂuences the individual’s view of the government.94 3. ‘Perceptibility’ and durability: These two factors, examined in the context of reactance theory, are also considered.95 Tax mentality and morality often function as intervening variables which inﬂuence the ‘response’ (e.g., tax avoidance, tax evasion, tax ﬂight). Schmolders ¨ (1960: 69f.) deﬁnes tax mentality as the basic attitude towards the taxation system, equality and honesty, etc. Tax morality directly inﬂuences tax evasion. It is also responsible for the rise of the shadow economy.96 Thus, from the point of view of ﬁnancial psychology, it is not the objective variables themselves (such as the rate of public expenditure, tax burden, probability of being detected and density of regulation) that induce 91 92 94 96

See Schmolders ¨ (1960: 61f.); Schmolders ¨ and Strumpel ¨ (1968); Veit (1927). 93 Bayer and Reichl (1997: 90f.). For current developments, see Frey et al. (1993). 95 See Schmolders See Mackscheidt (1994: 55f.). ¨ (1960: 81f.). See Schneider and Enste (2000a: 151).

Control and reactance

(Tax-)mentality

Figure 6.13. A few psychological causes

Group specific application

General application of the tax yield

Perceived efficiency of state activity

Contact to the administration

Influence possibilities

Possibilities to evade

(Expected) duration of burden

Perceptibility of burden

Basic orientation (risk preference)

(Tax-)moral

Distribution of burden/transfers

Personal motivation (involvement)

Social psychology

Feeling of burden

Economic psychology

Psychological determinats

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an increase in shadow economic activity, but the subjective perception and evaluation of this. On the macro-level, one can now attempt to analyse economic correlations, whereas the micro-foundation considers the subjective expectations, attitudes, and motivations, such as tax morality and control motive. 6.5.4

Empirical results on socio- and ﬁnance psychological factors

Figure 6.13 sums up the aforementioned psychological causes, which have been measured in questionnaires over the last few decades in Germany. 6.5.4.1 Weight and perception of burden in Germany According to Lamnek, Olbrich, and Sch¨afer (2000), the individual perception of the tax burden is the most important cause for illicit work and tax evasion. The majority regards both the amount as well as the distribution of the tax burden as problematical. One has to consider that perceptions regarding social security contributions no longer differ from attitudes to taxes. This conﬁrms the fear that ﬁnancing problems and the all too slow reform of social security systems will destroy conﬁdence in ofﬁcial institutions. For at least ten years, two-thirds of the population, working individuals between the ages of 30 and 59 in particular (with a rate of 75% in 1997 and 84% in 1999), have perceived their tax burden as being too high.97 6.5.4.2 Tax mentality, tax morality, and tax evasion Tax mentality, deﬁned as the general attitude towards taxation, can be measured by the perceived unfairness of taxation (redistribution from bottom to top). In 1997, in Germany, 80% perceived the tax system as unfair and in 1999 as many as 87%.98 A further indicator is tax compliance: in 1999, 84% of the population believed tax compliance was no longer rewarding (compared to 74% in 1997). At the same time, more than 93% agree that the well informed are the winners in the current taxation system. However, 88.4% believes that reforms will only complicate things and that they do not solve the problems. Assessment of tax morality (measured via the attitude towards tax offenders) shows that tax evasion is regarded merely as a peccadillo and that the evading individual is seen as a clever businessman. Yet, following 97 98

The representative poll comprised 1025 (951) interviews in the summer of 1999 (1997). See Forschungsstelle fur ¨ empirische Sozialokonomik ¨ (1997, 1999). See Forschungsstelle fur ¨ empirische Sozialokonomik ¨ (1997, 1999).

94

The shadow economy

%

3.6

4.5

10.8

14.1

100

80 75.2

60 85.6

40

64.9

81.4 25.6

20

16 8.8

0 Tax burden much too high

I agree/ I totally agree

Social security contribution much too high

indifferent

9.5

Fair distribution Fair distribution of tax burden of social security contribution I do not agree/ I completely disagree

Figure 6.14. Attitudes towards a choice of causes for illicit work

Lamnek, Olbrich, and Sch¨afer (2000), one can distinguish certain types. Some ‘well-behaved’ individuals (30%) regard tax evaders as fraudulent, whereas others (55%) judge them as being cunning. With regard to the attitude towards tax offences, it is clear that the waste of tax revenue by public institutions is seen as the greatest offence (1997: 70%; 1999: 77.2%), closely followed by professional tax evasion (founding a ﬁctitious ﬁrm: 1997: 65%; 1999: 71.5%). International tax evasion by top income classes is regarded as a serious offence by more than 41% in 1999 (1997: 29.6%), whereas the concealment of income on the side is condemned by merely 30% in both years. Over a longer period of time, one can detect a weakening of tax morality and a higher tolerance towards tax evasion.99 Correlation analysis proves that there is a signiﬁcant correlation (correlation coefﬁcient r = 0.51) between tax morality (as an attitude) and tax evasion. Thus, it seems sensible to integrate aspects such as attitudes and personal characteristics into the analysis of illicit work.100 In a regression analysis, tax morality contributes immensely to the explanation of the willingness to evade taxes (Beta coefﬁcient ␤ = 0.47) and tax resistance (␤ = 0.44). These results illustrate that psychological factors add to the analysis of the opportunity structure and to the restrictions. 99

Ibid.

100

The calculations were only carried out for 1997.

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95

6.5.4.3 Illicit work Surveys on tax psychology are traditionally restricted to the area of tax honesty and tax opposition. Recent empirical tests have rid themselves of this restriction, as the shadow economy is closely connected to this phenomenon and has moved centre stage. Besides the legal reaction to the increasing tax burden – legal tax-saving possibilities were used by 63.1% in 1999, compared to a mere 54% in 1997 – illegal avoidance strategies are established increasingly. This is conﬁrmed by both direct polls and indirect tests. The individuals interviewed expect a distinct rise in illicit work: they presume more than 32.5% (29% in 1997) to be working illicitly and the rate of the demand to be 27.7% (25%). This corresponds to an increase of 11% within two years. In addition, 30% of the population use tricks to decrease the tax burden. About 50% (1997/1999) are willing to evade taxes and to engage in illicit work! The rise in shadow economic activity can then lead back to increased motivation as well as to higher reactance within the population. The citizens feel restricted by the high tax burden, the complicated taxation system, and unfair distribution. These additional considerations will be included in the integrative model. 6.6

An integrative approach

The last step to explain deviant behaviour is to combine the different aspects and scientiﬁc directions in an abstract integrative model, which should support the causal analysis of the shadow economy. The considerations below are based on various, extensive empirical studies and experiments, as well as on theoretical contributions from the various sciences, some of which cannot be cited here.101 The possibilities of integration were mentioned above in the context of illicit work. Figure 6.15 brings together the theoretically and empirically derived variables. In principle, there are two starting points for the analysis of deviant behaviour: the given, circumstantial characteristics (restrictions, e.g., budget/time restriction, opportunity structures, price changes, and external norms, e.g., loyalty, voting) and personal characteristics (preferences, e.g., motivational structure, i.e., control motive and involvement, the basic orientations, i.e., risk preference and the internalised norms, i.e., conscience). These determine the subjective deﬁnition of the situation, that is, the objective circumstantial conditions are interpreted individually and integrated into the decision process. 101

For current theoretical and empirical analyses, see Andreoni, Erard, and Feinstein (1998); Fetchenhauer (1998); Bayer and Reichl (1997); Smekal and Theurl (1994); as well as Fischer, Kutsch, and Stephan (1999).

96

The shadow economy Situative characteristics and conditions • Restrictions • External norms

Situative personal characteristics

Subjective definition of the situation • Weighing moral inhibitions and utility • Feeling of burden • Restriction of freedom

Behavioural options • Illicit work • DIY • Reduction of regular working hours

Personal characteristics • Motivation • Basic orientation • Internal norms General personal characteristics

Figure 6.15. Integrative model for deviant behaviour

For example, the objective reduction of the tax burden can be distorted by the subjective perception, so that shadow economic activity does not decrease in the way that would be expected according to economic theory. This reaction could result from a distorted view of the personal burden, low tax morality, habits, etc. Thus, restrictions and external norms are responsible for the subjective deﬁnition of the situation, as well as personal characteristics, which in turn are inﬂuenced by general personal characteristics (demographic data) and circumstantial, personal characteristics (tax morality, speciﬁc qualiﬁcations, knowledge about the personal situation). This differentiation of personal characteristics follows the tradition of economic psychology and sociology. The general characteristics are mainly descriptive and not relevant for the decision process. The sociodemographic variables only inﬂuence behaviour, since they correlate with the personal characteristics. The socio-demographic data provide indirect information about preferences and internalised norms. As opposed to this, the personal characteristics are directly relevant for the decision process, yet they can only be changed in the long run. The circumstantial, personal characteristics vary with the situation and are variable in the medium term.102 102

See Bayer and Reichl (1997).

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97

Tax morality is a central characteristic in the context of illicit work. In general, the individual may be honest but acts with deviance because of the speciﬁc situation (betraying an anonymous institution), and because nearly everyone does and no one will notice. How is the decision made when one considers all of these factors? The situation is perceived according to the individual’s personal characteristics and information is collected to evaluate the former, bearing in mind the costs vs. the utility. The evaluation is inﬂuenced by the subjective perception of burden, as well as of restriction of freedom. The more intensive this perception is, the more probable deviant behaviour will become. On the basis of this, the individual chooses either one alternative or a combination. Examples of the latter are engagement in shadow economic activities (either part-time or full-time), or remaining within the ofﬁcial sector but decreasing one’s labour supply.103 Thus, deviant behaviour can be explained by two characteristics (personal and circumstantial). These give multiple approaches to a differentiated analysis of the development of the shadow economy and policy recommendations. The integrative model displays interdependencies and illustrates that mono-causal and unilateral approaches do not sufﬁce to treat this phenomenon. In principle, psychology can explain facts that are not grasped by pure economics. Richard H. Thaler (2000) regards integrating psychological theories into economic theory to be the future topic of research for economists: I am predicting that Homo Oeconomicus will evolve into Homo Sapiens . . . As economists become more sophisticated, their ability to incorporate the ﬁndings of other disciplines such as psychology improves. (Thaler 2000: 140)

The integrative model will be applied to the analysis of economic policy measures and the inﬂuence on the shadow economy. Here, the focus lies on altering institutions (e.g., the taxation system, regulations regarding work time). In addition, tax morality and the subjective perception of the situation are considered. Before that, however, it is necessary to clarify brieﬂy the normative foundation of the following analysis. 6.7

An evolutionary theory of the shadow economy

Illegal and semi-legal activities are undesirable for ofﬁcial institutions. A growing shadow economy can be seen as the reaction of individuals who feel overburdened by the state and who choose an ‘exit option’ rather 103

Adhering to former behaviour is also possible. However, the individual would only employ cognitive strategies to reduce, e.g., reactance.

98

The shadow economy

than a ‘voice option’.104 Because the increase of the shadow economy is caused by a rise in the overall tax and social security burden, together with institutional sclerosis, the increase of underground activities erodes the tax and social security bases. The result is a further increase in the budget deﬁcit or tax rates, additional growth of the shadow economy, and gradual weakening of the economic and social fundamentals of collective arrangements. This effect is illustrated in Figure 6.16. Apart from the shadow economy, physical or economic migration into other countries is an important ‘exit option’. Increasing mobility within the EU strengthens the effectiveness of the latter, as long as there is no harmonisation of the tax and social security systems. When dissatisﬁed with the public goods offered in their own country, taxpayers can emigrate. Also the possibility of engaging in shadow economic activities limits the taxation authority of the government. The shadow economy forms an endogenous boundary. The correlation between individual reaction and taxation is illustrated in the modiﬁed ﬁgure of the Laffer-Curve (1979) (Fig. 6.16), which originally depicts the effect of tax evasion via more leisure time. Gutmann (1981) modiﬁed the ﬁgure by integrating the opportunity to engage in shadow economic activities. The top part of the graph shows the correlation between tax rate and tax yield, which is at the centre of political discussions, especially in the USA. However, this has not yet been underpinned either theoretically or empirically. The axes show the aggregated tax rate as a percentage of income, and the tax yield. The more the state increases the tax rates, the more opposition is augmented. If the yield maximum in S (tax rate t∗ ) is surpassed, the internal revenue decreases despite rising tax rates, as the citizens try to avoid paying. In this case, lowering the rates would result in an even higher yield, as the negative incentives are no longer evident. The lower part of the graph shows the connection to the shadow economy.105 To simplify, the economy is divided into three sectors (public sector, ofﬁcial, and shadow economy). Considering the development of an economy over time, the informal sector was prominent at the beginning. The introduction of an extensive ofﬁcial economy is not possible without state activity. If the former grows, so does the latter, as it requires resources. When taxes are introduced, the positive effects predominate. There are positive incentives to switch to the ofﬁcial economy, if the state actually 104 105

See Chapter 9. For a simpliﬁed ﬁgure which ignores the effects of state activity, see Frey and Weck (1983a); Neck, Schneider, and Hofreither (1989); Blankart (1998: 240f.); and Windisch (1984).

An integrated approach to explain deviant behaviour Tax yield

99

S

Laffer-Curve

t∗

0

Tax rate 100%

100

Share of population (%)

Public sector

Shadow economy

Offical sector

0

Tax rate

Figure 6.16. The correlation between tax yield, tax rate, and the development of the shadow economy

ensures property rights as an equivalent for taxes. Where exactly the optimum lies cannot be generalised; it differs from country to country. One possibility is that the citizens become accustomed to the increasing use of resources by the state, so that this does not necessarily result in a growing shadow economy. Owing to the tax-yield maximisation connected to budget maximisation, the taxes are increased. Frey and Weck (1983a) show that this leads to an increase in the supply of jobs in the public sector and results in an ‘immigration’ of individuals who were employed in the ofﬁcial sector. The rising tax burden results in stronger incentives to work illicitly. Once the tax yield has reached its maximum, the public sector can no longer expand, as working persons will increasingly engage in shadow economic

100

The shadow economy

activities at each attempt to raise taxes. If the public sector expands even more, this could entail a return to the pre-constitutional state of the economy, and, in an extreme case, could lead to anarchy. Then, a new set of rules would be developed for society, as regulations and supply of resources for state activity are advantageous. Financing the state requires knowledge of economic activities. A part of shadow economic activity is transferred into the ofﬁcial sector as, here, property rights are protected. These considerations show that the perception of public equivalents is an important criterion in the decision to work illicitly. If the former is legitimate, this will not result in a rise in shadow economic activity. The income-leisure model is suitable to illustrate the basic economic concept, where the avoidance of allocation distortions is always the main objective. Yet, there are some topics that need to be looked at critically. These will be explained with the help of the welfare theory on taxation. In welfare economics, one assumes a government that acts as a ‘benevolent’ dictator and wants to maximise aggregate welfare. On account of this, broad tax liabilities, low marginal tax rates or, ideally, even poll taxes are proposed to avoid allocation distortions and to optimise taxation. The demands concerning taxation and transfer payments, based on this theory, have been thoroughly discussed in public ﬁnance. Besides the constraining assumptions, neglecting the behaviour of the government and other institutions is criticised. The optimistic assessment of the governing body, which does not maximise its own utility but that of society and thus acts entirely differently than otherwise assumed in economics, does not seem plausible to the supporters of modern public ﬁnance.106 In modern public ﬁnance, the presumption of the welfare-maximising government is replaced by that of a self-interested one, whose objective is to maximise its budget in order to gain more inﬂuence over public funds and thus have further power. In the Leviathan theory on taxation, it is assumed that the government raises more taxes than needed to supply the optimal amount of public goods, i.e., it reaps the full beneﬁts of the taxation potential. The taxpayer has no possibility of reacting except via tax evasion. Therefore Brennan and Buchanan (1980) refuse to support optimal taxation, even if allocation distortions could be avoided. A broad tax base, with little possibility of evasion, would ultimately augment the taxation power of the government and the taxpayer would be at the mercy of the ‘Leviathan state’ even more. Hence, Brennan and Buchanan ﬁnd it necessary to develop clear boundaries for taxation, i.e., regulation for taxation and for budgeting. Despite the critique of the Leviathan model, 106

For an illustrative compressed explanation of the various theoretical approaches, see Blankart (1998: 201–48).

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101

which is related to the pessimistic judgement of the government, the model has contributed to describing politicians as individual agents. This counterbalances welfare economic theory. In the context of the ‘new political theory’, numerous approaches are currently being developed where there are attempts to explain the behaviour of the governing body more realistically. Blankart (1998: 227f.) proposes the implementation of democratic elements to prevent budget maximisation and the waste of taxes. This is an alternative to the usual suggestion of introducing constitutional regulations as an effective control mechanism of the government. One possibility would be to introduce facultative referenda on the total budget or on public budgeting via taxes and loans. This form of control and protection is necessary in the context of regarding politicians as being self-interested economic players, as well as taking into account the considerations of the new political economy and the Leviathan-state model. This short insight into an evolutionary approach to the implications of the shadow economy, which serves as a normative foundation for the following analysis and the proposals for economic policy, is further elaborated and theoretically derived in Enste (2002).

7

Analysing the causes and measures of economic policy

7.1

Government failure – the main cause of illicit work

Increasing shadow economic activities in OECD countries, as illustrated in Chapter 4, can be explained by incorrect and market-distorting state intervention that does not conform to market principles. The consequences for taxation, transfer payments, and the reduction of working hours were derived theoretically in Chapter 6. They are the main causes for illicit work. Many of these state interventions have the re-allocation of income or work as their objective. Correcting market distribution is necessary and an important pillar of the social market economy. Yet, the current situation, in Germany, shows that these interventions overshoot their goals. The proposed reforms of the taxation, social security, and health care systems were triggered by the unsatisfactory economic situation with high unemployment and low (ofﬁcial) economic growth. To counter these, politicians demand further re-allocation, simultaneously criticising the (pure) market economy. Particularly after the fall of socialist regimes, a comparison of the two market systems is no longer possible. Thus, state interventions are often carried through with the argument of social injustice and (alleged) market failure. The demands of interest groups for social equalisation, increased fairness of distribution, and governmental interventions cannot be ignored. Yet, how much the state is actually able and willing to contribute to fairer distribution is in question.1 An increase in illicit work is also brought about by governmental failure to constitute, regulate, and correct its intervention, which inﬂuences economic activity and which may have been implemented against the will of the majority of the population (‘democratic failure’, Petersen and Muller ¨ 1999: 174). This does not imply, however, that the state should not carry out important tasks and supply public goods; it merely shows that current politics sometimes ignores the wishes and needs of the citizens. In this context, a distinction has to be made between economically proven market failure and the failure to which interest groups refer. 1

See Section 6.7.

102

Analysing causes and measures of economic policy

103

Besides the reasons of internal and external stability (inherently stable and unstable markets) as well as those of distribution, governmental interventions are justiﬁed by market failure.2 In addition to this, ‘Ordnungspolitik’ has to be considered, as well as the problem of governmental failure. Therefore, positive welfare effects and distortions have to be compared with the efﬁciency losses of governmental interventions, prior to a further analysis. The welfare effects of market allocation are illustrated in the introductory literature on economics.3 In general, the positive efﬁciency effects on allocation cannot be denied. The price indicates the scarcity of goods and production factors, without the necessity of central planning, as all the information needed is contained in the former. Market equilibrium is reached by decentralised decision mechanisms. In the Model of Perfect Competition, this leads to optimal production and exchange of goods on the macro-economic level. An equilibrium state on both the factor and the goods markets is the prerequisite for realising maximum production. The goods markets determine What has to be produced, whereas the factor markets ascertain the How. The equilibrium in the factor markets inﬂuences the optimal factor input and allocation; the equilibrium in the goods markets establishes the best degree of specialisation. The exchange optimum ensues when the goods markets are in equilibrium. The optimal production structure, i.e., production and exchange optima being simultaneously achieved, is ensured by this equilibrium. Under certain circumstances, market allocation is impeded and, therefore, there are no optimal results through competition. In the literature, this is deﬁned as market failure. The causes are:4 1. positive or negative external effects (e.g., pollution), 2. public goods (e.g., national security),5 3. vicious competition (e.g., on the labour market without minimal safety standards), 4. asymmetric information (e.g., unemployment insurance), and 5. natural monopolies (e.g., railway network). 2

3 4 5

For a summary of the line of argumentation, see also Watrin (1985, 1986). For the relationship between market failure and economic policy, see Fritsch, Wein, and Ewers (1999). For the ‘ten economic principles’, which outline the economic way of thinking and the advantages of the market, see, e.g., Mankiw (1999: 3f.). For an application on the shadow economy, see Rurup ¨ and Borchert (1988). Public goods are not supplied privately since no one can be excluded from using these, i.e., it is not desired, as there is no rivalry concerning the consumption of these (nonexclusiveness). They can only be ﬁnanced through taxes. See the relevant literature on public ﬁnance, e.g., Andel (1998); Blankart (1998); Brummerhoff ¨ (1996); Stiglitz and Schonfelder ¨ (1994).

Unemployment benefits

Health insurance

Health care

Unemployment insurance

Social welfare

Transfer payments

Pension insurance

Social security

Figure 7.1. Economic causes for the shadow economy

Indirect taxes (esp. VAT)

Marginal tax burden

Average tax rate

Direct taxes (esp. Income tax)

Taxes

Causes for the shadow economy

e.g., craftsmanship (Meisterbrief )

e.g., statutory period of notice

Other rules

Flexibilisation

Forced reduction

Work time

Regulations

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In these cases, the government can intervene but the price mechanism should be disturbed as little as possible.6 The distributive effects of the market are particularly subject to considerable criticism and controversy. The decision for whom the goods will be produced is in the factor markets, as households offer the production factors (work/capital) and receive the income necessary to buy the goods and services. Thus, the income corresponds to their share of the GNP. This is the primary distribution in the market according to the effort involved. This primary distribution is corrected by the government with the objective of achieving a more equal allocation. Reasons for this stem from an unfair primary supply of resources. This determines the individual welfare obtainable and causes inequality and injustice. Owing to these unequal starting positions, redistribution measures may appear advisable in spite of the loss of allocation efﬁciency. In an extreme case, this could result in an egalitarian distribution of income. Yet, these measures lead to a drastic reduction in the incentives of resource input (e.g., labour supply), that is, to a migration into the shadow economy. Besides the difﬁculties over the equal division of responsibilities between the state and the market, the state itself has its weaknesses. Thus, the solution does not lie exclusively in state intervention, as the counterpart to market failure is state or government failure. This occurs, when those charged with economic policy do not achieve the welfare objective, even though they are aware of the necessary instruments and their mode of operation. The new political economy further examines the manifold reasons for economic waste of resources by politicians and bureaucrats.7 For example, they try to regulate individuals in numerous areas of everyday life in a way that is not perceived as legitimate and which results in an unnecessary restriction of personal freedom. Often the methods used cannot achieve the desired results, as these could also be obtained with less restrictive methods and less resistance. In this context, a few of the most important causes for the rise of the shadow economy will now be examined. The focal point is on economic factors,8 which are assumed to be the main reasons. The importance of the ‘moral dimension’ and the ‘costs’ connected to illicit work, which arise due to the violation of social norms, are further scrutinised at the end of the chapter. Figure 7.1 gives an overview of the causes. 6 7 8

For some examples on the practical application of economic thinking, see Borsch-Supan ¨ and Schnabel (1998); Fritsch, Wein and Ewers (1999). See, among others, Kirsch (1997); Mueller (1997a,b). The term ‘economic factors’ implies that these causes have been analysed by applying economic approaches. See Dallago (1990); Thomas (1992); Pozo (1996); Lippert and Walker (1997); Karmann (1990); Tuchtfeldt (1984).

106

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7.2

Growing tax burden in the ofﬁcial sector

7.2.1

Negative incentives through taxes

In various surveys, the tax burden has always been identiﬁed as the main cause for the growth of the shadow economy. The consequences of the latter can be analysed with the income-leisure model. The basic correlations between tax rates and shadow economic activities are illustrated in Chapter 6 section 7 in the context of the Laffer-Curve.9 However, besides the tax burden, social insurance contributions lead to additional wage-like costs, making illicit work attractive. In principle, these contributions can be differentiated from taxes, as the persons concerned have a claim on the contributions. This formal difference, however, is becoming increasingly less important. The perception of insurance contributions (for pension, health, and unemployment) is shifting from the idea of contribution to the concept of paying (additional) taxes, which can no longer be justiﬁed with the principle of equivalence.10 The current development can be explained by the fact that the connection between cost and beneﬁt within the social security system is hardly noticed any more. The main causes are the redistributive elements, which are not part of the insurance but which are increasingly integrated into the social security system. Health insurance is not based on the calculated risk but on the respective income. This does not agree with the insurance principle. Flaws in the structure of pension insurance also often lead to an unintended redistribution, e.g., to the beneﬁt of couples without children. In the medium term, this will lead to a considerable additional burden for the contributors:11 the pension system is derived by applying the distribution method, so that the size of the future pension does not depend on contributions but on the correlation between the working population and the number of retired individuals (age quotient). Further reasons for resistance to making contributions include the fact that contributions are increased by law and that the amount of the contributions, and the beneﬁts, cannot be tailored to individual preferences. In common with taxes, this restriction leads to a restraint in personal freedom and, hence, to a sense of burden. Since public welfare systems are not designed according to the subsidiarity principle (i.e., the state not only secures a minimum level and leaves the rest to the individual, but provides a complete 9

10 11

See also Blankart (1998: 230f.); Langfeldt (1984a, b); Schneider and Enste (2000c). Furthermore, according to surveys in Austria, for example, the fact that the state itself is at fault regarding shadow economic activity is stated by 69% (1999), 68% (1998), and 63% (1996) of people questioned. See, e.g., Pommerehne and Kirchg¨assner (1994). Proposed solutions for a systematic reform of the social security system in Germany can be found in Eekhoff (1998); SVR (1996).

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107

insurance for everyone), this results in over-protection. Therefore, it seems obvious that social contributions have the same effect as taxes and that the increasing burden also leads to a rise in shadow economic activity. The incentive problem becomes clear, when one realises that the regular employee has to work four to ﬁve hours to pay for one hour of a tradesman’s labour with his net income. ‘Hence, the larger the difference is between producer and consumer wage, the stronger is the incentive to avoid this by engaging in illicit activities. Since this difference is determined by the design and amount of the state taxes and regulations, this is the core of the connection between ﬁnancial burden of social security and the existence, i.e., growth of a shadow economy’ (Sch¨afer 1992: 27.)

7.2.2

The development of the tax rates in OECD countries

The tax rates, showing the utilisation of resources by the state, can be seen as an indicator for negative incentives in an economy. Table 7.1 documents the development of the tax rates in the OECD in the past. However, the percentage share of taxes with respect to GDP can only be a crude indicator for tax-related incentives to engage in shadow economic activities. On the one hand, the individual decision is not considered. On the other, these tax share rates are on average too small, as they already include the changes of the tax base and rates, as well as the reactions of the individuals to these. Thus, the incentives to evade taxes are often underestimated when examining these shares. One should differentiate between professional groups, living conditions, etc., to make the analysis of causes more precise. From research, the consideration of marginal tax rates is even less suitable to record the burden, since it is not so much the statutory tax rates that are so important but the actual application of these, the tax exceptions, the concessions, and the tax base, etc. When these elements are ignored, one obtains inaccurate results.12 Section 7.5 includes a summary of empirical evidence about the inﬂuence of the tax burden on the shadow economy. Table 7.1 shows a tendency towards an increase of incentives to migrate into the shadow economy. Values vary according to the source and deﬁnition so that differences cannot be avoided. The development and the differences between countries can be revealed independently of the respective source. In many countries, the state increasingly uses up more economic resources by raising tax rates. In some countries (e.g., the Netherlands) the success of a reform can be seen in the decline of the public expenditure rate.13 12 13

For such an empirical study, see Friedman et al. (1999). For a detailed analysis of various countries, see OECD Economic Surveys, Paris, various years.

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Table 7.1. The development of public expenditure and tax rates in OECD countries

Tax rate as % of GNPa

Public expenditure rate as % of GNP

OECD countries

1970

1980

1990

1996

1970

1980

1990

1996

1. Belgium 2. Denmark 3. Germany 4. Finland 5. France 6. Greece 7. Great Britain 8. Ireland 9. Italy 10. Japan 11. Canada 12. Luxembourg 13. Netherlands 14. Norway 15. Austria 16. Portugal 17. Switzerland 18. Sweden 19. Spain 20. USA

35.7 40.4 32.9 31.4 35.1 25.3 36.9 31.2 26.1 19.7 31.3 30.9 36.7 39.3 35.7 23.1 23.8 16.9 40.0 29.2

44.4 45.5 38.2 33.0 41.7 29.4 35.3 34.0 30.2 25.4 31.6 46.0 44.7 47.1 41.2 28.7 30.8 24.1 49.1 29.3

44.9 48.5 37.7b 37.9 43.8 36.8 36.7 36.8 39.1 31.4 37.0 48.8 44.6 46.3 41.3 34.8 31.5 34.4 56.9 29.5

46.6 51.9 38.2b 48.8 45.7 27.9 35.3c 33.6 43.5 28.5c 37.2c 44.0 43.9 41.4 44.1 33.4 35.1 33.7 51.9 27.9c

— 47.0 38.1 29.9 37.5 — 37.8 37.0 31.7 19.8 33.5 28.8 — 36.7 38.5 — — 21.4 42.1 30.3

58.6 56.2 47.9 38.1 46.1 30.6 43.0 48.9 41.9 32.0 38.8 — 55.8 43.3 48.1 23.8 32.4 32.2 60.1 31.8

55.0 58.6 45.1 45.4 49.8 46.4 39.9 41.2 53.2 31.7 46.0 — 54.1 49.2 48.6 41.8 33.1 42.0 59.1 33.3

53.0 56.7 48.8b 57.4 54.8 44.6 41.8 36.6 52.7 36.2 44.7 — 49.6 44.6 51.9 45.0 39.3 43.6 64.3 32.7

a OECD

deﬁnition; direct and indirect taxation. and West Germany. c Values from 1995. Sources: Own calculations on the basis of the following sources: OECD (Paris, numerous years); Federal Ministry of Finances, Germany, Bonn, 1998; Federal Finance Administration of Switzerland, Bern, 1998. b East

Taxation policy is a very important area that requires reform. The objective of taxation policy to raise regular employment by reducing the unemployment rate would be a step against illicit work. Systematic proposals for tax reform in Germany, included in a comprehensive general reform proposal, are part of Section 7.2.4. 7.2.3

Bivariate correlation and regression analysis of the inﬂuence of the tax burden on the shadow economy

The data of the OECD countries (Table 7.2) can be used as a basis to calculate the correlation between the size of the shadow economy and

21.9 18.3 14.5 14.3 28.5 13.1 15.9 27.0 14.6 14.0 18.9 8.3 19.2 7.5 22.9 8.8

21.0 25.0 15.0 20.6 18.0 17.5 21.0 19.0 7.0 17.5 23.0 20.0 25.0 6.5 16.0 3.0c

Valueadded tax rate 2

19.0 36.0 18.0 6.0 11.0 16.0 20.0 12.0 21.0 10.0 19.0 8.0 20.0 10.0 13.0 17.0

Average income tax ratea 3 10.0 9.0 16.1 13.0 15.8 10.7 7.2 9.9 7.0 31.0 7.0 18.2 4.0 11.6 6.6 7.6

Social security contributions of employed individual 4 26.0 0.0 16.1 31.0 27.5 10.2 12.3 32.0 8.0 8.8 12.8 24.2 29.6 11.6 31.6 13.8

Social security contributions of employerb 5 36.0 9.0 32.2 44.0 43.3 21.4 19.5 41.9 13.0 39.8 19.8 42.4 33.6 23.2 38.2 21.4

Total social security contributions (sum of 4 + 5) 6 55.0 45.0 50.2 50.0 54.3 37.4 39.5 53.9 34.0 49.8 38.8 50.4 53.6 33.2 51.2 38.4

Direct tax burden (sum of 3 + 6) 7

b The

average income tax rate is calculated from the sum of all income taxes, divided by the gross income of the average worker. rate is calculated on the basis of the annual gross income of the average worker. c USA: average value-added tax. Sources: Own calculation and OECD Working Paper 1976, Paris, 1997.

a The

Belgium Denmark Germany France Greece Great Britain Ireland Italy Canada Netherlands Norway Austria Sweden Switzerland Spain USA

OECD countries

Shadow economy (as % of GNP) 1

Table 7.2. Shadow economies, tax, and social security contributions in OECD countries in 1996 (%)

76.0 70.0 65.2 70.6 72.3 54.9 60.5 72.9 43.0 67.3 61.8 70.4 78.6 39.7 67.2 41.4

Total tax burden (sum of 2 + 7)

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the tax burden and social security contributions, as the different countries are made comparable. Table 7.2 shows the burden of taxation and social security contributions in these countries in 1996. The bivariate correlation and regression analyses render a strong positive correlation between the amount of the tax burden and the relative extent of the shadow economy (see Table 7.2, columns 1 and 8 respectively). The higher the former, the larger is the latter. The theoretical considerations in this context are conﬁrmed by empirical tests with a very low probability error (p ≤ 0.01). The calculation of the Pearson correlation coefﬁcient gives r = 0.62, i.e., the correlation is very strong. If Austria is ignored in the calculations, the correlation is even stronger (roA = 0.74). The linear relationship can be illustrated by the Figure 7.2. The regression line is denoted by: y = −3.064 + 0.313x with y = Size of the shadow economy and x = Total tax burden. The result implies that, for the countries examined, increasing the tax burden by ten percentage points would lead to an increase of the shadow economy of more than three percentage points.14 It is especially interesting to analyse the extent to which the tax burden is indeed the most important cause of the rise of the shadow economy. The explained variance is determined by that part of the total variance of the dependant variables that, in turn, is determined by the independent variable. Its value is R2 = 0.38, i.e., the variable ‘total tax burden’ can explain more than 38% of the total variance of the variable ‘size of the shadow economy’. When ignoring Austria, R2oA = 0.54, more than 54% of the total variation of the size of the shadow economy can be traced back to the tax burden. After integrating the data into logarithms, the results become increasingly clearer; when employing a so-called double-log speciﬁcation, the adjusted variance (R2oA )is 63% for the OECD nations.15 Elasticity can be calculated by employing logarithms. This shows that an increasing burden (e.g., 1%) results in a more than proportional expansion of the shadow economy (1.3%).16 These results indicate that a considerable increase in shadow economic activity is imminent in Germany should reforms fail. 14

15 16

The Breusch-Pagan Test (i.e., Cook-Weisberg Test) on heteroscedasticity shows that the residuals are not heteroscedastic, i.e., the standard deviations of the regression coefﬁcient are not falsiﬁed. The estimation of the conﬁdence interval is not distorted and hence the t-statistic is valid. Thus, the zero-hypothesis of the correlation being coincidental can be ignored. The regression analysis renders correct statistical results. See Pindyck and Rubinfeld (1997: Section 5.1). When integrating Austria, the elasticity is 1.2.

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111

30.0

Size of the shadow economy as % of official GNP (1996)

GR

25.0 E B 20.0 N

DK

S

IRL D

15.0

F

CND GB

NL

10.0 USA CH 5.0 30.0

40.0

50.0

A

60.0

70.0

80.0

90.0

Total tax and social security burden as % of GNP

Figure 7.2. Correlation of tax burden and size of the shadow economy Key: A: Austria, B: Belgium; CH: Switzerland, CND: Canada; D: Germany; DK: Denmark; E: Spain; F: France; GB: Great Britain; GR: Greece; I: Italy; IRL: Ireland; N: Norway; NL: Netherlands; S: Sweden; USA: United States of America

Many other studies also prove this correlation. On the basis of Canadian data, Lemieux, Fortin, and Fr´echette (1994) calculate that the difference between the gross and the net wage has a strong inﬂuence on the extent of illicit work. Apart from this, they conﬁrm the tendencies of the Laffer- and Gutmann-Curve.17 The general inﬂuence of the tax burden is tested empirically for Canada by Hill and Kabir (1996), Spiro (1993), and Giles, Tedds, and Werkneh (1999). Giles (1999a) identiﬁes a positive correlation between a decrease in the tax burden and the size of the shadow economy.18 However, the causes have to be regarded as a whole with interdependencies, so that the empirical test of single variables only has limited validity. Attempts at an econometric analysis that integrates interdependent 17 18

See Section 6.7. The results are discussed in detail in Schneider and Enste (2000b).

112

The shadow economy

factors are rare.19 Schneider calculates that, for Austria, an increase of the direct tax burden and density of regulation leads not only to an increase in shadow economic activities,20 but also an increase in indirect taxation and a decrease in the complexity of the tax system. In principle, macro-economic indicators can only be a rough indicator for the incentives to engage in illicit activities, because the individual decision situation, the inﬂuence of personal characteristics, and further intervening variables cannot be considered.21 Nevertheless, they can illustrate the necessity for reforms. The following discussion of the proposed tax reform in Germany is carried through on the basis of the integrative model, while considering the boundaries of macro-economic and static analyses.22 7.2.4

Proposals for a tax reform – the example of Germany

7.2.4.1 Objectives of a tax reform The sciences, politics, and the public all agree that an extensive tax reform, as well as the restructuring of the social security system, is of utmost importance in most OECD countries. Various approaches to such a reform were extensively discussed repeatedly in Germany in the context of the announced ‘major’ reforms in 1997, 1999, and 2000. The main objectives that need to be considered in the context of the growing shadow economy are: 1. improvement of employment conditions to strengthen incentives for regular occupation, 2. relieving taxpayers from the high tax burden, 3. greater tax justice, and 4. a more transparent and easier taxation system and tax law. The reform proposals for Germany which are introduced here are based on the welfare economic theory of taxation, including ideas of evolutionary taxation. Reforms may increase incentives to migrate in the short and medium term, as the extent of the tax burden then becomes visible. Yet, in the long run, they are necessary for society so that the public can once again control the redistribution activities of their elected government and administration. 19 20 21 22

See Schneider and Enste (2000a: 140f.). See Schneider and Neck (1993); Schneider and Poll ¨ (1999); Schneider (1994a,b, 1997a,b). See Section 6.6. Integrating the reform of the social security system would surpass the context of this book and is therefore omitted.

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The optimisation of allocation and improvement of the incentive structure, which promotes willingness to work, is essential to assess a reform.23 How can the input of resources be distorted as little as possible? In the context of allocation theory, a taxation system is efﬁcient if there are very few evasive reactions (e.g., into shadow economic activities) resulting from taxes and if there are no incentives for such reactions.24 Distribution effects are at the centre of tax policy discussion. In this context, the current situation is compared to the one after the reform. Who is the winner and who is the loser of the tax reform? When evaluating the measures, one should not consider the status quo, which would drastically worsen the chances of the reform, but consider what is economically sensible and necessary, especially in the context of locational competition and an increasing shadow economy. German taxpayers/voters criticise above all the major complexity, the lack of transparency, and the inefﬁciency of the taxation system. This leads to a reduction of justice in taxation and increased effort, with the objective of inﬂuencing the income tax burden. The costs of the mere application of the income tax law by ﬁnance administrations, ﬁrms, and employees are immense. Even the Federation of Tax Consultants would like an extensive reform of the system, as owing to the ongoing changes, it spends more time on research than on consultation. The main problem lies in the many separate treatments and tax privileges which, in fact, are supposed to guarantee individual justice, but only succeed in decreasing the tax base and hence enforcing high, hostile tax rates. 7.2.4.2 Decreasing tax rates and simultaneously broadening the tax base The previously discussed reform proposals (e.g., in Germany) range from decreasing the minimum and maximum tax rates to 15% and 35% respectively, within the existing progressive taxation system, to the introduction of a proportional income tax with the same rate for all income groups, and to consumption-oriented, as opposed to savings-oriented taxation.25 Yet, one has to consider that not only is the minimum tax rate important when choosing to work ofﬁcially but, especially for women in doubleincome households, the higher tax rates of a progressive income tax are also relevant. Drastically reducing tax rates would be a step in the right direction towards an innovative tax reform, which could be an advantage for Germany and, in the long run, would decrease immensely the incentives to evade taxes and work illicitly. Nonetheless, there will be tax 23 24 25

For an explanation of the deﬁnition of optimal allocation, see Section 8.1. See, e.g., Musgrave, Musgrave, and Kullmer (1993: 89–112). For an overview, see Rose (1991); Smekal, Sendlhofer, and Winner (1999); and for contributions on the taxation system of the future, Krause-Junk (1998).

114

The shadow economy

revenue deﬁcits, which might be responsible for a reduced supply of public goods. Therefore, it is necessary to use the potential to save in the public sector as well as alternative ﬁnancing possibilities, which have been discussed controversially, as no group wishes to forgo their privileges. Hence, radically extending the tax base combined with examining and abrogating individual justices and privileges on all levels, if there are no systematic reasons for these, is the right thing to do. Interdisciplinary considerations, especially those based on reactance theory, demonstrate that, in the short run, the shadow economic activities can increase. The extent of the infringement of personal freedom by regulations and taxation will become clear after the tax base is broadened. Hence, the individual will search for alternatives. Nevertheless, in the long run, showing the costs for state activity to the public is sensible and leads to a more efﬁcient utilisation of taxes via increased control by the taxpayers. Hence the voters’ sovereignty is restored and the bureaucracy no longer has the power to decide on the application of resources. Following Homburg’s line of argument (1999) for Germany, an ongoing expansion of the tax base could lead to a tax rate of 21% for everyone. When broadening the tax base, one could attain the same revenue from income, corporate, and sales tax, while securing a subsistence level of 6,500 EUR for 70 million people (adults and children, excluding recipients of social or unemployment security, as these would not proﬁt from being exempted from the subsistence level).26 Decreasing tax rates in combination with simplifying the taxation system, on the one hand, would weaken one of the most important factors inﬂuencing the rise in shadow economic activity and, on the other hand, would lessen incentives to evade taxes and work illicitly in the long run.27 7.2.4.3 Further possibilities of alternative ﬁnancing The extensive reform of income taxation will produce ﬁnancial injections for growth, thereby leading to more revenue and, in the medium term, to a rise in ofﬁcial employment. The superior allocation of resources, better division of labour, decrease in illicit work, and the improvement of the position of Germany in international competition, regarding taxation, are all attractions to additional investment. This results in economic growth and a recovery in economic trends, and the state will be able to ﬁnance its expenditures. Furthermore, considerable savings can be attained by decreasing the public expenditure rate. Reducing it by only 1% would render an additional 17.3 billion EUR for alternative ﬁnancing in 26 27

For an analysis of an expansion of the tax base see, among others, Enste (1997). For empirical proof of the considerations, see Section 7.5.

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115

Germany, as calculated by the Federal Ministry for the Economy. A further possibility is to shift taxation from direct to indirect via the introduction of new taxes or by raising value-added tax. Here, the danger lies in the fact that political pressure to reform the taxation system would decline. The urgency to economise is then no longer obvious, and a reduction of the rate of public expenditure can no longer be carried through successfully. Another alternative is to introduce ecological taxes. Besides the objective of protecting the environment, they imply further ‘dividends’ (double dividend). Apart from strengthening incentives to avoid negative external effects, (e.g., pollution), eco-taxes are supposed to combat unemployment when combined with a reduction of tax rates on wages.28 When considering the direction of the objective, a CO2 tax is to be preferred over a general energy tax, as – following the line of argument of the Kronberg Circle – the latter raises the same amount of tax revenue, regardless of the form of energy used, and thus does not provide incentives to decrease CO2 emissions. Nevertheless, such a tax, if enforced only in Germany, causes ﬁrms with energy-intensive production to move to another location. Private households as well as private trafﬁc jointly produce approximately 25% of CO2 emissions, so that taxing these would already induce proper incentives for the reduction of energy consumption. Simultaneously, this results in alternative ﬁnancing possibilities for an income-tax reform. However, the danger here is that efforts to save will dwindle signiﬁcantly if taxes are raised using the excuse of environmental protection. 7.2.4.4 Cutting back subsidies to reduce the rate of public expenditure Besides the saving possibilities directly connected to an income-tax reform, the possibilities of cutting back public expenditure should be considered in order to decrease the rate of public expenditure and thus taxation. The extraordinarily high volume of subsidies, generally regarded as exaggerated in the literature, has to be examined. When considering the demand that state intervention should only ensue in the case of market failure, one receives clear instructions for policies on how to economise. Further potential to cut down expenditure lies in the socially motivated types of expenditures, if the needs of the people concerned are considered and examined more closely. A policy, according to the subsidiarity principle, that would imply better prospects for market power while, at the same time, restricting state intervention to the necessary areas, results 28

Donges et al. (1996, 1999). For a discussion on ﬁrst, second, or even third dividends of an ecological tax reform, see Kirchg¨assner (1998); Krause-Junk (1997); Zimmermann (1997).

116

The shadow economy

in more equal taxation and uses new growth impulses due to a reduced taxation rate. When reducing expenditure, one has to start with state consumption, (personnel costs and current expenditure for goods and services), as well as with public sector transfer payments. To reduce personnel expenditure, one should continue to privatise public services to exploit the costreducing potential and to avoid X-inefﬁciencies. There may be negative employment effects in the short run, but in the medium and long term, reducing the public expenditure rate will result in more productive and proﬁtable working possibilities. It is feasible to reduce the tax burden, and hence shadow economic activities, not only by restricting public administration but also by cutting subsidies, as these also provide wrong incentives, e.g., to raise costs. Subsidies have been in the spotlight for criticism for a long time, as often they merely maintain declining industries, thereby slowing down structural change. To judge from research, transitional subsidies repeatedly turn into permanent ones due to lobbyists. This results in distorted competition, inefﬁcient production, and inﬂexible wage structures. The costs can be passed on to third parties, e.g., the taxpayers, so that sensible cost control is hardly possible. The consequences of an inappropriate funding policy are especially obvious in East Germany, where a considerable number of subsidies was endorsed but competitive ﬁrms are scarce. Meanwhile, the Federation, the states, and the communities, as well as the ﬁscal administration, have to carry the enormous burden. Current calculations by the Institute for the World Economy in Kiel illustrate the amount of open and hidden subsidies.29 Assuming a general deﬁnition of the term ‘subsidy’, the volume of these in 1999 was around 160 billion EUR. Without this amount of money, wage and income taxes could be abolished immediately, as they render approximately the same yield. This illustrates the importance of the subsidy and expenditure policy in the context of a systematic reform of taxation. The areas in which money can be saved have to be clariﬁed: 1. Agriculture The dirigible market-order system of the European Union, combined with national assistance, can render incentives to produce more than needed, as the EU guarantees to buy any remaining goods. Simultaneously, this implies high administration and transaction costs. If these were replaced by a direct payment sent to the farmers, it would help to reduce drastically the transaction costs without putting the persons concerned at a ﬁnancial disadvantage. At the same time, this would 29

See also Boss and Rosenschon (1998).

Analysing causes and measures of economic policy

117

imply considerable cost reductions for the public sector, which in the long run would lead to a relief for ﬁrms and private households and induce positive stimuli for the ofﬁcial economy. 2. Coal mining Mineral coal mining has been subsidised since the 1950s in Germany. The idea was to facilitate the adjustment process with respect to changing demand and relative scarcity. Financial assistance at the federal and state level is manifold and leads to a considerable number of wrong developments, e.g., the improper utilisation of capital and highly qualiﬁed workers by distortions in wages. This leads to an impediment to both necessary structural change and to international division of labour, as well as to the detriment of more efﬁcient mining in the Eastern European countries. In 1995/96, the German Council of Economic Experts proposed a plan to cut back subsidies for coal for electricity generation in three stages. They were to be cut back over a period of ten years from 3.8 billion EUR in 1996 to 0.6 billion in 2005. Simultaneously, the people concerned would be compensated and, in the long run, this would lead to considerable savings, which could be passed on to everyone via a decrease in the tax burden. 3. Subsidising research and technological development 30 Promoting the industries of the future is not always sensible as politicians’ knowledge of such things almost always lags behind that of the ﬁrms themselves. This results in similar government subsidiarity programmes in many countries, as the governments are unsure about the nature of future technological processes and which industries and types of production are promising. Financial and other kinds of subsidies should therefore be restricted to preliminary research and to better coordination, and should not be used for strategic support of technologies. Industries strongly affected by structural change often demand an ‘active industrial policy’, which can lead to deceptive developments, as described above with the example of mineral coal mining. Furthermore, the support of prestigious single projects is to be reduced, as they seldom lead to products which are appropriate for the market. Since the state has a share of the risk, this creates incentive distortions. 4. Other areas Other areas, where subsidies can be cut back, are the space and aeronautical industry, shipbuilding, trafﬁc, and savings. Private saving is supported immensely, independent of need. However, most people are able to make considerable savings without the help of the state. Restriction on subsidised forms of saving is no longer particularly necessary. 30

See also Eekhoff, Enste, and Wehmeier (1998).

118

The shadow economy

An alternative, or even a supplement, is a balanced reduction of all subsidies that would lead to income and employment losses in the short term, but would yield a positive outcome resulting from the decline in tax rates in the medium and long term. In an economic context, this would be a less efﬁcient proposition, yet politicians could enforce it more easily. However, the experience from income-tax reform shows that an extensive reduction of beneﬁts is open to heated debate on policy emphasis. If there is no political solution, the taxpayers will increasingly make use of exit options and then migrate into the shadow economy or even to foreign countries. 7.2.5

Exceptions regarding part-time employment

Changes concerning part-time employment, put into place in Germany on 1 April 1999 (Regulation regarding minor employment from 24 March 1999), strengthen ‘negative incentives’ for taking up a regular job.31 The new regulation regarding 325-EUR-jobs should lead to an obligation for those in part-time employment to make social insurance payments. Here, the objective is to convert part-time employment back to regular full-time work, and to reduce the ﬁnancial problems of social security systems. Relieving some of the workers from their duty to pay social security cannot be justiﬁed in the context of systematic considerations. In principle, it would make sense not to enforce any exceptions from the rules in any area. An extensive structural and tax reform is necessary, applying to everyone, with the objective of attaining a smaller tax burden, combined with a reduction of the regulation density. Nonetheless, until this is achieved, the price increase for part-time employment has considerable negative effects.32 The introduction of a partial duty to pay social security (employers’ health and pension insurance contributions), and cutting the lump-sum tax (20%) in return, has sometimes led to an increase in costs of 22% for each worker, as each worker no longer has their income taxed individually. In addition to this, some ﬁrms also have to carry 2% more costs for the other employees, combined with a further costly increase in complexity and regulation density. Who ultimately has to carry these costs depends 31

32

Combating ﬁctitious self-employment (Regulation correcting social security to secure employees’ rights of 1 January 1999) has similar effects on the potential of illicit labour and at the same time reduces incentives to move from the unofﬁcial sector into the ofﬁcial one. An example of non-intended consequences of this measure is the price increase of student auxiliaries in the universities. The additional burden of 22% has led to a drastic cutback in supply (opening hours of libraries, book supply, etc.) even though the colleges are considerably overloaded. Furthermore, the students have not been the group to be burdened. See also e.g., Roth (1999); Sproß (1999).

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on the possibilities of passing them on. If households concede to working for a smaller net wage, they will carry the burden of the increased taxes (inelastic supply of labour). If this is not possible, ﬁrms can pass the higher costs on to consumers via a price increase. This depends on the price elasticity of supply and demand, i.e., on the competition situation and the business cycle. Here, it is probable that the result will be an additional burden for both the employees and employers, according to the conditions of respective industries. The drastic reactions of the unions regarding the legal changes point to considerable difﬁculties in passing on the costs. Thus, working illicitly is still becoming increasingly attractive. The goal of the new regulation was to transform minor employment back into full-time employment, an aim that has been partially achieved. Yet, another section of the jobs market has been irrevocably destroyed or shifted into the shadow economy. The decreased net wage induces migration into the latter.33 As a consequence, many services are either no longer offered or demanded ofﬁcially because of the price increase. Another problem, according to representative polls from 1997, is that more than 50% state that minor employment is exactly what they want. Here, one can assume a large inclination to engage in shadow economic activities. Broadening the base for social insurance aims to continue ﬁnancing the existing regulation in the short run. After that, there will be no alternative to adjusting the systems to the changing working environment. ‘Normal’ jobs will diminish in the future. Reducing the ﬂexibility of the labour market is not appropriate, especially in the lower segment with the new regulation for the 325-EUR-jobs. The restoration of the basis of traditional security systems fails due to the pressures and desires of the people concerned. Social security cannot be saved by new regulations but by adapting the systems to the changing conditions of working. Otherwise, individuals will further refuse to accept the ofﬁcial norms. The problem surrounding the obligation to pay for health insurance is that, due to the design of the legal security systems, there is no equivalent in return for most of those in minor employment, yet they still have to make the contributions. Many are either fully insured by their main occupation or by their partner. As regards pension insurance, there are no claims from the share paid by the employer. The part which the employers pay for pension insurance does not secure any form of pension claim. Only if the employee can make additional contributions does this result in higher pensions in the future, which could counteract the positive ﬁnancing effect. Furthermore, owing to the possibilities of evasion illustrated above, it is unclear as to whether or not the state actually has an 33

This is also stated by Meinhardt, Schupp, and Schwarze et al. (1997).

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increase in its revenues. Thus, the calculations of the additional returns are vague, as the number of minor jobs varies between 0.8 and 3.2 million EUR, according to the estimates.34 However, it cannot be ignored that phoney self-employment and the exploitation of the possibilities of minor employment both pose a problem for economic policy, as they result in injustices and inequalities, inducing the need for change. There are no systematic reasons to free these employees from their obligation. Yet, the solution now introduced can only reach its goals with high costs. Social security systems have to be reformed to decrease the tax burden for everyone, rendering obsolete the exceptions to the existing rules, in the long run. As long as these reforms are not enforced, the labour market should be kept ﬂexible, and not just because of shadow economic activities. The new regulation can also be criticised in the context of current discussion about reforms of the taxation of minimum wages. Simplifying the laws in this segment is of utmost importance in order to make these occupations more attractive to employers and workers alike.35 7.2.5.1 Reduced value-added tax on labour-intensive services The measures agreed upon by the EU Ministry at the end of February 2000, and to be enforced until the end of 2002, are aimed directly at combating illicit work. This decision allows the EU nations to increase the number of reduced value-added taxes on labour-intensive services from two to three out of ﬁve speciﬁed branches.36 The recommendation by the Commission to limit these regulations to certain branches is based on studies regarding sociological determinants of illicit work. The personal characteristics and opportunity structures are treated separately.37 In Spain, this exception is relevant for hairdressers and builders only, whereas in France, almost all activities concerning renovation are subject to the lower tax except for non-manual (intensive) and other household activities, including window cleaning. Belgium, Italy, Luxembourg, the Netherlands, Portugal, and Greece apply the exception retrospectively from 1 January 2000, mainly aimed at the renovation of private real estate and small businesses. At ﬁrst glance, these single measures seemingly tend to weaken incentives for illicit work; however, with regard to the transparency and 34 35 36 37

See Bohlich ¨ (1999: 20); Schlenger (1998). For an illustration of the problems of minor income taxation, see, e.g., Boss (1996); Sesselmeier, Klopﬂeisch, and Setzer (1996). See decision by the ministry of 28 February 2000 (2000/185/EC) published in the Ofﬁcial Journal L 059, 04/03/2000, pp. 0010–0011. See Section 6.4.

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simplicity of the system, they are problematical. From the point of view of economic order, single measures to reduce illicit work should not be carried out, as they lead to involuntary and unequal treatment of corresponding jobs and incomes. An extensive reform is necessary, which solves several economic problems and reduces state intervention simultaneously. 7.2.5.2 ‘Servants’ privilege’ and service cheques A further policy in Germany against illicit work is the ‘servants’ privilege’. The employer can deduct the costs for the latter from his taxable income. This is justiﬁed by the so-called net-principle, i.e., certain private costs can be deducted from income, as they are unavoidable. They are speciﬁed in §2 IV/V EStG. In principle, these are special costs, unusual burdens, children’s allowances, or household allowances. In tax law, the deﬁnition is problematical, which is why it is the subject of many regulations, court verdicts, and publications. Since 1997, the costs to employ servants can be deducted up to the amount of 9,000 EUR p.a. (§10 No. 8 EStG), if social insurance is paid and it is not a job on the side (§8 Abs. 1 No. 1 of Germans Vierte Sozialgesetzbuch). A service chequebook was introduced to simplify administration. However, it merely conﬁrms the right to deduct the costs from taxable income. The servants’ privilege cannot be justiﬁed from a taxation point of view. Here, the focus was on labour-market objectives and the reduction of illicit work. However, the expected employment effect of 100,000 jobs did not materialise – a mere 8,449 jobs were actually created by the end of 1998.38 The minor employment effect of this model leads us back to the fact that this instrument is only advantageous for households with a high income, and is not used due to the existence of other, even cheaper, alternatives. The informal sector further impedes the establishment of a formal service sector with low wages. In general, this single measure also has to be criticised. A tax law that considers evolving taxation, with rules for everyone, offers a better chance of reducing incentives for illicit work. 7.2.5.3 Declaring private real estate as an investment The discussion on declaring private real estate in Germany as an investment rather than a consumption good, became especially controversial in the context of income-tax reform in 1987. In 1995, the Expert 38

See Fels et al. (1999: 17f.) as well as www.globalcare.de.

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Commission on Housing reconsidered this problem. Eekhoff (1993, 2001) stresses that a declaration of estate as an investment is the best solution, as this is a clear outcome from a taxation point of view, which also contributes to the reduction of illicit work.39 Taxing the value would make it possible for the owners to offset the costs of building or renovating against the saved rent. This would increase the incentives to demand legitimate work and an invoice, as only then could these costs be deducted from the income. Besides depreciation and interest, costs for renovating, etc., could be included.40 This solution appears to be the most elegant in theory. However, there are virtually insoluble, practical impediments as the value cannot be calculated and taxed properly. Even if it were possible, there would still be the opposition of the owners to a tax, when there is no income from their real estate. In the past, citizens have successfully resisted this form of taxation. So there still is the dilemma of non-refundable costs and the incentives of illicit work. Therefore, Eekhoff (2001) suggests that the second-best solution of declaring real estate is as a consumer good. Illicit work cannot be reduced, as there are great incentives to invest both capital and work into the housing used, as the costs for gardening and renovating cannot be deducted from taxes. Moreover, as Eekhoff (2001) states, consumptionoriented income taxation has several advantages. On a macro-level, there is no longer a distinction between saving and investment, as consumption is taxed and the aspect of double taxation is no longer relevant. This results in increased investment, especially on the housing market, and in dynamic growth. This apart, the practical problem of the taxation of owner-occupied real estate is solved. The consumption-tax method will be the practicable alternative in the long run. 7.2.6

Transfer payments

Besides the factors included in the empirical studies, further causal relations have to be considered in a theoretical context. Through its social security systems, the state makes various income-like payments to those private households who receive little or no earnings in the ofﬁcial economy. Transfer payments such as welfare, unemployment assistance, and unemployment beneﬁt can increase migration into the shadow economy. 39 40

In this context, Switzerland can be regarded as a forerunner, as it has enforced this model. Maybe this is a further reason for the rather small amount of illicit work there. See Eekhoff (1993: 55f., 2001); Expert Council for Housing (Expertenkommission Wohnungspolitik 1995: 300f.); Rusch ¨ (1996: 140f.).

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Financial services of the social system induce negative incentives for the ofﬁcial labour supply (‘disincentives to work’). These consequences can be examined in the context of the neoclassical income-leisure model. Welfare is granted to ensure a minimum subsistence level when needed. The earnings of an individual who obtains welfare payments are credited to his welfare. In many countries this corresponds to a 100% marginal tax rate on the additional income. Thus, for someone receiving welfare, the incentive to work illicitly is especially high. If the agent is risk-neutral, he will maximise the income by additional ‘black economy’ work, where these hidden earnings cannot be liable to deductions. The Institut der Deutschen Wirtschaft (iwd 48/1998) has calculated that it is not profitable for a German family, with two children, and which receives 1,100 EUR welfare, to regularly earn an additional larger sum. Owing to the fact that it is deducted from the welfare payment, an extra income between 700 and 1,500 EUR results in an overall income of 1,300 EUR; this is a mere 200 EUR above the initial earnings. The marginal tax burden in this case is 100%, and clearly minimises incentives to work. An additional incentive for transfer-payment recipients to work illicitly is the increased opportunity to ﬁnd a future regular job through contacts made during this occupation. Moreover, the legal right to claim welfare induces incentives to engage in illicit activities. Due to the existing information asymmetry, the possibility of dubious behaviour increases, e.g., by self-inﬂicted unemployment or by turning down job offers. The level of security is an important factor that inﬂuences incentives to work illicitly. When one considers the possibility of those who are unemployed, yet working illicitly, being discovered and penalised, it is critical to know if their standard of living is higher than it would have been in an ofﬁcial occupation.41 Because of this, the legal punishments (e.g., ﬁnes) for beneﬁt abuse were doubled to a maximum of 5,000 EUR in Germany as part of 1998 law against illicit work. Nevertheless, one should not approach the problem by ﬁghting the symptoms, but the causes, e.g., by reducing the high marginal tax rates. Various reform proposals in this direction are discussed under the keyword ‘negative income tax’42 in economics, and as ‘citizen money’ or ‘community work’ in politics.43 The objectives here are twofold. First, there is the objective to produce minimal transparency by pooling 41 42

43

See, e.g., the quality interviews in Lamnek, Olbrich, and Sch¨afer (2000). For exemplary calculations documenting the high costs, see, e.g., Klopﬂeisch, Sesselmeier, and Setzer (1997); for an overview of the controversial discussion, see Fuest (1995). See, e.g., Eekhoff (1998); Siebert and St¨ahler (1995); Vaubel (1996).

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together many redistributive transfers, which will permit a rational social policy. The second objective is to give to the recipients of transfer payments pecuniary incentives to take up a regular job. Introducing community work as an equivalent to the payments would minimise the possibility of earning an additional income in the shadow economy. Although this would be a voluntary task, at least 50% of unemployed individuals would still take it up.44 This could eliminate one incentive for illicit work, namely that of obtaining vital contacts. At the same time, public ﬁnances could be relieved, as certain beneﬁts could be distributed more cheaply.45 Unemployed individuals would no longer bear the stigma of unwillingness to work and, at the same time, would obtain better opportunities to ﬁnd a conventional job.46 Civil servants could be employed in different areas and the savings passed on to the public in the form of tax reductions, resulting in further positive effects on economic incentives. 7.3

Density of regulation

Individual freedom of action is not only restricted by raising taxes, but also by increasing state regulation as, for example, with legal and administrative rules, which contribute to higher transaction costs.47 As the Monopoly Commission (Monopol Kommission 1998: 50) states, German regulation has become increasingly dense, partially as a consequence of the increasing importance of the services sector, which is very strongly regulated. In general, the usual subjects to be examined in this context are: collective agreements on working conditions (working time, security, protection against unlawful dismissal), the abilities prescribed in the working scheme of the handicraftsmen (e.g., ‘Meisterbrief ’), marketentry restrictions and prohibitions concerning the employment of foreigners, and the ‘passing on of bureaucracy to the economy’ (Muckl ¨ 1986: 13).48 The manifold propositions needed to correct existing regulations are rarely carried out. Yet the liberalisation of the telecommunications sector illustrates the advantages of deregulation, such as innovation, growth, and price decreases. Reforms often fail, owing to the resistance of pressure groups, and are carried out only because of outside pressure, especially that of EU regulations (e.g., telecommunications, 44 45 46 47 48

See Eekhoff (1998: 111), who cites a poll of the opinion research institute IFO from 1994. For example, in New York, the introduction of community work allowed the city to reduce public expenditure. Eekhoff (1998: 110f.) very vividly describes this correlation and the secondary effects. See, among others, BMA (1998a); Donges (1992); Fredebeul-Krein and Schurfeld ¨ (1998); Langfeldt (1984b: 99f.); Monopoly Commission (Monopol Kommission 1998). See Deregulation Commission (Deregulierungskommission 1991).

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insurance, energy). Further pressure stems from the fact that these regulations can be evaded by engaging in shadow economic activities.49 7.3.1

Regulation in the labour market

The number of legal regulations in the labour market is large. For example, one of the problems is that of market exit restrictions, which are not only costly in the case of dismissal, and thus less ﬂexible, but are also market-entry barriers for individuals seeking employment. The employers consider these potential difﬁculties when hiring labour. In the case of women and disabled persons, who are protected against unlawful dismissal, this anticipation of costs leads to fewer opportunities for these individuals to become employed. The objective of increasing protection is only attained for the ‘insiders’, i.e., those employed already. The ‘outsiders’, i.e., those searching for a job, have lower chances as they not only have to be more productive than the insiders, but also have to compensate for the potential costs of dismissal.50 Other regulations, such as special rules when a certain size of ﬁrm is reached (e.g., the obligation of social plans), induce the ﬁrms to introduce overtime in response to short-term boosts in orders. They wait for the order situation to stabilise before employing new workers and then risk exceeding this limit, which leads to further costs. A minimal security level to protect workers from exploitation by employers is justiﬁed if there is market failure. For example, vicious competition could lead to wages being held beneath the subsistence level, leading to an increase in labour supply when wages decrease even further (anomalous labour-supply curve). In the EU, this danger is clearly not signiﬁcant in comparison to other countries largely due to the social security systems. Furthermore, whilst there is almost no risk of salaries decreasing in the EU, there are dismissals conditioned by structural change or wage decreases in certain industries, with higher earnings in others. In part, the regulations are also justiﬁed by the argument of asymmetric information and the resulting unilateral (economic) dependence of the employees. This reliance is particularly strong if the worker has to move home in order to take up his new occupation, as in this case the costs of mobility are especially high. The dependence is one-sided in cases where the employer has no costs resulting from the loss of a worker with skills speciﬁc to the ﬁrm. Nevertheless, there are labour-market theories and other considerations that regard regulation as being sensible for other reasons.51 49 51

50 See Berthold and Fehn (1995). See Monopoly Commission (1998: 56). A detailed estimation cannot be made at this point. For an overview, see Berthold and Fehn (1994, 1995); also Franz (1994, 1996); and McConell and Brue (1995).

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Table 7.3. The density of regulation as an inﬂuencing factor for the size of the shadow economy Burden due to state regulations indicated by share of civil servants of all employed individuals (%) Country

1960

1970

1980

1990

Difference 1960–90

Belgium Denmark Germany Finland France Great Britain Ireland Italy Japan Canada Netherlands Norway Austria Sweden Switzerland Spain USA

11.8 9.9 7.9 7.9 12.1 14.7 9.1 7.8 6.7 15.9 11.6 12.5 10.5 12.6 6.3 6.9 14.9

23.0 26.4 17.0 17.9 20.1 23.4 16.4 16.2 17.9 32.0 21.4 18.5 15.8 27.1 16.0 17.1 28.0

30.4 32.8 23.5 23.7 25.1 26.7 20.0 20.9 19.4 26.7 26.6 29.6 19.9 34.7 20.5 17.5 30.3

34.1 35.3 25.4 28.9 29.0 28.4 24.2 27.8 21.3 29.2 33.7 34.3 23.7 37.5 21.9 23.3 32.2

+22.3 +25.4 +17.5 +21.0 +16.9 +13.7 +15.1 +20.0 +14.6 +13.3 +22.1 +21.8 +13.2 +24.9 +15.6 +16.4 +17.3

Source: OECD (1993).

In principle, one has to take into account that regulation restricts the freedom of both the worker and the employer and raises further transaction costs for administration and enforcement. 7.3.2

Empirical ‘proof’ for the intensifying density of regulation

By means of the statistical method of unobserved variables, Frey and WeckHannemann (1984) discovered that the most prominent motives for the public to engage in shadow economic activities are the tax burden and tax morality, as well as the burden on the private economy of rules and regulations. The latter is extremely difﬁcult to measure. In many cases, it is not possible to record the direct costs systematically over a longer period of time. Thus, most studies try to measure the effects of state regulation indirectly, by applying different indicators for the extent of government intervention. One indicator can be legal and regulatory activity, as well as the execution of laws and regulations. Schneider and Poll ¨ (1999) use the examples

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of the USA, Switzerland, and Germany to show how this has risen noticeably over time. Until now, a more or less exact statistical measure of all the laws and density of regulation can only be determined for the USA, as this country has the most extensive data available. The different indicators – both the rising share of civil servants as well as the regulatory activity – clearly indicate a rise in state intervention. The other OECD countries show a similar tendency. The speciﬁc inﬂuence of these factors on the development of the shadow economy can only be analysed with substantial difﬁculty. Section 7.5 illustrates this using the example of Austria. 7.4

Working hours agreements

7.4.1

Forced reduction of ofﬁcial working time

In the light of the high rate of unemployment, public discussion focuses repeatedly on alternatives to combat this phenomenon, besides reducing wage bonuses. The central issue here is not to make the wage structure more ﬂexible, but to secure jobs by redistributing paid work or reducing regular working hours.52 Behind this lies the idea of lowering unemployment via working-time policy. In general, one can differentiate between two concepts: forced working-time reduction versus (individual) working-time ﬂexibility.53 These two alternatives are based on different fundamental positions concerning the levels at which the regulation should be enforced. The advocates of collective bargaining rely on state intervention and promotion to achieve a redistribution of work via a general reduction in working hours, possibly against the will of the individuals concerned. In France, the normal weekly working time was reduced, by law, from 39 hours to 35 from the year 2000 (from 2002 in ﬁrms with less than twenty employees) (OECD 1998: 169). In Germany, ofﬁcial working hours have also been reduced by industrial agreement. Since 1984, one can observe a decrease in the negotiated weekly working time from an average 40 hours a week to 37.5 in 1997.54 52 53

54

For a summary of different economic policy measures to redistribute work in the OECD countries see OECD (1998: 173f.). See, among others, Bosch (1997, 1998); Bosch and Lehndorff (1998); Eekhoff, (1998: 68f.); Kronberger Kreis (1999); OECD (1998: 123–88); Walwei (1997); Weidinger (1997). At the same time, one can observe a differentiation of working time. 75% of employees have collectively agreed working hours of 37 hours or more, whereas 20% work 35 hours. See BMA (1998a: 1997a).

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Table 7.4. Regulation regarding working hours and overtime in OECD countries, 1997

Country

Regular weekly Weekly Maximum weekly working overtime working time time (exceptions) (exceptions)

Overtime extras ((%) from . . . to . . . rising with the amount of hours worked)

Regular working time in the wage agreement

Australia Austria Belgium Canada Denmark Germany Great Britain Finland France Greece Ireland Italy Japan Netherlands Norway Portugal Sweden Switzerland Spain USA

38–40 40 40 40–48 37 48 none 40 39 40 48 48 40 45 40 40 40 45 (50) 40 40

50–100 50 50–100 50 50–100 25 In wage agreement 50–100 25–50 25–50 25 10 plus 15 for UFa 25 none 40 50–75 None 25 — 50

35–40 36–40 38 35–40 37 35–39 34–40 37.5–40 39 40 38–40 36–40 40–44 36–40 37.5 35–44 40 40–42 38–40 35–40

none 5 (10) 10 none none 12 none 5 9 8 12 12 none 15 10 12 12 16 2 none

none 50 (60) 50 none 48 60 none 45 48 48 60 60 none 60 50 54 48 (52) 61 (66) 47 none

= Unemployment Funds. Source: OECD – Employment Outlook (1998: 168).

a UF

Table 7.4 illustrates the regulations concerning normal weekly working hours and overtime in OECD countries. These rules are supplemented, and partly intensiﬁed, by collective bargaining agreements. The individual countries differ quite substantially, especially concerning the agreed overtime. However, within the EU, one can observe a certain convergence. When these rules do not meet the preferences of the individuals concerned, these individuals will migrate into the shadow economy. The employment effects of reduced ofﬁcial regular working hours result from the decisions of ﬁrms and households. The nature of the agreed wage compensation is crucial: does the work-time reduction come with full, partial, or no wage compensation? It is not only the regulations that include wage compensation that imply extra costs for ﬁrms; the latter also often rise due to higher transaction costs, ﬁxed costs of employment, and overtime extra charges. At the level of working time in OECD countries,

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these costs are generally not met by an appropriate rise in productivity by the employees. In the case of full wage compensation, negative employment effects are even stronger and, due to the increase in the price of work, they lead to a substitution of work for capital. The input of the latter seems increasingly attractive because of the higher costs of the former, and so there is a tendency to employ relatively more capital, as far as a substitution is possible. The expected partial rise in labour productivity does not justify a forced reduction in work time, but promotes a greater ﬂexibility of working hours, according to the desires of ﬁrms and employees. This implies the possibility to choose an optimal work time according to existing conditions.55 The changing occupations of households depend on whether or not the regulated reduction of working time corresponds to the desires and preferences of employees. In general, reducing working hours leads to increased personal leisure time. However, regarding the general worktime reduction, the following important aspect is often ignored, so that the desired objectives (e.g., decreasing unemployment) often cannot be met. A successful work-time policy would require no further reduction in ofﬁcial work time as this would provide further opportunities for work in the shadow economy. This can only be achieved if an individual is either unable to work or desires absolute maximisation of leisure time. As this is rarely the case, the reduction in working hours results in an increasing potential for overtime and/or illicit activities. The decrease in the average collectively agreed weekly working time from 40 to 37.5 hours (1984–97) has raised the macro-economic potential of illicit work in West Germany by 2.5 hours per week. When this does not meet their preferences, the people concerned may be increasingly willing to participate in illicit work or to take up a second job. It could also lead to poverty due to decreased income. Indeed, the receipt of social security may seem more attractive than the retention of a position of employment. In the ‘theory of optimal time allocation’, the decision of labour suppliers is modelled with consideration for alternatives such as overtime, illicit work, and leisure time. The consequences of a reduction in working hours were analysed using the income-leisure model.56 7.4.2

Part-time work and reduction of lifetime employment

State intervention to promote part-time work and reduce lifetime employment, (e.g., by early retirement or premature pension plans) should 55 56

For a short illustration of the theoretic considerations, the importance of speciﬁc labour market conditions, and some empirical results, see OECD (1998: 178f.). See Chapter 6.

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Table 7.5. Part-time employment in the OECD countries 1973–96 Country

1973

1979

1983

1990

1993

1996

Australia Austria Belgium Canada Denmark Great Britain Finland France Germany Greece Ireland Italy Japan Netherlands Norway Portugal USA Sweden Switzerland Spain

11.9 6.4 3.8 9.7 — 16.0 — 5.9 10.1 — — 6.4 13.9 — 22.9 — 15.6 — — —

15.9 7.6 6.0 13.8 22.7 16.4 6.6 8.1∗ 11.4 — 5.1 5.3 15.4 16.6∗ 27.3 7.8 16.4 23.6 — —

17.5∗ 8.4 8.1 16.8 23.8 19.0 7.7 9.6 12.6∗ 6.5 6.7 4.6 16.2 21.2∗ 29.6∗ — 18.4∗ 24.8∗ — —

21.3 8.9 10.9∗ 17.0 23.3∗ 21.7∗ 7.2 11.9 15.2∗ 4.1∗ 8.1∗ 4.9∗ 19.2 31.7∗ 26.5 5.9∗ 16.9∗ 23.3∗ — 4.9∗

23.9 10.1 12.8 19.1 23.3 23.4 8.6 13.7 15.1 4.3 10.8 5.4 21.1 35.0 27.1 7.4 17.6∗ 24.9 27.0 6.6

25.0 12.6 14.0 18.9 21.5 22.2 7.9 16.0 — — 11.6 6.6 21.8 36.5 26.6 8.7 18.3 23.6 27.4 7.7

Values in percent of those fully employed Comparisons between the countries are only roughly possible, due to the different deﬁnitions used in the countries. — = no data available; ∗ = Change in the deﬁnition Source: OECD – Employment Outlook (1998: 161).

also be considered critically. The development of the share of part-time work in OECD countries from 1973 to 1996 shows a constant rise until 1993 and, in many countries, until 1996 (see Table 7.5). This rise is not a problem for shadow economic activities as far as it corresponds with the preferences of the employees – in this case, the desire to have more leisure time. However, if people wish to work longer, they can use their available time for illicit activities. The rise of the hidden economy could then be explained by the rise in the share of part-timers. The relationship is ambiguous. A small share of part-time workers could also imply a low degree of ﬂexibility in the ofﬁcial sector, leading to a shift into the black economy, in order to be able to choose a work time according to individual preferences. A differentiated analysis of voluntary part-time work is necessary. There are results for Spain, which reveal the lowest share in part-timers, together

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with Italy, which show that over 90% would rather have a full-time occupation.57 On average, part-time employment in the EU does not meet the preferences of 30% of the individuals concerned. Yet this is difﬁcult if it has to be carried out against the desires of the individual. In this context, one has to differentiate between the wishes of males, who unwillingly carry out such work, and females. More than 55% of the men questioned stated that they would prefer a full-time job.58 In OECD countries especially, public programmes to promote early retirement have contributed to a decrease in the share of older employees. In Germany, the regulations concerning early retirement from 1989 were redrafted into the ‘Law to promote smooth transition into retirement’ on 23 July 1996 (Bundesgesetzblatt 1996: 1078),59 which concerns parttime employment before one becomes eligible for a pension. Besides the dangers of increasing shadow economic activities, the most pressing consequence is the additional burden on social security, as the costs of this promotion have to be borne by third parties. The regulations concerning early retirement are a burden on the pension system and lead to high additional contributions, so that this promotion has had to be abandoned. Yet, the new regulation has also led to a considerable additional charge on social funds, in this case on unemployment insurance. The costs are passed on to the taxpayers. Nevertheless, it is not clear whether the desired redistribution from older to younger workers actually results in additional jobs. Neither is it clear whether or not new employees were hired without subsidies as well. With this typical example of labour-market policy intervention, it is proven that the attainment of the supposedly positive objective was achieved without consideration for side effects and reactions. All of this results in setting up the wrong incentives. Additionally, the line of argument ignores the fact that working gives people a feeling of being active, which may be missed by the over-55-year-olds in particular. This is the group to whom the state suggests the possibility of early retirement in order to make way for younger individuals, or to help make the reduction of jobs socially acceptable. Table 7.6 illustrates that the promotion of part-time work or early retirement for older individuals has led to a drastic cut in ofﬁcial employment of males over 55 years. In Germany, France, and the Netherlands, where such a promotion has been carried out, the share of occupational activities has decreased sharply, whereas in Japan, the USA, and in Sweden the decline has not been that signiﬁcant. These differences cannot be 57 58 59

See Bohlich ¨ (1999: 111f.); EUROSTAT, Poll on employees (1997). See Bohlich ¨ (1999: 108ff.). For an explanation of the organisation see Eekhoff (1998: 73).

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Table 7.6. The share of employed persons older than 55 years (%)

Country

Year

Male 55–64 years

Germany

1968 1988 1994 1968 1988 1995 1968 1988 1995 1968 1988 1995 1968 1988 1995 1968 1988 1995 1968 1988 1995

83.2 58.7 53.3 76.9 47.4 41.5 91.9 68.0 62.4 86.4 82.3 84.8 80.6 46.9 42.3 89.0 74.6 70.4 81.9 67.0 66.0

France

Great Britain

Japan

Netherlands

Sweden

USA

Female 55–64 years 30.5 25.0 28.4 41.0 31.7 30.9 38.1 36.2 40.8 44.9 45.2 48.5 14.9 15.8 18.6 42.9 64.1 63.4 41.5 43.5 49.2

Change in the share of employment of men between 55 and 64 years, 1968–95

−29.9a −35.4 −29.5 −1.6 −38.3 −18.6 −15.9

a 1968–1994

Sources: Bosch (1998: 355); OECD – Labour Force Statistics (1996).

explained by work-time policy measures alone, but by the incentives of such a retirement policy which should not be underrated.60 The data illustrate clearly the time potential that older males have for illicit work, as both their health and life expectancy have improved. The rise in female employment cannot compensate for this decline, except in Sweden. When one considers that illicit work is undertaken predominantly by men, the importance of the decreasing rate of ofﬁcial gainful employment becomes clear. It is summarised in the last column of Table 7.6. A direct causal relationship cannot be deduced from the data listed above. Yet the data illustrate that the promotion of work-time reductions ignores the requirements of the dynamic working world. The desired objectives are not met, as employers and employees have opportunities 60

See, among others, OECD (1998: 131f.).

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to evade this and that the macro-economic costs are higher than the gain. This will be derived in the following section. 7.4.3

Macro-economic consequences of the reduction of working time

On a macro-economic level, reducing work time induces a forced suboptimal input of a production factor. This is a waste of resources, which leads to a decline of social welfare and – under certain conditions – to a production below the one possible. This results in lower production, higher transaction costs, and higher costs of social security (e.g., for pension payments or subsidies from the federal labour ofﬁce). In addition to this, the potential to work illicitly rises. Such a reduction will, therefore, be to the detriment of taxpayers and contributors.61 One also has to point out that measures of distribution and social policy do not consider individual need but focus on a general reduction of work time. Thus, one can hardly detect distribution effects. 62 As for part-time employment, there is the additional problem that (part-time) workers – depending on the structure of the insurance system – are still entitled to health insurance, medical care, and unemployment insurance, even though their contributions to these decline. This leads to higher contributions for other individuals. This further increase in the tax burden is another incentive to migrate into the shadow economy. Thus, one can see the connection between these two causes. Another, secondary, effect is a decline in the domestic revenue’s receipts as, on the one hand, illicit work increases and, on the other, the (ofﬁcial) production of goods drops. As the taxation system is progressive, the wage tax revenue sinks, since the wage of younger employees is lower in comparison with those going into retirement. The social security systems are additionally burdened. They are either confronted with a smaller contribution sum and the same demands (full service in the legal health insurance for part-timers) or with even higher costs (unemployment insurance), due to the promotion of part-time work for older individuals. Social security systems require extensive reform and not only because of the working–hours policy. Changed preferences regarding work time and its regulations (e.g., lifetime working models) and, by association, the degree of ﬂexibility of working time, can lead to immense ﬁnancial difﬁculties for the insurance systems. Contributions are linked to the 61 62

For the basic logic of this behaviour, see Olson (1968), for a further development of these thoughts, see, among others, Mueller (1997a,b). See Franz (1984) and, as an example for newer surveys, Bosch (1998) and Hunt (1999).

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Table 7.7. ‘Atypical’ working hours of employees in the EU (1993) Countries

Saturday jobs

Sunday jobs

Shift work

Evening work

Night shift

Belgium Denmark Germany Spain France Italy Netherlands Great Britain EU-12

30.9 44.9 30.6 34.3 36.3 56.1 34.4 56.9 40.7

18.8 33.5 16.3 14.2 18.1 17.5 19.6 37.4 21.3

19.0 10.0 12.0 7.0 8.0 22.0 10.0 17.0 13.0

28.0 37.0 23.0 — 11.0 25.0 21.0 49.0 25.0

13.0 15.0 12.0 9.0 14.0 13.0 10.0 22.0 14.0

Values as percentage of employed persons; multiple entries are possible, as theoretically every employee can use every form of working time. Sources: Eurostat (1995a,b); Walwei (1997).

hours worked, yet certain services are always rendered, independently of the amount of contributions paid. As the share of full-time jobs and typical working relationships progressively diminish, a reform of social security systems has to be carried out.63 The large number of employees in the EU working ‘atypical’ hours (see Table 7.7) demonstrates that the differences concerning work time compared to self-employed individuals and freelancers will become gradually smaller in future. Making working time more ﬂexible can lead to more time being available for illicit work in the long run, yet fewer incentives to supply or demand it, as the regular supply can adapt more easily (e.g., if craftsmen are able to work on the weekend) and thus meet the preferences of workers and consumers. Even if there are divergences amongst the EU nations, one can clearly detect an ongoing ﬂexibility of working hours. These changes cannot be explained just by company demands, which have been enforced against the will of the employees. On the contrary, the workers also insist on a larger individual variation of working time, as the next chapter will illustrate.64 7.4.4

Divergences between desires and the regulations concerning work time

The proposals to enforce part-time work and governmental subsidies should not be rejected only because of negative macro-economic effects 63

64

Comprehensive reform proposals on this subject can be found in Eekhoff (1998) and Kronberger Kreis (1999: 18f.) as well as in the annual opinion of the German Council of Economic Experts (SVR, 1996). For working time models, see Wagner (1995); Bohlich ¨ (1999).

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such as the additional burden on social security systems. In the context of a growing shadow economy, these regulations should also be discarded if they do not meet the desires of the people concerned. An economic policy of regulating work time should guarantee that the input factor work is actually not reduced any further. If concerned individuals wish to continue working, this could lead to an increase in illicit activities. Empirical surveys on Germany illustrate the possible extent of the shadow economy in this country. The results of a representative poll by EMNID (iw-trends 1997a) demonstrate how the potential to work illicitly could increase if an enforced reduction of working time were carried out. In principle, this survey shows that, for 40% of employees, their working time corresponds with what has been collectively agreed and, at the same time, 27% wish to work longer hours. In East Germany, longer working hours are desired in order to increase income, even though the average working time in this part of the country is two hours longer than in the West. The desired weekly working time is 38 hours for 49.7% of the employees with a corresponding change in income, according to the hours worked. The 40-hour week does not meet the preferences of a third of the employees; they wish to work longer. But there are also individuals who are not interested in working as much; a third prefer a week of less than 35 hours. To sum up, one can say that a general reduction in working time does not only fail to meet the wishes of many employees but that it will result in a rising potential and willingness to engage in shadow economic activities. The main reason for this is the preference for a higher income, or at least maintaining one’s standard of living, as has also been stated by Lamnek, Olbrich, and Sch¨afer (2000) in their survey. The results stated above can be criticised in that they were derived by a closed questionnaire, which was tailored to obtain the desired results. It was administered by a body that is under the inﬂuence of the employers (Institut der deutschen Wirtschaft in Cologne). However, the ﬁndings were conﬁrmed (by an analysis of the data obtained by the SOEP)65 by another institute (DIW-Berlin), which is traditionally more inﬂuenced by 65

The SOEP (Socio-Economic Panel, 1984–97) is a representative longitudinal section survey of the private household in Germany (SOEP, 1995). It is a yearly inquiry on Germans, foreigners, and immigrants in the old and new federal states. In 1996, the sample was made up of 7,000 households with more than 13,500 individuals. Detailed inquiries on a variety of areas of everyday life were the basis for this survey. Thus the SOEP is a unique source, which provides a record of development on a representative database over a longer period of time (long-run surveys or panel analyses). Thematic focal points are the composition of the household, occupational and family biography, share of income mobility concerning employment, the development of income, and satisfaction with life. For current information to be used e.g., for scientiﬁc purposes, see www.diw.de/soep.

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trade unions. Similarly extensive data have rarely been found for other countries outside the ofﬁcial statistics (e.g., the micro-census in Germany or public opinion polls). The outcome of the analysis of working-time preferences in East and West Germany is unambiguous: ‘Potential to reduce working hours decreased’ (DIW Wochenbericht 37/1998: 667). The employed do not wish to further decrease their work time, as additional leisure time is not desired, or they can no longer maintain their standard of living. A comparison of the desired average with the agreed work time shows the size of the potential to ‘redistribute’. Since work is not a homogeneous good and the qualiﬁcation demands differ considerably, this general inquiry gives us a crude value only, which has to be further differentiated. It becomes clear, that the potential to redistribute working time in West Germany has declined by 1.5 hours per male worker from 1993 to 1997. As opposed to the decrease in work time by 0.5 hours (1993), there is on average the desire to work one hour longer in 1997. Looking at female preferences, one can see a similar development: in 1993 there was, on average, a desire for a reduction of 2.2 hours, but in 1997 it was only 0.5 hours. Thus, the actual reduction of full-time employees (male: 1.7 hours to 37.2 weekly working hours in 1997; female: 1.2 hours to 37.1 weekly working hours) obviously had already ignored the desires of employees in West Germany. In East Germany, the redistribution potential is very small: 0.5 hours. However, on average, individuals work longer in that part of the country: 37.5 hours. In West Germany the average is only 33.5 hours. To sum up, one can state that in Germany there is no longer a potential to redistribute working time with a given change in wages. Yet a more detailed analysis shows that the general view falls short of some aspects. A general reduction of working hours is as inappropriate as a general increase. The following results prove that making working time more ﬂexible is most likely to meet the preferences of employees. A few basic divergences can be found when comparing males and females, and women in East and West Germany. Furthermore, within the groups, one discovers clear differences in preferences. Individual evidence can be deduced from Table 7.8. 71% of men in West Germany work, as stated, between 36 and 40 hours a week. Of the employed individuals, 9% wish to work at least 6 hours less and 16% between 2 and 5 hours less. The actual working time corresponds with that desired by 47% of the group (plus/minus 1.5 hrs.), almost 14% would rather work 2–5 hours longer every week. 16% wish for 6 hours more weekly working time. For the males in East Germany, there are very similar results. Owing to the traditionally higher share of female occupation, there is a tendency

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Table 7.8. The divergence between agreed and desired working hours in Germany (1997) Agreed working hours without overtime

Desired weekly work time with adapted incomea Interval of 1.5 hrs more or less work

2–5 hrs more work

6+ hrs more work

Males in West Germany (13.4m. employees b ) 1–34 9 4 2 35 10 5 5 36–40 71 9 16 41 and more 10 48 14 % 100 12 13

27 38 47 20 41

6 46 14 5 15

61 5 15 13 19

Males in East Germany (2.8m. employees b ) 1–34 5 0 7 35 2 0 4 36–40 79 7 16 41 and more 14 50 22 % 100 12 15

32 7 57 16 48

4 86 7 1 7

57 3 14 13 17

Females in West Germany (10m. employees b ) 1–34 48 4 8 35 4 10 12 36–40 46 31 16 41 and more 2 43 25 % 100 17 12

48 38 44 26 44

12 39 4 1 9

28 1 5 5 18

Females in East Germany (2.4m. employees b ) 1–34 26 2 4 35 5 4 38 36–40 64 18 25 41 and more 5 47 12 % 100 14 19

35 34 46 19 41

14 24 6 2 8

45 0 6 21 18

Weekly work time

%

6+ hours less work

2–5 hrs less work

a Persons

gainfully employed, including civil servants, excluding trainees and insigniﬁcantly employed individuals who regard themselves as being unemployed; values as a percentage of the questioned group. b Projection. Sources: Own calculations; SOEP 1997; DIW 37/1998.

to wish to work longer. The share of females working part-time in East Germany (one-third) is distinctly lower than that of women in the West (nearly 50%). None the less, 60% of the former would much rather work longer hours or even take up a full-time job, whereas in West Germany, females are quite satisﬁed with their status quo (a ‘mere’ 40% desire to work more).

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To sum up, the analysis of the SOEP data documents that more than half of the people employed are considerably dissatisﬁed with the agreed work time. They either prefer working two to six hours longer or less each week. Even if there are more elements inﬂuencing the decision to take up illicit work, the factor of working-time preferences should not be ignored. The only conclusion from this is to demand more ﬂexible work time, according to the requirements of ﬁrms and, at the same time, to consider individual preferences. 7.4.5

Greater ﬂexibility of work time as an alternative

As the analysis of time preferences has illustrated, a general reduction of working hours does not meet the interests of employees. Rather than enforcing it by regulations or collective agreement, the advantages of greater ﬂexibility should be exploited. Instead of promoting a partial nonusage of work, it seems more sensible to improve the conditions for job creation. Numerous positive employment and welfare effects are connected to greater ﬂexibility of working time.66 Material assets can be applied more efﬁciently, leading to decreasing capital and production costs. The advantages include work organisation, increasingly intensive utilisation of facilities and goods (‘longer running time of the machines’), and lower storage costs (e.g., just-in-time production). Furthermore, the competitive position of the ﬁrm improves, due to an increased willingness to perform (especially if the ﬁrm considers the preferences of the workers) and, hence, higher productivity. For the workers, more sovereignty regarding allocation of time offers the chance to distribute the latter between work and leisure according to individual preferences. Thus, agreements can be made on varying weekly working hours, educational or leisure periods (e.g., sabbaticals), yearly work-time accounts, etc. In the long run, this would imply arranging work time in keeping with the respective phase of the individual’s life. The possibility of an intra-ﬁrm agreement, accompanied by consultation with the trade union, seems the most sensible option. A collective agreement is of use for general health insurance. The current regulations, however, lead to an unnecessary reduction of freedom both for the workers and for the employer. Without starting a discussion on market failure at this point, the health-care argument can be easily criticised. Justifying worktime regulations with this argument is not acceptable, if they can be easily evaded by taking up a second occupation or extensive exceptions exist for 66

See Eekhoff (1998: 69–80); Eekhoff and Henman (1997); Kronberger Kreis (1999).

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some professions (e.g., self-employed individuals, doctors in training). In addition, ﬁxed maximum hours (e.g., 48) or even general reductions to 35 hours cannot be warranted. In principle, one can expect further standardisation and greater homogeneity of work time in the future for various reasons: availability, order situation, and shifts. Yet greater ﬂexibility would lead to a decrease of trafﬁc jams, for example. A creative (yearly) work plan could cut seasonal unemployment (e.g., in the building trade). Altogether, this is a pillar for extensive reform of the conditions to reduce structural unemployment in the labour market, as it ﬁghts a cause (too little ﬂexibility/mobility), which could also correct the distorted wage structure. Yet, a successful ﬂexibility policy requires an adaptation of the social system. The potential to work illicitly is also generated if the greater ﬂexibility of the collectively agreed work time has the objective of reducing the latter, in combination with less pay. An example is Volkswagen AG who decreased work time to 28.8 hours. Here, there are fewer negative consequences for the employees and fewer incentives to work illicitly, as this can be arranged according to preferences regarding working time. In particular, the forced reduction of working hours, against the desires of the employees, poses a problem and leads to a ‘forced’ migration into the shadow economy. The reduction of work time has been elaborately analysed here for various reasons. First, the public often does not recognise the correlation between illicit work and reduction of ofﬁcial working hours. Secondly, the negative consequences are not known. Then, there is deﬁnite empirical proof for an increase in shadow economic activity. And last, but not least, the effects could be derived by applying the income-leisure model. 7.4.6

The special German and Austrian case: Meisterbrief

7.4.6.1 Requirements for independent craftsmanship One area in which illicit work is evident in Germany is the manual/skilled trade. One reason for this is the extensive regulations concerning entry in to the ofﬁcial market, which is part of the order of craftsmanship (Handwerksordnung – HwO). Here, the job licence and training, as well as the tasks of the chambers, are regulated. For those occupations listed in Appendix A, one can only be self-employed in Germany, if one is on the register. To be a part of the latter, one has to be a certiﬁed foreman after several years work experience as a journeyman. Owing to the very strict exceptions to this rule, the market-entry barriers are very high for journeymen wishing to become self-employed. In 1994 and 1998, the HwO was slightly modiﬁed, so that now a foreman of one trade can work in others trades. However, this extension does not have

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a positive effect on possibilities for market entry. A ﬂexible, easily obtained occupation, according to general demand, is still impeded by the narrow deﬁnition of related trades, rendering supply by single-handed ﬁrms increasingly difﬁcult, making this viable only for larger companies with the appropriate number of foremen. These regulations impeded start-up dynamics and increases in selfemployment, even though this is, in fact, supported by the state. In international comparisons, Germany has the smallest share of self-employed individuals (after Denmark) in the EU.67 This results in increasing dynamics in the shadow economy. ‘The causes for this cannot be unambiguously identiﬁed; regulation concerning market entry is one, which is clearly evident in the German craftsman trade’ (Monopoly Commission/Monopol Kommission 1998: 51). 7.4.6.2 Market failure as a justiﬁcation for the foreman’s certiﬁcation The foreman’s certiﬁcate is not only necessary as a qualiﬁcation, but also within the trade in general. Market failure is often quoted as a justiﬁcation for this.68 The certiﬁcate of a foreman is used to prove quality, since consumers can rarely identify the value of a service (consumer protection due to asymmetric information).69 If it did not exist, there would no longer be market barriers and the consequence would be a decrease of quality as cheaper, but inferior, goods could be supplied (adverse selection). Since the customers could only then take the price as a decision criterion, the suppliers of superior quality would be pushed out of the market. This would lead to a downward spiral regarding quality and, in extreme cases, could even result in dangerous activities. Ruinous competition, due to prices from dumping and inferior quality, would result in a destabilisation of the skilled crafts markets. The foreman’s certiﬁcate claims to impede such a development, as well as indicating quality, and protecting consumers. Furthermore, it should lessen the transaction costs for consumers, as controlling service quality is simpliﬁed. Finally, positive external effects regarding education of skilled workers are mentioned, as other areas of the economy can instruct their personnel in the trade of the crafts. 7.4.6.3 Analysing the justiﬁcation This global argument regarding market failure cannot be maintained, as has been shown in detail by the Deregulation Commission 67 68 69

See Fredebeul-Krein and Schurfeld ¨ (1998: 29). For an illustration of the supposed necessity of regulation from the point of view of craftmanship, see Kucera and Stratenwerth (1990). For introductory explanations of the terms, see, among others, Fritsch, Wein, and Ewers (1999).

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(Deregulierungs Kommission 1990/91); Monopoly Commission (1998), and Fredebeul-Krein and Schurfeld ¨ (1998).70 Other countries in the EU, with the exception of Austria and Luxemburg, are empirical proof for the fact that, in some cases, fewer registration regulations exist for certain trades. For example, there are none in Great Britain and very few in the Netherlands. German rules for market entry for tradesmen are unique in the world. In other countries, the markets did not collapse and the quality is comparable to that of Germany, whereas the prices are considerably lower. An examination of the arguments of market failure shows that this reason cannot be sustained. An example here is ensuring quality. In many cases, there is no asymmetric information, i.e., the customer has the opportunity of rating the value very well, be it from his own experience or given information. Furthermore, in some areas, the service depends more on the behaviour of the person than on his training (service orientation, fair dealing). Also, in the context of the fast pace of technological change nowadays, obtaining the foreman’s certiﬁcate, devised two centuries ago, does not guarantee an ability to handle ever-changing modern machines which require innovation and adaptation to new ideas. Quality can be secured through competition on the market. Not only is the price important but also the quality of the goods, deﬁned through the reputation of the supplier. However, this word-of-mouth reputation also causes increasing illicit work in the manual trades. Not only is the cheaper price important here but also increased ﬂexibility, speed, and reliability of service: For this, one backs away from a legal guarantee, as it can for the most part be replaced by a personal relationship. The Deregulation Commission (Deregulierungs Kommission 1990/91) and the Monopoly Commission (1998) both came to the conclusion that trade supervision, existing liability laws, and privileges are sufﬁcient. Apart from that, many tradesmen voluntarily wish to obtain the foreman’s certiﬁcate, if they consider it to be regarded as a sign of quality by the customers, which is especially the case in a dangerous trade. Fierce competition is not to be expected and its intensiﬁcation does not induce suppliers of higher quality to leave the market. As this increase will lead to sinking prices, the market will expand. Because the services previously rendered illicitly are now ofﬁcial, perhaps less is done at home, which often proved to be inefﬁcient, or new ﬁrms enter the market.71 For trade education, the foreman’s certiﬁcate still makes sense 70 71

For an early critical contention on the foreman’s certiﬁcate, see Watrin (1957). See, e.g., the paper of the Federal Association of Independent Craftsmen (‘Bundesverband der unabh¨angigen Handwerker–BUH’), which represent craftsmen, who do not have a certiﬁcate but are independent professionals, e.g., in the travel trade. (http://www.aries.de/buh/index.html).

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as a qualitative presupposition (Meisterbrief). However, the Monopoly Commission (1998: 56f.) states that to combine this with professionalism as an incentive to learn is not necessary. The incentives (continuing employment of the best scholar, economic search and coaching costs, and employment as a general labourer) are large enough in many areas to further ensure education. If the costs of the latter are too high in certain cases or industries, a lower training salary should be considered, to equalise demand and supply.72 7.4.6.4 On the necessity of deregulation Abolishing the foreman constraint for self-employment is also necessary in the context of European integration. In the EU, there are four basic liberties (free goods trafﬁc, free service trafﬁc, freedom of movement, free capital movement). This implies that individuals from other European countries are free to settle in Germany. Furthermore, foreign trade services can be offered without a foreman’s certiﬁcate. This leads to a multiple location disadvantage for German craftsmen. On the one hand, market-entry costs are higher for Germans and, on the other hand, resulting prices are also above the ones offered by the foreigners. The consequence is discrimination against the indigenous population, which cannot be tenable, especially if these disadvantages attributable to regulation become stronger in the process of integration of the Eastern countries into Europe. The competitive pressure then becomes particularly obvious, as the differences in wage costs are considerably larger, not only in a comparison of the EU countries but also when considering the shadow economy. The consequences of regulation that is too extensive are: expansion of shadow economic activities; running short of the ofﬁcial supply; price increases of services without improvement of quality; and a decline in ﬂexibility, e.g., of skills. On the one hand, the services cannot be offered by a single ﬁrm, unless the certiﬁcate has been acquired in several areas, thus drastically increasing both the demand for coordination and the transaction costs; on the other hand, the craftsmen cannot shift the ﬁrm’s core, which is necessary to adapt to structural change. This impedes the procurement of new jobs, especially in the services sector. Germany still has considerable potential to expand, as opposed to the USA, for example. This potential can also be seen, when comparing the trade and related sectors that do not have any certiﬁcation obligation. The number of trade ﬁrms has decreased tremendously from 1970 (585,000) to 1996 (485,000), whereas associated industries have expanded signiﬁcantly in 72

See Eekhoff (1998: 249f.).

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this period (from 29,000 to 120,000). A similar growth dynamic is evident in the shadow economy, which has also quadrupled during this time. A part of this growth can be attributed to the density of regulation, as analysed in the following section. 7.5

Empirical examination of the inﬂuence of main causes

7.5.1

How the taxation system and the regulation density inﬂuence the shadow economy

To establish empirically the inﬂuence of various factors on the extent of the shadow economy is difﬁcult due to the complexity of relationships. In the past twenty years, there has been a signiﬁcant amount of theoretical work on tax evasion. In most cases, however, experimental work is seldom done, and its results concerning the inﬂuence of various factors affecting tax evasion are ambiguous.73 Empirical surveys on shadow economies and illicit work are more convincing. Besides the contribution by Johnson, Kaufmann, and ZoidoLobaton ´ (1998a,b), calculations by Cebula (1997) record the impact of the tax burden, marginal tax rates, Inland Revenue, and penalties on the size of the shadow economy. On the basis of their data, Lemieux, Fortin and Fr´echette (1994) determine that, for Canada, the net wage has a substantial effect on the extent of illicit work. Besides that, they partially conﬁrm the predication of the Laffer- i.e., Gutmann-Curve.74 Hill and Kabir (1996) and Giles, Tedds, and Werkneh (1999) can empirically prove the overall impact of the tax burden on Canada.75 Giles (1999a) determines a positive correlation between a decrease of the tax burden and the extent of the shadow economy in New Zealand. In the following section, we will elaborate on a study of Austria. The importance of several causes was measured empirically,76 based on the cash demand approach. To begin with, a cash demand function was econometrically estimated, including the real consumption per person (as an income variable), the number of Euro cheques per person (as a substitute for cash), and the real interest rate (opportunity costs variable) (Schneider 1994a; 1997a,b) as independent variables. Besides the conventional factors determining cash demand (real consumption per person, real interest rate, and number of inhabitants), four additional independent variables were introduced to the regression: 73 74 76

See Section 6.2.3.4; Pommerehne and Weck-Hannemann (1992); Andreoni, Erard, and Feinstein (1998). 75 See Spiro (1993). See Section 6.7. See Schneider and Neck (1993); Schneider and Poll ¨ (1999).

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1. a variable for the direct tax burden, including the social security contributions (the sum of average tax rate and average marginal tax rate for wage income); 2. a variable for the indirect tax burden, (an average tax rate for all indirect taxes); 3. a variable for the complexity of the system, (the HerﬁndahlHirschmann concentration measure for tax types and exemptions). The complexity of a taxation system is measured by the amount of types and tax exemptions. The more there are of either, the more complex the tax system becomes; 4. a variable for the intensity of regulation (the number of laws and regulations regarding the labour market and the area of social security). The estimation results for the adjusted cash demand function are listed in Table 7.9. The econometrically estimated coefﬁcients are statistically signiﬁcant and all estimated coefﬁcients have the theoretically expected sign. Thus, for example, an increase in the direct tax burden and density of regulation leads to a rise in shadow economic activity, as the positive coefﬁcients indicate. Regarding the other two factors, indirect tax burden and complexity of the taxation system, there is also a positive correlation between the independent and the dependent variables. Even if this is only weak, the theoretically derived hypotheses can be statistically veryﬁed, even though there are many shortcomings and restrictions, concerning the measurement procedures. A true ex-post forecast for the period 1985 to 1995, with the function estimated over 1960 to 1984, also rendered satisfactory results, indicating that this calculation allows reliable empirical statements, which support the theoretical argumentation. To determine the size of the shadow economy, it is ﬁrst presumed that it would not exist if the above-mentioned independent variables 1 to 4 remained at the 1960 minimal level. Assuming this holds, the amount of cash for conventional transactions can be simulated. The difference between the actual and the simulated values is attributed to the shadow economy. The exact effects of tax reforms on the extent of the shadow economy will be analysed in the following section. 7.5.2

Effects of tax reforms on the extent of the shadow economy

The effects of tax reforms were also simulated with the model introduced in the preceding section. The results from Tables 7.10 and 7.11 illustrate that the extent of shadow economic activity in Austria has risen steadily from 1.8% of GNP in 1970 to 9.6% of GNP in 1999. This seems surprising at ﬁrst, since some signiﬁcant changes to the tax rates and the

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Table 7.9. Estimation results for the cash demand functiona Dependent variable: real cash ﬂow (CF) per person, ln (CFt /POPt ) –estimation period Independent variables

1956–95

1956–89

Lagged dependent variable ln (CFt−1 /POPt−1 ) Real consumption (C) per capita ln (Ct /POPt ) Number of eurocheques(ES)/capita ln (ESt−1 /POPt−1 ) Real interest rate (IR) ln (IRt ) 1. Direct tax burden (DIRTX) ln (DIRSTt ) 2. Indirect tax burden (INDTX) ln (INDTXt ) 3.‘Complexity’ of the taxation system ln (COMPt ) 4. Intensity of regulation (REG) ln (REGt) Constant

0.621∗∗ (10.43) 0.724∗∗ (6.53) −0.165∗∗ (−2.24) −0.103∗ (−2.31) 0.194∗∗ (3.80) 0.139∗ (2.28) 0.134∗ (2.49) 0.213∗∗ (3.36) −1.06 (−0.80)

0.663∗∗ (11.47) 0.739∗∗ (6.09) 0.194∗∗ (−2.49) 0.122∗ (−2.55) 0.159∗∗ (3.21) 0.129∗ (2.02) 0.129∗∗ (2.71) 0.199∗∗ (2.92) −1.88 (−1.63)

0.999 0.014 1.31 0.21 31

0.993 0.015 1.45 0.23 25

Test statistics R2 S.E. Durbins h Rho(1) D.F. a The

equations were estimated with annual data and using the OLS-Procedure. POP is the population (18 years and above) and t the period of time (Year). R2 is the coefﬁcient of determination, adjusted by the degrees of freedom, S.E. is the standard error of the estimation, Durbins h is the h-test from Durbin on autocorrelation of lagged dependent variables as regressors, rho(1) is the estimated auto correlation coefﬁcient of the ﬁrst order. D.F. is the number of the degrees of freedom. ‘ln’ is the natural logarithm of the respective variable. The numbers in parenthesis under the coefﬁcient estimators are the t-values. (∗ ), ∗ and ∗∗ denotes signiﬁcance and the level of 90%, 95% or 99%. Source: Schneider and Poll ¨ (1999).

system were enforced during this period. Thus, we will attempt to show empirically how the different factors have inﬂuenced the development of the shadow economy over time. For this purpose, three larger changes to the Austrian taxation system are considered:

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Table 7.10. Inﬂuence of changes to the taxation system on the development of the Austrian shadow economy Size of the shadow economy (billion AS) due to:

Year

Extent of Complexity the shadow Direct tax Indirect tax of the taxation Intensity of economy burden burden system regulation

Case (i) 1972 10.41 1973 13.34 Difference 2.93 (73–72) (in %) (100.0) Case (ii) 1983 31.86 1984 36.38 Difference 4.52 (84–83) (in %) (100.0) Case (iii) 1988 46.37 1989 50.89 Difference 4.52 (89–88) (in %) (100.0)

5.58 6.82 1.24

1.45 2.20 0.75

2.37 3.24 0.87

1.01 1.08 0.07

(42.3)

(25.6)

(29.7)

(2.4)

13.48 16.12 2.64

7.74 9.57 1.83

5.19 5.16 −0.03

5.45 5.53 0.08

(58.4)

(40.5)

(−0.7)

(1.8)

19.01 17.86 −1.15

11.27 12.21 0.94

6.12 8.90 2.79

9.97 11.91 1.94

(−25.4)

(20.8)

(61.7)

(42.9)

Sources: Schneider (1994b); Schneider and Neck (1993).

1. 1972/73: Put into practice on 1 January 1973, value-added tax was introduced with a normal rate of 16%. Income tax was transformed from family to individual taxation. Furthermore, additional tax exemptions were introduced to promote investment. 2. 1983/84: All the value-added tax rates were increased, the normal rate from 18% to 20%, the high rate from 30% to 32%, and the low rate from 8% to 10%. Taxation on proﬁt from interest was introduced as a source tax. Further taxation exemptions were enforced in order to promote risk capital. 3. 1988/89: All marginal rates of income tax were reduced to a considerable extent (e.g., the peak rate from 62% to 50%). The number of scale levels was reduced from 10 to 5, thus causing a decline in the average tax rates on income. Simultaneously, the exemptions from income taxation were cut signiﬁcantly. Finally, proﬁt taxation was greatly trimmed down and the system was further simpliﬁed.

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Table 7.11. Dividing the development of shadow economic activities into its components by their respective inﬂuencing factors Share in % of the shadow economy due to: Extent of the shadow economy in billion AS

Year

Direct tax burden

Indirect tax burden

Complexity of the taxation system

1965 1966 1967 1968 1969

5.12 51.8 49.3 49.6 50.6

12.1 12.4 11.2 11.9 12.6

25.9 25.3 26.1 25.3 24.6

9.8 11.1 13.4 13.2 11.9

5.14 5.69 5.49 6.21 8.31

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979

51.3 52.3 53.6 51.1 52.0 50.9 51.4 51.0 49.6 47.6

13.5 13.3 13.9 16.5 16.0 15.9 18.4 20.1 22.0 21.9

23.4 23.0 22.8 24.3 24.0 23.4 21.2 20.6 18.7 18.8

11.8 11.4 9.7 8.1 8.0 9.8 9.0 8.3 9.7 11.7

10.47 9.58 10.41 13.34 12.46 12.02 15.39 18.01 20.06 22.88

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

46.3 45.0 42.2 42.3 44.3 44.0 43.1 40.9 41.0 35.1

21.6 23.3 24.9 24.3 26.3 25.2 25.2 24.0 24.3 25.6

17.9 17.0 17.1 16.3 14.2 15.2 14.1 13.7 13.2 17.1

14.2 14.4 15.8 17.1 15.2 15.6 17.6 21.4 21.5 22.2

24.98 26.96 29.09 31.86 36.38 36.98 39.64 41.22 46.37 50.89

1990 1991 1992 1993 1994 1995

34.6 34.1 33.1 31.9 30.5 28.7

25.1 25.4 25.6 25.9 26.2 26.6

17.3 17.0 17.4 17.9 18.2 18.7

23.0 23.5 23.9 24.3 25.1 26.0

54.56 59.89 68.23 74.46 82.34 89.56

Intensity of regulation

Source: Schneider (1994b); for the years 1992–95 Schneider/ Poll ¨ (1999)

The effects of these three cases of tax measures on the development of the shadow economy are illustrated below. The latter is divided into its components. The following conclusions can be drawn from Table 7.10:

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1. 1972/73: the change in indirect taxation and the introduction of individual taxation had the strongest effect on the shadow economy. Owing to the shift from the sales tax to a simpler value-added tax, the complexity of the system was reduced. Yet, since the latter is a clear and simple tax, shown on every invoice, individuals feel the impact of it more strongly and hence the incentive to evade it rises. The simultaneous rise in the sales tax burden also augmented the extent of illicit work. 2. 1983/84: the ‘cold progression’ of income tax had the strongest inﬂuence on the shadow economy. Of course, the increase of value-added tax also caused an increase in illicit work, but this was not as strong as the (non-discretionary) escalation of the direct tax burden. 3. 1988/89: the income tax reform had two contrary effects. The reduction of the burden of direct taxation, ceteris paribus, caused a cut in illicit work. At the same time, the complexity of the income taxation system was reduced and the burden clariﬁed. Combined with the automatic increase in the indirect tax burden and the higher regulation intensity, the overall outcome is a rise in shadow economic activity. The division of the development of the Austrian black economy into its component parts, according to the inﬂuential factors over time, can be carried out for the entire period under examination, namely from 1965 to 1995. It can be seen that the direct tax burden quantitatively has the largest inﬂuence on illicit work. Yet, it has decreased immensely from 50% to 29%, which can be attributed to the decreasing yield from income taxation and discretionary tax cuts. A contrary trend can be seen when looking at the indirect tax burden, whose inﬂuence on the shadow economy has increased considerably from 12% to 27%. The effect of the complexity of the taxation system has declined from 25% to 19%, as the system was more complex and unclear prior to the income tax reform of 1988/89. This implies that there are more legal evasion possibilities and thus the incentive to work illicitly diminishes so as to evade the control of the Internal Revenue ofﬁce. Here, the theoretical consideration of control plays an important role, indicating that the taxpayer answers with less reluctance, if he/she has options to shape the individual burden. The more the taxpayers believe that they themselves control their payments, the less they feel restricted in their own personal freedom. Although undesirable to the Treasury, this effect of systematic and drastic simpliﬁcation of tax has to be considered when looking at tax reforms. Apart from all this, the inﬂuence of the intensity of regulation has increased (from 10% to 26%).

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Certainly the most interesting result of this calculation is the effect of the tax reform in 1988/89. Here, the share of the burden of direct taxation has fallen by 5.9 percentage points to 35.1%. However, the simultaneous reduction of the complexity of the taxation system has rendered the burden clearer and tenable. Thus, the result was an opposite effect on the shadow economy, as the latter led to an increase in illicit work. The importance of the component rose from 13.2% to 16.5%. So, the tax reform of 1988/89 does not seem to have reached its objective regarding a decrease in illicit activities. The decline of the direct tax burden has been counteracted by the cut in complexity and by intensiﬁed regulation so that the black economy has grown further. This result should be kept in mind when considering the current tax reform proposals. Nevertheless, the conclusion to be drawn is not that the taxation system should be made even more complicated but, instead, that the rate of public expenditure should be decreased whilst, and at the same time, positive public services should be clariﬁed. Instead of complaining about tax evasion, one could emphasise the large number of honest taxpayers and the considerable supply of public goods. Responsible citizens should not be deceived by a complex and complicated system. More current surveys on the correlation between corruption and illicit work show that the enforcement of regulations, rather than the tax rate, is the deciding factor regarding migration into the shadow economy.77 The result of the simulation clariﬁes that the current shape of the taxation system does not comply with the principle of consumer or voter sovereignty. By the design of the social security and taxation systems, the governing body impedes the passage of information to its citizens. In reality, reducing shadow economic activity via extensive tax reform is difﬁcult for various other reasons as well. These include social contact, habit, the ongoing high utility (especially since deviant behaviour was always rewarded with a high wage), and completed investments (e.g., machines).78 Spiro (1993) has ascertained a very similar effect of reforms for Canada: ‘Unfortunately, once this habit is developed, it is unlikely that it will be abandoned merely because economic growth resumes’. (Spiro 1993: 255). Above all, reforms can be helpful in stopping the growth of the shadow economy but cannot really reduce it. 7.6

Control frequency and the level of punishment

In politics, there is often a demand for increased control and intensiﬁcation of punishments. The reaction to the rise of the shadow economy has 77 78

See Schneider and Enste (2000c) for further literature. See Schneider (1998a: 45).

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The shadow economy

been to combat the symptoms via legal regulations. Thus, there is, for example, the threat of higher ﬁnes and intensiﬁed controls (e.g., publicly effective major crackdowns on building sites in Berlin). The regulations in the ‘Law Against Illicit Work’ in Germany show the ﬁnes to be paid or avoided by the respective workers in the different areas. In §1 section 1 phrases 1–3, the following activities are summarised under the term illicit work. Illegal actions include bringing forward services or production without notifying the federal bureau of labour; being selfemployed and running an individual trade without complying with the legal prescriptions; and practising as a craftsman without being part of the appropriate chamber. Explicitly excluded are activities done as favours, neighbourhood help, or self-help in the sense of the Second Building Law. These are part of the informal sector. Breaches of this law are prosecuted as irregularities and are punished with a ﬁne of up to 300,000 EUR since 2002.79 If this is combined with an abuse of beneﬁts in the form of lying about, or hiding, important facts (e.g., employment), a term of imprisonment of up to ﬁve years is possible with the added punishment of having to pay back the beneﬁt. Above that, the controls are increased, making a regular occupation more attractive. In the theoretical model (e.g., the income-leisure model), these factors can be very well illustrated, so that they can be found in nearly every study, e.g., on tax evasion or illicit work. One has to differentiate between two probabilities: the likelihood of being discovered and that of being punished. Both are part of the decision process. Yet, the overall probability of being discovered is extremely small, largely due to the fact that there are so many people in the same category.80 Subjective assessment of the danger of being discovered can vary immensely, so that allusions to stronger controls can be the correct deterrent. Empirical studies (Weck-Hannemann and Pommerehne 1989) demonstrate that the chance of being discovered is the relevant economic variable which has a signiﬁcant inﬂuence on tax evasion. However, to raise this probability is very costly, and again has to be ﬁnanced via taxes. In addition, the state has to take into account that its citizens and taxpayers might ﬁnd new quasi-legal possibilities of evading controls. An ongoing modiﬁcation of the tax laws, which still lags behind the development on the market (e.g., insurance or buying contracts), shows that the public institution cannot keep pace with the creativity of the competitive ﬁrms on the market. The Expert Commission on Housing Policy (1995) has 79 80

See also BMA (1997b, 1998b). Riebel (1983: 119) that the likelihood of discovery is one per million for an illicit worker. For similar results, see Lamnek and Luedtke (1999).

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ascertained that rational investment tactics are ignored in order to avail tax advantages. ‘It seems that for many citizens a Deutschmark that they can hide from the exchequer is worth much more than one regularly earned Deutschmark.’ (Expert Commission Housing Policy (Experten Kommission Wohnungs Politik) 1995: 10, Tz.1201). Thus, aggravating state controls leads to increased efforts on behalf of the people concerned and results in a waste of resources on both sides. Combating the abuse of beneﬁts is a focal point of state control, as here the exploitation of the state is at its clearest. Yet, the demand by the public to combat the latter seems very strongly related to ‘St. Florian’s principle’, as illustrated in the study by Lamnek, Olbrich, and Sch¨afer (2000). Increased controls and punishment are called for, but only when it concerns others. One’s own exploitation is justiﬁed when there is a personal emergency.81 In considering the causes, and in the absence of additional reforms, the intensiﬁcation of controls and ﬁnes, as in the law of 1998, will not effectively hit the desired target. This economic policy solution is a very expensive strategy, as will be shown in chapter 8.1.1. 7.7

Tax morality and the supply of public goods

A further important cause of shadow economic activity is tax morality or, in general, the public attitude towards the state. If citizens perceive that their interests are properly represented and supplied with public goods and services, they will not wish to work illicitly. Considering this factor via an economic approach is possible in the context of interdisciplinary issues.82 A quantitative record of the public moral attitude towards the shadow economy is harder to establish. Yet, there are attempts to quantify its inﬂuence on the black economy. Table 7.12 illustrates tax morality in two different years (1960 and 1978) in OECD countries. The table shows that, according to these calculations, tax morality, especially in Belgium, Italy, France, Germany, and the USA, has decreased during the period in question.83 The results point to the fact that the willingness of citizens to work illicitly has risen. Clear variations between the countries can explain the differing extents of the shadow economy. Weck (1983), Weck, Pommerehne, and Frey (1984), and Frey and Weck-Hannemann (1984) applied the Model Approach to prove empirically the importance of tax morality for the development of the hidden 81 82 83

See the evaluation of qualitative interviews by Lamnek, Olbrich, and Sch¨afer (2000). Klein (1997) considers this in a (tax) legal context, pleading for an acceptance-oriented development of tax law, increasingly bearing in mind the views of the public. For the calculation, see Weck (1983); Weck, Pommerehne, and Frey (1984).

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Table 7.12. The tax moral as an inﬂuencing factor for the rise of the shadow economy Development of the tax moral (%) (the higher the value, the lower the tax moral, i.e., the higher the tax immorality) Country

1960

1965

1970

1975

1978

Difference 1960–78

Belgium Denmark Germany Finland France Great Britain Ireland Italy Japan Canada Netherlands Norway Austria Sweden Switzerland Spain USA

7.1 2.2 5.5 2.2 8.7 2.2 3.8 10.4 3.8 3.8 5.5 2.2 5.5 2.2 0.6 7.1 3.8

8.6 2.7 6.7 2.7 10.6 2.7 4.7 12.6 4.7 4.7 6.7 2.7 6.7 2.7 0.7 8.6 4.7

11.6 3.6 9.0 3.6 14.3 3.6 6.3 17.0 6.3 6.3 9.0 3.6 9.0 3.6 1.0 11.6 6.3

13.7 4.2 10.6 4.2 16.9 4.2 7.4 20.1 7.4 7.4 10.6 4.2 10.6 4.2 1.2 13.7 7.4

14.0 4.4 10.9 4.4 17.3 4.4 7.6 20.6 7.6 7.6 10.9 4.4 10.9 4.4 1.2 14.0 7.6

+6.9 +2.2 +5.4 +2.2 +8.6 +2.2 +3.8 +10.2 +3.8 +3.8 +5.4 +2.2 +5.4 +2.2 +0.6 +6.9 +3.8

Source: Weck, Pommerehne, and Frey (1984).

economy. A further inﬂuencing factor is the level of the tax burden. The authors differentiate between the share of GNP of direct tax that of indirect tax, and that of social security. Apart from this, the variation in direct taxes (as part of the GNP) is modelled as an approximation to both the perception of the tax burden as well as to the regulation density (measured as a share of state employment of overall employment). Other inﬂuential factors are available real income, the ten-year average of the unemployment ﬁgures, and tax morality as recorded through polls. Despite the warranted criticism of this method and the chosen parameters (e.g., the regulation density; see chapter 3), these models allude to the relevance of individual factors, whose importance was theoretically derived. Weck (1983) discovers, on the basis of this data for seventeen OECD countries, that tax morality has the strongest statistical inﬂuence on the size of the shadow economy. This is stronger than the inﬂuence of both the direct tax burden and of regulation. To explain the development of the shadow economy, it is necessary to integrate tax morality with economic approaches, as becomes clear when comparing the results of the above authors. This has been done

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by Kirchg¨assner (1999: 431f.). Despite a signiﬁcantly higher burden of direct taxes and a denser regulation in the Netherlands, the shadow economic activity here was considerably lower in 1978, the year the calculation was made. At the same time, it is not promising to achieve better tax morality by the appropriate roll call.84 To promote a sense of fairness, a perception of justice and respect, and compliance with the existing laws is economically not sensible. Socio-psychological considerations even suggest that appeals to morality can have contrary effects. Only then do honest taxpayers realise that considerable evasion exists and that they are the ‘dumb’ ones. By applying the ‘theory of comparative processes’, one can demonstrate that emphasising tax immorality can lead to an increased individual perception of injustice, when comparing one’s own input-output relationship with that of others, resulting in an increased willingness to reduce one’s own input (i.e., to hide income to evade taxes). The output in this case is a public good, which can be used by everyone. The development of the shadow economy is inﬂuenced by the publicly provided goods and services state equivalent, which the citizen receives partly in the form of public goods, e.g., infrastructure, defence, public safety, social security, basic education. The deciding factor is whether this supply can be regarded as being ﬁnanced by individual taxes. A common problem is the ‘free-rider’ phenomenon.85 An illicit worker can also proﬁt from these goods, as pure public goods are characterised by the fact that no one is excluded from utilisation and there is no consumption rivalry. In this context, it becomes clear that taxes are necessary to ﬁnance public goods.86 Thus if taxation has to be enforced by law, and the positive external effect of public goods cannot be internalised, there has to be an alternative to achieve a stronger connection between tax payments and supply of goods to reduce the incentives for tax evasion and illicit work. A promising approach is to increase the participation of citizens in the production of goods by strengthening the direct democratic elements. Identiﬁcation with the state is reinforced and thus the willingness to pay taxes rises. Such an afﬁnity can be expected if public administration is smaller and easier to overlook (federal structure). Loyalty towards the public institutions can be fortiﬁed.87 This produces an opportunity to organise the supply 84 85 86

87

For proposals on political communitarism see Gaertner (1989); Etzioni (1995, 1997). See Section 7.1. Reducing shadow economic activity often promises an amelioration of the supply of public goods. This relation can only be derived and proved empirically with very restrictive assumptions. See Loayza (1996) and Chapter 8.1.3. See Kirchg¨assner (1999) for conclusions for economic policy.

154

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of public goods according to the desires of individuals. Preliminary research on the importance of direct democratic elements conﬁrms their inﬂuence on the extent of tax evasion.88 Apart from this, the manner of the supply and the design of the administration are very important.89 In recent studies, this can be seen in the inﬂuence of corruption on the size of the hidden economy.90 We will return to this subject in the context of recommendations for economic policy. 88 89 90

See Weck-Hannemann and Pommerehne (1989). See, e.g., Schmolders ¨ (1960, 1975, 1980); and Pommerehne and Frey (1992). For the current discussion, see among others Bardhan (1997); Schneider and Enste (2000c); Rose-Ackermann (1999); Tanzi (1998); Shleifer and Vestny (1993).

8

Effects of the increasing shadow economy

Having analysed the extent of the global shadow economy and the causes of its dramatic rise in OECD countries, we now focus on the consequences of its development for economic and social policy. Despite the importance of this, there is hardly any literature on the effects of the shadow economy.1 There is no comprehensive model for such a causal analysis beyond micro-economic welfare studies.2 Here, some empirical considerations will be made. Analysing the consequences of shadow economic activities in a welfare economics context is too restricted to fully portray causal connections.3 Thus, we will also explain some effects derived from evolutionary economics, although, we do not claim to make ﬁnal and completely satisfactory statements. The evaluation of the welfare effects of shadow economic activities varies according to the basic point of view and deﬁnition adopted, as well as to the underlying reference model. For some, this is the purest and most efﬁcient form of economic action (Friedman 1982); for others it is a danger to state authority and a sign of deteriorating morality. This chapter gives an overview of the various positive and negative effects of the hidden economy from a macro-economic perspective, and tries to convey a complete and balanced picture. In general, welfare economics consequences are examined, e.g., on the GNP, as an indicator for the material welfare of society. In economic sciences, these are divided into allocation, distribution, and stabilisation effects.4 A very important objective for economic policy is to improve allocation. This implies optimising the input of scarce resources, i.e., putting the production factors (work, capital, land, etc.) to their most 1 2

3 4

See the omnibus volume by Gross and Friedrich (1988) on the discussion about the positive effects of the shadow economy in a social science context. As there are only a few newer models with empirical proof, the following chapter is based on one of the few systematic analyses by Gretschmann (1984), into which the more current cognitions are integrated. See Allingham and Sandmo (1972); Sandmo (1981); and Section 6.7. See Musgrave, Musgrave, and Kullmer (1994).

155

156

The shadow economy

proliﬁc use, or, put another way, increasing efﬁciency by achieving the same output with a lower factor input. Improving allocation by shadow economic activities would be possible if, for example, an input factor was used more effectively and not wasted. Alternatively, higher welfare can also be obtained if more output is achieved with a constant input. Higher efﬁciency results in higher welfare, as scarce resources can be applied to a production with a higher quality or quantity. The GNP in a market economy, in an ideal case, with perfect competition, is produced in accordance with the supply of goods and services. However, income distribution on the market is corrected by the state, since primary allocation in the western world is not regarded as being ethically and morally justiﬁable. These measures (e.g., the progression of income tax or securing subsistence level by welfare) are part of redistribution policy. Distribution effects are the topic of Section 8.2. The questions to be answered are as follows: Who proﬁts from illicit work? How are the chances of earning an illicit income allotted in society? Is the likelihood of equal chances increased or decreased? Opinions vary immensely, when evaluating these distribution effects as well as over topics such as growth, the business cycle, and employment (stabilisation effects). However, empirical studies partially prove the more positive stabilisation effects, theoretically derived. Apart from this, of course, the ﬁscal effects on the tax yield and the social security systems are important from the state’s point of view (see Section 8.4). In part, public discussion is restricted almost exclusively to the expected high tax losses and the increased burden due to illicit work, as well as to higher unemployment and any further consequences are ignored. Yet these are relevant not only for OECD nations, but also for developing and transition countries. For example, it is possible that without shadow economic activity there would be considerable additional problems in granting the subsistence level and achieving a higher growth rate.5 Some shadow economic effects on the ofﬁcial economy are examined by integrating the former into macro-economic models.6 Welfare economics can also aid in evaluating the causes. The following analysis tries to go beyond the traditional model analysis in attempting to consider the probabilities and to substantiate these with empirical data. Our analysis focuses on the shadow economic effects on the allocation, growth, business cycle, and employment of OECD nations. We wish to 5 6

Due to the restricted amount of space these aspects can only be broached. Thomas (1992) has a very detailed description. See, e.g., Neck, Schneider, and Hofreither (1989); Quirk, (1996); and Andreoni, Erard, and Feinstein (1998).

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157

Allocation effects

Positive effects

Negative effects

1. Prices are indicators of scarcity

1. Waste of economic resources

2. Division of labour is promoted

2. Too little capital intensity in the shadow economy

3. Competition is intensified

due to inadequate access to the credit market - because of the risks of being detected 4. Scarce resources are used

- because of the illegality

due to too little labour intensity in the official sector 5. Additional potential for innovation

- because of a too high tax burden - because of rules and regulations

6. Creating income and demand

7. Additional supply of goods and services

3. Distortion of competition due to tax evasion

4. Difficulties in financing public goods

Figure 8.1. Systematisation of allocation effects

demonstrate that, besides the obvious negative consequences, there are positive ones. 8.1

Allocation effects

The shadow economy affects the input of production factors in a variety of ways. Here, they will be differentiated into positive and negative consequences. The basic reference model is important for the evaluation. The ﬁrst two negative effects have to be seen in a welfare economic context.7 Ideally the allocation there is not distorted. Figure 8.1 gives a preliminary overview of all the aspects described below.8 7

8

See Heertje (1987: 303–10), who, by abstracting moral and ‘law-and-order’ considerations, comes to the conclusion that there is nearly perfect competition functioning without state and collective regulation and producing pareto-optimum results. For the causal analysis, see, e.g., Cassel (1986); Gretschmann (1984); Langfeldt (1984a,b); Pommerehne and Kirchg¨assner (1994); Sch¨afer (1986); Dohrn ¨ (1990).

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8.1.1

Macro-economic waste of resources

Shadow economic activity is always combined with an immense waste of resources.9 On the one hand, dissimulation and gathering information is very costly for illicit workers and, on the other hand, the state has also increased expenses connected with control, ascertainment, and prosecution.10 This waste can be clariﬁed when considering an optimal taxation system which is widely accepted by the public and does not distort allocation decisions as much. When aggregated, these transactions costs are generally compensated by the additional added value, so that the result is always higher welfare, despite the fact that the resources are not applied to support growth. Increased overall economic costs result from inferior marketing possibilities. Advertising illicit jobs in the media in Germany is penalised with a ﬁne of up to 50,000 EUR. Other negative consequences are the decreased warranty conditions that cannot be enforced by consumers. Furthermore, ﬁrms cannot impose legal claims. Then again, there is a lack of insurance, as basic risks, such as accidents, liability responsibilities, and illness cannot be pooled or secured. The state has high costs of supervision that relate to regulation, the control of construction sites, and the (supposed) pursuance of breaches in the context of help or favours in the neighbourhood. Deﬁning these actions is as hard as deﬁning the situation from which the individuals are working illicitly, as only then is this illegal. The costs of jurisdiction also have to be considered. A further increase in ﬁnes (e.g., in Germany the maximum ﬁne for illicit work was increased from 100,000 to 300,000 EUR in 2002) and the intensiﬁcation of controls would not lead to the desired reduction of costs, but to a strengthened dissimulation on behalf of the people concerned. The incentives to avoid these punishments are high and so are the costs in hiding the activities. This is so if the taxpayer rates a dollar saved from taxes higher than an additionally earned dollar. In principle, the probability of being punished is low relative to the possible yield, as illicit work is more or less quietly tolerated and difﬁcult to verify. It is partly for these reasons, that there is demand for a partial legalisation of the soft forms of illicit work.11 9 10

11

See, e.g., Shleifer and Vestny (1993). These costs arise extensively in the case of pure tax evasion and avoidance. Many employees in the real estate, ﬁnancial, and banking industries are occupied with novel investment possibilities to evade taxes, while the federal ministry of ﬁnance tries to close these gaps. For these and other reasons, there is always a demand for a simpliﬁcation of the taxation system when proposing reforms. Staudt (1999) proposes, e.g., to ‘partially legalise illicit work’.

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159

Reduced economic growth due to a distorted production structure

Shadow economic activity is always combined with various negative welfare effects. Social security systems and public ﬁnances aside, the main problem is the distortion of competition between the two sectors. The regular suppliers have to carry the tax burden, the fringe beneﬁts of wages, and the costs to comply with the rules and regulations, whereas those occupied in the hidden economy can avoid these. As a result, capital is relatively cheaper in the ofﬁcial economy and thus the ﬁrms utilise it more intensively than would be sensible for scarcity reasons. The capital coefﬁcient in the regular sector is too high, as the labour factor is made more expensive artiﬁcially due to state and collective agreements. This implies that production in the irregular sector is too labour-intensive, as this factor is relatively cheaper than capital. This distortion is additionally intensiﬁed by the mobility of the labour factor as it can evade taxes by engaging in shadow economic activities. When exclusively considering taxation, the marginal burden is the difference between the gross marginal product in the ofﬁcial and the unofﬁcial economy. The higher this is, the higher is the incentive to work illicitly, as far as it is possible. The inferior capital intensity in the shadow economy can also be explained by the fact that illicit workers cannot make use of credit markets, except at a high cost. Thus, they have very little incentive to employ them at all. If the probability of being discovered is relatively high, it is not worthwhile, as the risk of losing the capital is high. As all the knowledge that the individual has gathered automatically becomes worthless when he is discovered, training or on-the-job education is not proﬁtable. This impedes economic growth even further and, in the long run, increases long-term unemployment, as it becomes harder for illicit workers to obtain a regular job, owing to lack of education. However, illicit workers on the side do not have this problem. The scarcity of both human resources and capital in the shadow economy has negative consequences for economic growth, especially in countries with a large hidden economy, e.g., the transition and developing countries.12 Brockmeier (1997) states that under-development in some countries not only results from scarce real capital, but also from the given institutional rights of action. The insecurity, regarding property claims and rights on real capital, prevents even the most innovative ﬁrms from developing new and better products or services. The lower growth rates in the shadow economy, resulting from complementary correlations, have a negative effect on the ofﬁcial sector as well.13 12

See Chapter 4.

13

See Schneider (1998b).

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In the long run, scarce human resources lead to decreased growth potential, as the development and application of modern technologies increasingly fail due to the lack of know-how on the part of the workers. Nor can productivity be augmented with more capital input. Many ﬁrms have experienced this after shifting their production location into Eastern European countries, where wages and productivity are low. The differing production functions do not explain the distortion between the two sectors. The higher labour intensity in the shadow economy can be explained by increased service concentration. The tertiary sector is more labour intensive and illicit work comprises services in general. The consequence is that labour becomes more expensive in the ofﬁcial economy, resulting in rationalisation and capital intensive production. 8.1.3

Reduced economic growth due to the lack of ﬁnancing of infrastructure projects

The fact that necessary public investment (e.g., infrastructure) cannot be carried out because of a lack of ﬁnances resulting from tax evasion, results in negative ofﬁcial economic growth. Public goods cannot be supplied to the desired quantity, and the aggregate supply of the economy falls. As the ﬁnancial situation deteriorates, shadow economic activity is viewed increasingly negatively. Yet this can only be proven empirically with very restrictive assumptions. On the one hand, not all publicly supplied goods ﬁt the above deﬁnition. They are partly ﬁnanced via contributions or contributions to be paid by every user, including illicit workers. Individuals working in the hidden economy can be seen as free-riders, who do not participate in the ﬁnancing of those purely public goods entirely ﬁnanced through taxes. On the other hand, there has to be a certain rivalry in consumption, contrary to the deﬁnition; i.e., there have to be bottlenecks when using the infrastructure. Apart from that, the ﬁnes enforced on the offenders caught are not to be used to ﬁnance the goods. With these assumptions applied to his endogenous growth model, Loayza (1996) comes to the conclusion that the shadow economy has a rather negative inﬂuence on economic growth. His calculations for Latin America (1980–92) convey a negative correlation between the increase of the shadow economy and the ofﬁcial growth rate. A rise in illicit work of only 1% of GNP decreases the ofﬁcial growth by 1.22%. Besides the restrictive assumptions, the neglect of further omission can be criticised. This negative correlation between the ofﬁcial GNP and the shadow economy is denied by calculations for Canada and New Zealand.14 14

See Schneider and Enste (2000c). For the empirical results, see Giles (1999a).

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8.1.4

161

Undistorted scarcity prices in the shadow economy

As the causal analysis in Chapter 7 has shown, the ofﬁcial economy can deviate immensely from perfect competition with ﬂexible price and quantity reactions of the agents and efﬁcient production as described in allocation theory (e.g., by regulations and minimum prices). In the hidden economy, many of these state and collective agreement interventions do not exist, resulting in a higher amount of consumer sovereignty, individual freedom, and price ﬂexibility, where the latter can function as indicators of scarcity.15 This is an important presupposition for the efﬁcient input of resources. Price equalises supply and demand and coordinates the individual decisions of households and ﬁrms. Thus, the shadow economy has almost ‘ideal’ conditions for an optimal resource allocation. The economy is not burdened by over-regulation and administration, as in the ofﬁcial sector, which holds back economic growth considerably, especially in developing countries.16 From an allocation point of view, the informal sector is the cheaper alternative for small enterprises in urban surroundings, particularly in transition and developing countries. Ongoing growth can be guaranteed, if property rights are organised in this sector as well.17 In the long run, the pressure from shadow economic activity can help transform legal regulations as well as social and economic institutions. In particular, if the state budget situation has become desperate, market reforms are inevitable. External pressure for such reforms, from the likes of the International Monetary Fund, can support this development. 8.1.5

Supporting division of labour in the economy

Shadow economic activities allow an increased division of labour. Many services, hitherto not available on the market or too expensive, can now be demanded in the shadow economy. The main argument for the increase of division of labour is the possibility of an implicit tax cut, as the illicit income is hidden from the Internal Revenue Service. This leads to a rise in welfare as the comparative or absolute cost advantages are exploited.18 Transferring the idea of comparative cost advantages to the shadow economy means that a doctor (even if he can paper a wall better) should leave decorating to the craftsman. Because of the high prices in the ofﬁcial 15 16 17 18

For an explanation of the price functions and the importance of prices, see the relevant literature, e.g., the classic by Samuelson and Nordhaus (1998), or Mankiw (1998, 1999). De Soto (1989) documents these effects very vividly with the example of Peru; for basic correlations, see Thomas (1992). On the importance of the legal order, see Brockmeier (1997). Most economics students should be familiar with foreign trade and Ricardo’s theory of comparative costs to explain the goods exchange between two economies, where the specialisation advantages are often explained using the example of England and Portugal; see, e.g., Rose and Sauernheimer (1995); Krugman and Obstfeld (1997).

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sector, giving the job to a regular ﬁrm is often not worthwhile, as a working hour in the ofﬁcial sector costs four times the average net income per hour, thereby eliminating the specialisation advantage. Giving the job to an illicit worker is efﬁcient for the doctor, as he can make use of the division of labour in the shadow economy. The exploitation of comparative advantages in the shadow economy also leads to increasing overall economic welfare in a country. The doctor treats the family of the craftsman while the latter renovates the former’s house. The difference between the services is compensated in cash. So, migrating into the shadow economy is the rational strategy in order to compensate for individual income and asset disparities despite a high tax rate. If one chooses to deﬁne the underground economy generally, this could result in a decline in division of labour, as this deﬁnition not only includes illicit work but also self-sufﬁciency. The increase of the latter and do-ityourself reduces the division of labour. Instead of letting the occupation be managed via the market, the high-earning doctor prefers to paint his ﬂat himself.19 Differentiating the shadow economy is helpful to clarify the contradictory tendencies. When illicit work implies an increase in division of labour, then greater self-sufﬁciency has the reverse effect. The cause in both cases is the considerable difference between gross and net wages. Again, it is pointed out that the negative welfare effects of economic criminality (criminal sector) such as drugs trafﬁcking, illegal foreign workers, and industrial fraud, are a part of the shadow economy, which is not integrated into the current study.20 8.1.6

Does the shadow economy intensify or distort competition?

The intensiﬁcation of competition that comes from shadow economic activity has positive effects on allocation. Supply from the unofﬁcial economy leads to additional competition for established industries which are under legal regulations, e.g., by high minimum wages. This gets in the way of the positive stimuli of competition, e.g., cheap and efﬁcient production, economic ﬂexibility, and the promotion of technological progress. It leads to high costs and prices as well as to inefﬁcient inputs of factors of production. Some interest groups beneﬁt from the competition in 19

20

Taylorism deﬁnes a direction of business management promoting an extreme division of the work into smallest units. This should increase human productivity. However, the improved efﬁciency is restricted by the monotony, the limited work contents, and the considerable lack of individual freedom, resulting in a decline of motivation (despite incentive wage). The consequence was increasing DIY (Do-it-Yourself). Kirchg¨assner (1999), and Schneider and Poll ¨ (1999) discuss the negative effects, e.g., on the basis of past moral conceptions.

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other industries and they personally proﬁt from the protection of their own branch, e.g., for reasons of quality or social fairness, etc. To sum up, state intervention cannot often be justiﬁed from an economic point of view. It should be designed so that the price functions are restricted as little as possible.21 Distortions arise, since shadow economic ﬁrms can offer their goods at low prices because of tax evasion. Honest businesses can be pushed out of the market. As a result, the motivation to supply illicit labour increases, which in the long run puts pressure on public ﬁnances. In some instances, regular suppliers are forced to move underground. However, this is only the case if the shadow economy offers similar or substitute goods or services, as opposed to complementary ones.22 The welfare effects of a shifting demand for similar goods are ambiguous. The additional demand in the hidden economy can compensate for the overall loss, so that it could result in positive multiplier-accelerator effects.23 Distorted competition does not have to lead to a further increase of the shadow economy, which would imply additional transaction costs. Instead, the conditions for regular suppliers should be improved by deregulation and more ﬂexibility to strengthen their position. Combating illicit work with ﬁnes and controls often leads to a dead end. When certain areas are protected from national competition, through subsidies and regulation, they cannot become internationally competitive. International competition can be simulated by national illicit work. Those sections protected by market-entry restrictions have to be opened to competition. Then they can anticipate the consequences of shadow economic activities. The problems resulting from competition protection are apparent in the European Union. The freedom of movement for labour is one of the most important basic freedoms, which has to be guaranteed within the EU. Capital, labour, goods, and services have to be able to move freely to allow for trade, proﬁts, improved industrial competition, and division of labour in Europe.24 In combination with the freedom to work and establish a business in Germany, this has led to increased competition by the neighbouring states. Yet craftsmen in Germany are still protected from competition by the Meisterbrief. Since foreign craftsmen can go into business independently, this leaves Germans at a disadvantage. This paradoxical situation has to change in the near future. Freedom of movement cannot be sacriﬁced to the interests of certain pressure groups. European integration has also decreased protection for other sectors. Protectionist 21 22 24

See Section 7.1 and, for an easy illustration connected with economic policy considerations, Fritsch, Wein, and Ewers (1999), and Kirchg¨assner and Frey (1994). 23 See Section 8.3. See Gretschmann (1984: 108f.). For the implications of the basic freedoms, see Sinn (1995).

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measures against other countries can rarely be enforced any longer. In the context of the ongoing internationalisation of trade and globalisation, such exemptions are no longer acceptable. 8.1.7

Additional innovation potential in the shadow economy

In the developing and transition countries, in particular, the shadow economy offers an immense potential for innovation. Here, one can ﬁnd numerous individuals of the Schumpeterian type, i.e., those who are willing to take the initiative and risk and who discover niches for their products.25 For the most part, these goals can be achieved when evading regulation and taxes. They can be realised in the shadow economy with fewer costs and hence lower risk. Firms can be founded without the burden of ofﬁcial administrative requirements.26 As illicit work presupposes a certain degree of enthusiasm for risk, there are more people open to structural changes on the black market, so that technical innovations can be carried through more easily. A famous example is Bill Gates, who, had he been in Germany, could only have realised his idea – which he supposedly invented in his garage – in the shadow economy. Most of the innovations, however, take place in the social sphere. New supply creates social networks, care, and organised self-help. This can support the traditional way of living and existing connections, which are diminishing as mobility and individuality increase. The so-called local exchange systems are an interesting development in this context, forming an institutionalised local network to exchange goods and services, which are offered insufﬁciently in the ofﬁcial economy or which may be too expensive.27 These communities are a modern form of organised neighbourhood help. They try to evade the negative consequences of the shadow economy by introducing an individual currency and a cashless payment system.28 Utilising money as a means for calculation, payment, and evaluation leads to an immense reduction of transaction costs, as opposed to the use of cash and payments in kind, which are the norm on the black market. 29 This is one reason why local exchange systems were brought into being. However, a re-invention of money is taking place, which is not very sensible from a purely economic point of view. The 25 26

27 28 29

See Schumpeter (1950). For an extensive empirical study on start-ups see the current project ‘Start-ups from Cologne Universities’ (1999) at the Cologne University by Backes-Gellner; Sternberg; Demirer and Moog. See Meier (1998). In principle, local exchange systems are not illegal and thus not part of the shadow economy (irregular sector). The Euro was also introduced, among others, to reduce transaction costs.

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origin and success can be explained only when psychological factors are considered.30 8.1.8

Making use of fallow resources by employing illicit work

From a macro-economic point of view, the sub-optimal exploitation of production potential leads to considerable losses in welfare.31 The factor of labour is not used, e.g., when there is involuntary unemployment, premature retirement, or a general reduction of working hours against the will of the employees. The ‘defensive’ strategies, which strive to combat unemployment via a decrease in the volume of ofﬁcial working time, may be regarded as desirable for an equal distribution of work.32 Reducing the working lifetime, or even weekly working hours, and ignoring the desires of the individuals concerned, either leads to a loss of welfare (as the production possibilities are not optimally exploited), or encourages the agents to migrate into the shadow economy. This demonstrates that a redistribution of work against the wishes of the employees is hardly possible. Those who have no desire to maximise their personal leisure time will work in the shadow economy and possibly trigger a shift in demand, thereby counteracting the purpose of reducing working time. In principle, the use of unused resources has a positive effect on the economy, i.e., the ofﬁcial economy also proﬁts from the additional incomes derived from work. Further resources are manufactured (materials, tools, services) and the supply of qualiﬁed labour increases due to enhanced division of labour. Individuals with higher qualiﬁcations can take up an appropriate occupation and people with fewer skills can also ﬁnd a job. Thus, the shadow economy offers to both the unemployed and to the underemployed the possibility of actively taking part in business life. In the medium term, they will be integrated into the regular working process. Employers are willing to hire former illicit workers, as these are more ﬂexible and bring new expertise into the ﬁrm; thus they can be easily incorporated. The violation of the law is obviously tolerated. 8.1.9

Summing up allocation effects

As the extensive analysis above has shown, the allocation effect on production and growth can be both positive and negative. The macro-economic effects can only be offset against each other, to a certain extent. On the 30 31

Frey (1997b), for example, discusses psychological and economic approaches. In this context, see Meier (1999). 32 See Section 7.4.3. See, among others, Langfeldt (1984a,b); iw-trends (1997b).

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whole, a net gain in productivity and employment can be expected, owing to the stimulation of competition. As, by deﬁnition, the results for the latter are unsure and cannot be forecast,33 this increase cannot be exactly quantiﬁed. Making the whole system more dynamic leads to an increase in international competitiveness in the medium term and to a stimulation of the ofﬁcial economy. Furthermore, an allocation according to individual preferences is reintroduced, safeguarding consumer sovereignty.34 The higher labour intensity in the shadow economy has a negative inﬂuence on economic growth. If illicit work gains momentum, the amounts of capital and material assets decline, as does production potential. The increased work volume can hardly guarantee growth, which offsets the slowing down of capital accumulation, resulting from shadow economic activities. Hence, growth is hampered in the long run, which weakens the positive effects gained from the stimulation of competition. The low intensity of research and technology in the shadow economy has roughly the same effect. The potential for innovation, especially in the high technology sector, is lost if the capital supply decreases. Yet, the Schumpeterian entrepreneurs in the shadow economy contradict this.35 Here, one can ﬁnd exceptionally risk-enthusiastic and innovative individuals who ensure creativity and invention. A priori, the net effect cannot be determined. The varying possibilities of participation in illicit work may lead to negative incentives for those who neither evade taxes nor migrate into the shadow economy. These taxpayers with their ‘glass wallet’, and restricted possibilities of working illicitly, will perhaps reduce their labour input, which again has a negative effect on welfare. At the same time, the ability to ﬁnance public goods is diminished. The argument for making use of unused resources stands against all this. The production factors are used in the shadow economy and thus contribute to a higher national product. The improvement in the division of labour, combined with efﬁciency advantages, increases added value. Thus, the overall effect is positive, as the above considerations have shown. There will also be a number of changes regarding the allocation of income. The interpersonal distribution of opportunities and income is now the focal point of the analysis. 8.2

Distribution effects

Apart from the allocation effects, one also has to consider the equality of distribution. In principle, economic policy measures have to ﬁnd a 33 35

34 See Cassel (1986); Schmidt (1982). See Hayek (1968). See Schumpeter (1950).

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compromise between efﬁciency and social justice. The discussions on this topic are controversial and lead to various proposals, according to the respective points of view. A general deﬁnition of ‘social justice’, repeatedly demanded by politicians, cannot be found. Weizs¨acker (1984) has demonstrated that, in the long run, an ‘efﬁciency regime’ is superior to a ‘distribution regime’ and points to the positive effects, which result in higher welfare for everyone. It is vital that society agrees on certain distribution rules, which will then be integrated into the constitution. The nature of the arrangement is controversial, and not only among economists.36 The discussion cannot be elaborated upon in this context. Independent of the desired redistribution, economists can hint at how objectives can be met with as little distortion of the market results as possible; i.e., which measures alter allocation the least and thus cause the fewest economic costs. To correct primary allocation (according to the market productivity), via redistribution measures, is deﬁned as distribution policy. In the past centuries in the western welfare states, state intervention has often been carried out for reasons of ‘social justice’. There is rarely a politician or union representative who does not ask for more uniformity and thus for state intervention to guarantee social equalization. To date, all attempts to verify empirically which groups should proﬁt from the state correction of income allocation have failed. The implementation of redistribution instruments is not restricted to the progression of income tax and to public transfer payments for the needy (public relief, housing support, etc.), none of which can be offset by the taxation system. Further areas include education policy, industrial and subsidy policy, as well as numerous exemptions in taxation law. As a consequence, the winners and losers can no longer be determined, as these distribution effects would have to be revealed for every household. This fact leads to the fatal outcome that almost everyone feels discriminated against by the system. Consequently, everyone corrects the distribution effects individually, according to personal attitude and any possibilities via tax evasion, subsidies fraud, the abuse of beneﬁts, or illicit work. The indicators of the personal (e.g., Lorenz-Curve) or the functional (e.g., wage rate) income distribution are hardly informative, due to lack of transparency and the large amount of unsystematic state intervention, as well as to the possibility of working illicitly. In this context, the distribution effects of the shadow economy can be estimated only with extreme difﬁculty. The income effects vary considerably, largely because of the geographical and personal differences related to the region, 36

See, e.g., Brennan and Buchanan (1985); for an introduction, see Blankart (1998: 81ff.).

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industry, occupation, the size of household, sex, and moral attitudes. As both suppliers and buyers can proﬁt from illicit activities, the analysis is even harder. However, we will attempt to give an insight into the distribution effects. It is important to note that there are many other possibilities to evade taxes, both legally and illegally, besides working illicitly. Such possibilities may be employed by ﬁrms or by the higher income classes. This ‘asymmetric distribution of chances’ (Gretschmann 1984: 112) adds to the attraction of illicit activities. The ‘discriminatory’ design of the taxation system leads to a ﬂight into the shadow economy in the middle and lower income classes, as it is by now regarded as the only possible way to evade increasing taxation.37 Therefore, Gretschmann (1984: 112) deﬁnes illicit work as a ‘democratisation of tax opposition’. An important consequence here is that the state no longer has control over the amount of income.38 Nevertheless, the basic principle of public ﬁnance is evaded, i.e., efﬁciency taxation, which is an important pillar of the taxation legislation. In the long run, this is a threat to the tax system and thus, to the ﬁnancial basis of the state. The illicit workers are ‘free-riders’: as long as public services are not or cannot be ﬁnanced according to the equivalency principle (e.g., public goods), they can make use, for example, of the public infrastructure (such as roads) without paying taxes. This diminishes the tax yield and hence decreases both public investment and the supply of public goods, which negatively affects the middle and lower income classes in particular.39 Furthermore, if the state decides to reduce the social budget to counteract the tax deﬁcit, this could have a regressive effect. If the transfer payments are not cut in accordance with the whole budget, i.e., if the level of the whole ﬁnancial plan is reduced, these income groups are further discriminated against. This regressive distribution effect is especially evident for those households that cannot proﬁt from additional illicit income. The state has fewer opportunities to support and aid the really needy. Thus, moral and risk-averse individuals are indirectly punished, as they receive relatively less in transfer payments. Besides these vertical effects, there are also horizontal distribution effects, which vary according to the differing structure (e.g., the ﬁeld of skilled craftsmen, industry). Illicit labour is supplied by the lower and middle income groups (especially by male unemployed individuals and persons in education, such as students), whereas the demographics of 37 38

The options for the taxpayer are ‘exit’ (migration), e.g., into the shadow economy, and ‘voice’ (objection), e.g., in elections. For the basic explanations, see Hirschman (1974). 39 See Section 8.4. See Section 6.7.

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demand are considerably more heterogeneous.40 If the additional possibility of demanding illicit work is integrated into the analysis, the direction of the redistribution from shadow economic activities is ambiguous. Higher income groups demand illicit labour as well, mostly for car repairs or renovation work around their places of residence. In principle, one can say that the utility of all individuals engaged in illicit activities rises, as the latter would otherwise not be included in a rational utility-cost calculation. The utility, whether it be in the form of additional income, more ﬂexibility due to individual hours, or the securing of basic supply on a regular basis, exceeds the costs that generally result from ﬁnes, when assessing the risk of being punished. However, an extensive reform of redistribution systems should strive towards the ‘efﬁciency equality of the system’ demanded by the public. Only then will the discussion about unwanted combinations of transfer payments, illicit work, and non-desirable redistribution effects become superﬂuous. Society seems no longer to agree on the concept of the social market economy with extensive state regulation and redistribution. In the long run, no institution can tolerate the fact that an increasing number of people feel discriminated against and, ultimately, that normal behaviour is seen as an exception. Besides this discussion of social policy, the effects on the whole economy play an important role. Therefore, they will be examined in the following section. 8.3

Stabilisation effects

When looking at stabilisation, (macro-) economics examines the changes in the price level, employment, and the growth rate. Stabilisation policy tries to reduce cyclical ﬂuctuations or structural shifts through the implementation of monetary or ﬁscal instruments. Global state control, however, has proven to be impractical for various reasons (e.g., time lags, information deﬁcits). Therefore, rational economic politicians should restrict themselves to setting a reliable framework (clear objectives concerning inﬂation, limited instruments regarding the labour market, and a consistent and solid ﬁnancial policy). This ensures safe planning for economic agents. The monetary policy of the European Central Bank keeps this in mind and can be regarded as a successful model of an independent central bank and its corresponding monetary policy. A successful ﬁscal policy has to be based on correct macro-economic data (e.g., on the unemployment or inﬂation rate, growth rate of the gross 40

See Section 6.4.

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national product). The development of the shadow economy distorted the economic indicators in ofﬁcial statistics, possibly resulting in wrong political decisions. Gretschmann (1984: 117f., in combination with Feige 1979) deﬁnes this effect as the indirect (negative) effect of the black market on the real economy. A further consequence of distorted data, arising from illicit activities, is that stabilisation policy is not in accordance with the actual situation, thus further exaggerating the cycle. Possible distortions are:41 1. wrong size of the gross national product, 2. wrong calculation of the economic growth rates, which is signiﬁcant if the shadow economy grows faster/slower than the ofﬁcial economy and additional production factors are used,42 3. systematically too high inﬂation rates, if the assumption is correct that the prices in the shadow economy grow more slowly than in the ofﬁcial one,43 and 4. a wrong calculation of the unemployment rate, which would be rather too high, owing to the illicit workers being registered still as being jobless. Yet this distortion is offset by the politically desirable decrease of unemployment, which is carried out via statistical changes (e.g., increasing the basis of employed individuals) and ‘hiding’ unemployed persons, e.g., in re-education programmes. When calculating this rate, both these counteracting effects should be considered. In his macro-economic model, Houston (1987) demonstrates distortions and concludes that the effects of the shadow economy should be considered in monetary and ﬁscal policy. Fichtenbaum (1989) demonstrates that, for the USA, the decline in production has been overstated in the national accounts, as the drastic rise of shadow economic activity was not taken into account. Illicit activities result immediately in negative wage and employment effects on the ofﬁcial labour market. The ofﬁcial rate of unemployment rises, if the ofﬁcial can be substituted by the black market and wages drop as a result of additional competition.44 Furthermore, there is a direct (possibly positive) stabilisation effect. The shadow economy functions as a kind of ‘economic buffer’ (Cassel 1986: 93).45 It ensures the mitigation of cyclical ﬂuctuation and is a ‘stabilizer of last resort’ (Gretschmann 1984: 120), thus having an anti-cyclical function. Put another way, the hidden economy is a sort of ‘ﬂexibility reserve’ (Cassel 1986: 93), 41 42 43 44

See Adam and Ginsburgh (1985); Cassel (1984); Fichtenbaum (1989). See Gretschmann (1984: 119f.); Fichtenbaum (1989); Adam and Ginsburgh (1985). For the importance of monetary policy, see Langfeldt (1984a,b); and Houston (1987). 45 See Mackscheidt and Steinhausen (1978: 80f.). See Section 8.1.

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compensating economic disturbances, which result from governmental failure. Increasingly ﬂexible prices and wages can adapt to the changing framework such as exogenous shocks (due to foreign policy, technological, or weather problems), as well as ﬂawed measures of process or tariff policy. This is especially important because of the price inﬂexibility of the ofﬁcial economy. It reduces quantitative adjustments (e.g., unemployment). In theory, the shadow economy has a ‘quasi-Walrasian’ equilibrium, whereas the ofﬁcial industries are in a non-equilibrium system with price or quantity rationing. The ensuing over-demand, or supply, is absorbed by the black market. The more inﬂexible the ofﬁcial economy, the greater the importance of this function. The adjustment costs in labour market decline both in the case of bankruptcy and a mass lay-off due to structural change. The hidden economy can help to correct structural inconsistencies in the ofﬁcial economy in the short and medium term. In the long run, however, there is no alternative to an amelioration of the framework because of the effects on ﬁscal policy and society in general. A further cyclical effect of illicit work results from the demand effects on the ofﬁcial sector. The income increase, due to illicit activities, induces a rise in ofﬁcial and unofﬁcial demand. Schneider (1998b) has ascertained that, for Germany and Austria, two-thirds of illicit income is spent in the ofﬁcial economy. There is empirical evidence for Great Britain that the hidden economy has a signiﬁcantly positive inﬂuence on consumption expenditure. Bhattacharyya (1993) can make differentiated statements for the period 1960–84: besides a positive effect on consumption in general, there is a strong positive effect on durable goods. The shadow economy has two contradictory effects. On the one hand, demand is stimulated by cheaper prices and, on the other, the demand shifts from the ofﬁcial to the unofﬁcial sector. The net effect is, therefore, not clear overall. In addition, we must take account of the contrary relations between the different products (complementarity or substitutability of the sectors). In principle, the desires of consumers are increasingly met, as the shadow economic supply is tailored to the wishes of individuals and these are satisﬁed with the quality of what is on offer. However, these partially positive effects are counteracted by the openly discussed negative consequences for households, which will be analysed in the following section. 8.4

Fiscal effects

The negative consequences of the shadow economy on the yield of the state are not contested. Politicians concentrate on deﬁcits when discussing

172

The shadow economy

illicit work. Whereas politicians hope to consolidate their household or to ﬁnance higher expenditure by combating the hidden economy, honest taxpayers anticipate a tax reduction for everyone, by increasing the tax base. In the long run, the attractiveness of migrating into the shadow economy could be decreased by an extensive reform with a cut in the tax burden.46 A further rise in illicit work will threaten to lower the benevolence of the state. Consequently, the level of public beneﬁts cannot be held without raising taxes and contributions, thereby resulting in a downward spiral. The shadow economy increases further, resulting in the necessity to increase the tax burden that, in turn, makes illicit work more attractive. This is a vicious circle of increasing burden and private evasion reactions.47 This correlation is evident only when one considers pure tax evasion with ﬁnancial transactions. Illicit work requires a more differentiated analysis. The ﬁscal effects are no longer as clear when the secondary and tertiary consequences are integrated into the study. The primary effect is a drastic deﬁcit in yield from taxation, as well as in social security contributions, both leading to an increased burden for honest taxpayers if public services are to be kept at the current level. In a dynamic context, the secondary consequences of shadow economic activities have to be considered. In particular, the differing effects of combating illicit work have to be examined. An overall, analytical economic model, which considers the multiplieraccelerator effects and which combines these with comparative static ideas, cannot be developed. The economy is simply too complex. In the current context, only some consequences of shadow economic activities can be outlined, which will then be illustrated empirically with data from Germany and Austria. 8.4.1

Inﬂuence on tax yield

As mentioned above, the primary ﬁscal effect is a deﬁcit in the public budget, as illicit work is not subject to income and other taxes. These debits induce higher tax rates, thus additionally burdening the general public, either directly or indirectly (via higher interest and discharge payments). According to the design and assumptions of the applied model, the calculations of tax shortfalls result in considerable differences in the amount of the losses.48 Furthermore, it is said that a large part of the yield immediately ﬂows back into the ofﬁcial sector in the form of consumption. This leads to further income of the other agents, resulting in additional taxes. Yet, the amount of this compensation is controversial. 46 48

47 See Mettelsiefen (1984: 66f.). For reform proposals, see Section 7.2.4. See Chapter 7.5.2 and Mettelsiefen (1984: 68f.); Feige and McGee (1982: 36f.).

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Illicit work clearly has negative consequences for the tax yield, under the assumption that it leads only to a suppression of ofﬁcially produced goods and services.49 To combat it would lead to a shift of activities back into the ofﬁcial sector, again resulting in more tax revenues for the state. This is based on the belief that illicit occupations correspond to those in the ofﬁcial sector. As has been demonstrated with the causes of shadow economic activity, the effects on the demand and supply side are not as clear, due to the calculations of individual decisions. The agents demanding the goods will no longer have full discretion as the prices of supply are higher and ﬂexibility is lower. The cheaper prices on the black market can satisfy a higher demand, which would not have existed were there only an ofﬁcial economy. The supply can no longer be kept on the same level if the net price or wage does not compensate for the loss of utility of leisure time. The costs then predominate in the utility–cost calculation, so that the supply is no longer proﬁtable when viewed personally. Both the price elasticity of the demand and that of the supply are very important. If they are high, taxation does not lead to the desired rise in income but to a decrease of the tax base, as the agents evade the payment either by working illicitly or by increasing their leisure time. The additional consumption expenditure may lead to an increased tax yield in a different context. If there is a partially complementary correlation between the shadow and the ofﬁcial economy, an extra supply ameliorates the provision of goods and creates further incomes, which are then spent in the ofﬁcial economy. In the ﬁght against illicit work, this supply is not shifted into the regular sector, as the conditions are less favourable (e.g., due to regulation). Yet, these are often goods and services, which are no longer offered in the ofﬁcial sector, as the capacities are used up and suppliers have more attractive possibilities. Illicit incomes are, for the most part, used in the ofﬁcial sector, resulting in an increasing value-added tax (VAT) yield for the state, arising from an increase in taxable sales. In addition, higher consumption activity leads to more work for employees in the respective ofﬁcial sectors, resulting in more income and thus more taxes. Another source of increased VAT yield is the raw material produced illicitly, which is then manufactured further in the ofﬁcial sector and hence is subject to taxation. This income, from indirect taxation in the shadow and ofﬁcial economy, has to be considered when examining the development of the tax yield, as it would no longer be as high if the black market were challenged. The overall economic tax yield is the strategic variable, which is important for the state. For this reason, 49

See Gretschmann (1984); Mettelsiefen (1984); and Sch¨afer (1986).

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the totally analytical perspective gains importance, where the argument of tax losses due to illicit activities has to be examined critically. 8.4.2

Inﬂuence on social security systems

The crisis of ﬁnancing social security systems is explained, amongst other things, by income losses due to illicit workers. According to this line of argument, these workers do not contribute to society, but take advantage of it. Consequently, the increasing beneﬁts of social insurances cannot be ﬁnanced any more, and regular jobs will eventually be burdened with excessively high taxes, resulting in an offence against social solidarity. In short: ‘Illegal is antisocial’ (BMA 1997b). In principle, this argument can be contradicted by stating that a decrease in the obligation to contribute results in a decline of claims for beneﬁts. Financing the social security system according to the equivalency principle would actually lead to this, so that it would not be endangered. However, the design of the social security system results in some distortions due to illicit work. A few examples are listed below.50 The abuse of beneﬁts (e.g., receiving unemployment beneﬁts, welfare, disability pensions) results in drastic distortions and unjustiﬁed selfenrichment at the cost of the general public. A reason for the attractiveness of illicit work lies in the fact that if individuals receiving beneﬁts start working, they immediately have to give up beneﬁts, even if the wage is miniscule. This implies a marginal tax rate of 100%, which minimises incentives to take up a regular occupation! The same holds for unemployed individuals. The higher the transfer payments are, the higher is the incentive to abuse beneﬁts. To avoid these negative incentives, the introduction of community work has been suggested, where people receiving beneﬁts would give an equivalent back to society. This reduces the possibilities of beneﬁt abuse and thus either cuts the number of illicit workers, or the number of individuals receiving welfare, as some deﬁnitely have a better income potential in the shadow economy. 1. The public pensions system, which is structured according to the distribution method and which includes redistribution elements contradicting the idea of equivalency, also results in unsystematic losses and in an additional burden. During unemployment, contributions for pension and health insurance are still being paid. If the individual decides to work illicitly, he continues to receive unemployment beneﬁts. Thus, the negative effects of the abuse of beneﬁts, in combination with illicit work, are clearly stated. 50

See Sch¨afer (1992); Schm¨ahl and Prinz (1988); Schm¨ahl (1986).

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2. With unemployment insurance, illicit workers avoid the obligation to social solidarity and do not make contributions according to their ability. However, they do not receive any insurance against unemployment or other payments when problems arise (e.g., illness). This is seen as a negative aspect by many of the people concerned.51 3. The health insurance aspect has an unambiguously negative effect for illicit workers. A person who has only minimum insurance, e.g., through an ofﬁcial part-time occupation, receives the whole beneﬁt in case of illness. 4. To draw a complete picture, reduced costs for social insurances have to be taken into account. They decrease because of the possibility of engagement in shadow economic activities. A part of the public will not be interested in abusing beneﬁts and, therefore, will accept cuts or even the complete loss of state payments and, instead, work in the hidden economy. Furthermore, public services could also be offered on the black market, e.g., revision lessons or baby-sitting as a substitution for day-care centres. DIY, self-help groups, or neighbourhood help schemes relieve the government of some of its obligations. This short description of the effects on the social security systems, portrayed more elaborately by Sch¨afer (1992), shows that reforming these is of the utmost importance, not only because of ﬂaws in the system, but also because of the growth of the shadow economy. The reaction of politicians to the increasing ﬂexibility of the economy is too slow, and not only because of the opposition of large parts of the public, who are currently proﬁting from the system in force at present.

8.4.3

Summarising the ﬁscal effects

The consequences for the state yield are controversial. The German Federal Ministry of Labour and Social Order calculates tax losses per 10,000 jobs lost through illicit work of more than 160 million EUR (BMA 1998a). This would mean 16,000 EUR of taxes and contributions, per job, which are lost for the government. According to our calculations, the number of full-time illicit workers in Germany in 1997/98 was 5 million. This would result in tax deﬁcits of 80 billion EUR. However, these calculations do not take into account the positive effects of the shadow economy on the tax yield. Estimates for Austria demonstrate the extent to which secondary effects can compensate for the immediate tax losses. 51

See also the Federal Union of Independent Craftsmen (BUH – Bundesverband der unabh¨angigen Handwerker) (http://www.aries.de/buh/index.html).

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Table 8.1. Tax deﬁcits due to illicit work in Austria (1997) Primary effects Expected extent of the shadow economy in 1997 - losses in VAT – Yield - Losses in Income Tax Yield - Losses in Social Security Contributions Total losses in taxes and contributions

220 billion AS 44 billion AS 35 billion AS 18 billion AS 97 billion ASa

Secondary effects 70% of the estimated 220 billion AS from shadow economic activity will have an effect on the added value in 1997 - additional VAT Yield - additional income tax and social security contributions Total additional tax yield and contributions due to shadow economic activity

154 billion AS 31 billion AS 26 billion AS 57 billion AS

Total losses in taxes and contributions

−97 billion AS

Total additional taxes and contributions

+57 billion AS

Net effect: Losses in taxes and contributions due to illicit work

−40 billion AS

a If

one compares this calculated sum of tax losses of 97 billion AS with the 18 billion in 1982, as calculated by the Austrian institute for Economic Research (Lehner, 1984), it becomes evident, that the extent has quintupled in the past 15 years. Source: Schneider (1997a).

If, for example, one takes the estimates of the size of the Austrian illicit labour force as a basis (see Table 8.1), the consequences of shadow economic activity can be approximated as follows: Lehner (1984) calculates that in 1982 the Austrian black market induced tax losses of approximately 18 billion AS (Austrian Schillings), 40% of which were social security contributions with the remainder being taxes. More up to date calculations for Austria (Table 8.1) in 1997 show that, when solely regarding the primary effects, one notices that there are considerable tax deﬁcits. If, in addition, the secondary consequences are integrated into the analysis, the losses fade. It has to be considered that at least 70% of the volume of the shadow economy in Austria (domestic) has effects on the added value. On the one hand, goods produced illicitly are processed further in the ofﬁcial economy and, on the other hand, the money earned on the black market is spent on legally produced consumption goods. The net effect on taxes of the shadow economy can be derived from looking at the primary and secondary effects, which partly depend on the elasticity of the labour supply. Table 8.1 documents the size of the effects and shows that simple calculations do not illustrate the complexity

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of these. According to the results, the yield deﬁcit is cut, nearly 60% of the losses are compensated. To sum up: the ﬁscal effects cannot be determined unequivocally, yet our considerations and the preliminary calculations show that the sizes of tax deﬁcits, as stated by governments, are far too large. However, the net effect is considerable, so that reforms are unavoidable. Thus, the following recommendations for economic policy make up the ﬁnal part of the book.

9

The ‘two-pillar strategy’

9.1

On the necessity for a rational economic policy

In many countries, the shadow economy has reached a size that makes it an important economic factor and a challenge for every government. One objective of this book was to analyse the advantages and disadvantages of illicit work and to see what can be done to reduce it. A promising economic policy to deal with illicit work has to consider the causes. Higher ﬁnes or more intensive controls alone merely ﬁght the symptoms and do not lead to the desired outcome. Yet, the interests of political decisionmakers stand in the way of a rational economic policy. Nevertheless, we would like to make a few suggestions regarding a more efﬁcient policy, which attains the desired goals. Such a policy will become necessary in the long run due to the increasing international competition of systems and increasing pressure resulting from the growing shadow economy. A reference model for the respective measures will then be needed. A rational economic policy can be ideally deﬁned as follows: A policy is rational if it concentrates on the realisation of an extensive, well thought through and equalized system of objectives, reaching the highest degree of success possible under the given conditions. (Giersch 1961: 22.)

It is important to detect the conﬂicts between different goals and the effects of some economic policy measures on other objectives. State interventions, which at ﬁrst seem rational, can have devastating consequences on economic development in the long run. At the same time, the instruments should be chosen, so that the objective can be reached with as little input as possible.1 That is the deeper meaning of the ‘highest degree of success’. It is in this context that the causal relations in the shadow economy were analysed and some economic policy recommendations were derived. Our recommendations can be integrated into the ﬁeld of the supply-side 1

Or achieve the best results with a given budget.

178

The ‘two-pillar strategy’

179

oriented economic policy, which is broadly advocated in western economies. ‘Ordnungspolitik’, following Eucken (1990), should assist us in reaching a consistent economic policy, creating a reliable framework for agents in which they can plan properly. Stabilisation policy should include intervention conforming to markets, e.g., for the redistribution or correction of economic calculations, in the case of external effects. At the same time, it should avoid impeding consumer sovereignty. In the long run, there is no way to avoid quite ‘radical’ reforms. Such reforms have been successfully implemented in New Zealand and, partially, in Australia. Besides reforming the administration, the welfare state was considerably remodelled, e.g., by reforming the labour market. Therefore, the ‘two-pillar strategy’ introduced here should function as a rational economic policy recommendation.2 The recommendations derived do not promise quick solutions, but in the long run, enable a successful reintegration of ‘black’ economic activities into the ofﬁcial sector, or at least stop migration into the shadow economy. 9.2

‘Exit’ and ‘voice’ as behavioural options

One main reason for the necessity of a rational economic policy is the possible reaction of people to economic policy measures. Following Hirschman (1974), they can be divided into an ‘exit’ and a ‘voice’ option; these are the two aspects of the ‘two-pillar strategy’. In a democracy, one has the possibility to voice one’s preferences regarding public goods through elections. One votes for the party whose policy best corresponds with one’s own attitude. To further inﬂuence economic policy measures, one can either make use of other democratic communication channels, e.g., referenda, direct elections, or organise citizen initiatives. Active participation in pressure groups and unions has an even more intensive impact on the contents of the political process. Although these groups often follow their own interests, they are an important source of information for politicians.3 The mass media can also inﬂuence public opinion considerably. Even though the power of the media has not yet been fully explained in theory, its importance cannot be denied.4 Its ‘agenda setting function’ is 2 3 4

See Enste (2001, 2002) for the elaboration of this strategy in the context of the shadow economy. See, e.g., Kirchg¨assner and Frey (1994: 201f.); and Pommerehne and Weck-Hannemann (1996). For an illustration of the theoretic approaches of research on media effects and empirical results, see Schenk (1987).

180

The shadow economy Behavioural options Voice

Exit

Elections

Moving location

Direct democracy

Pure tax evasion

Citizen initiatives

Shadow economy

Pressure groups Mass media Polls Economic policy consulting

Illicit work Informal sector Household sector Criminal sector

Expertise/commissions Expert councils Research institutes

Figure 9.1. Behavioural options of households and ﬁrms

well suited to bringing certain topics to public attention and raising public awareness.5 One example of such inﬂuence is the discussion about 325-EUR-jobs, intensively led by the media in Germany.6 If the mass media publishes surveys, these could inﬂuence public opinion and election results.7 Consultation over policy also plays a signiﬁcant role. Various expert councils and economic research institutes form opinions on political decisions on a regular basis and strive to inﬂuence politics through numerous publications. To complete the elements that inﬂuence politics, expert opinions by commissions and boards or committees are another possibility of co-determination.8 An alternative to this ‘voice option’, which is regarded as unsuccessful by many, is the ‘exit option’. Firms have the option of changing locations to evade an unwanted economic system of taxation or social security, and households can decide to migrate.9 Engaging in shadow economic activities is another possibility. Here, the options are either tax evasion, via ﬁnancial transactions, or a ﬁctitious change of location. Alternatively, 5 6 7 8 9

See Enste (2001, 2002); and Schneider and Enste (2000a: 192–202). See Schneider and Enste (2000a: 1–2) for a documentation. See Noelle-Neumann (1982, 1989a,b) on the theory of the ‘silence-spiral’. Kirchg¨assner and Frey (1994) elaborate on the different methods. For a simple explanation of the implications of the four basic freedoms within the EU, see Sinn (1995).

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181

individuals can decide to work illicitly in the informal, irregular, or criminal sector. The fact that these options exist implies that the democratic state is restricted, as it cannot ignore the preferences of its citizens. This internal pressure to correct economic policy is intensiﬁed by external pressure stemming from rising globalisation. Mobility is increased and so is the number of alternatives. The limit of loyalty is reached if the ﬁnancial burden becomes too great. The political and social stability and the ‘common good’ are endangered by the rise of the shadow economy. This could lead to a malfunction of democracy.10 The shadow economy signals considerable disruptions within the regulatory system. However, actively participating in illicit work seems to strengthen social peace rather than to disturb it. 9.3

Decreasing the attractiveness of the ‘exit option’

Implementing the ‘two-pillar strategy’ decreases the threats to society. The recommendations are summarised in Figure 9.2. Reducing the tax rate considerably is the main demand, as the rate has been found to be the main cause for the rise of the shadow economy in the integrated model. In addition, the system has to be simpliﬁed in order to attain more transparency and less density in regulation. The complicated tax system has undermined the tax base and made tax law complicated, which results in misallocation and distortions regarding input and welfare losses, and leads to the erosion of tax morality in the long run. Furthermore, an extensive reform of the social security system is necessary so as to reduce the burden of contribution payments. Reactance Theory proposes the following possibilities to reduce resistance to the tax burden.11 On the one hand, to credibly set a time limit to the burden could avoid reactance and negative economic consequences resulting from migration into the shadow economy.12 On the other hand, if the infringement of personal freedom is perceived as being legitimate, it will not lead to reactance. The demand for more transparency of the taxation system and expenditure policy13 is then based on socio-psychological 10 11 12

13

See Biedenkopf (1986); Enste (2002); Rurup ¨ (1983); Schmidt (1988); Pommerehne and Kirchg¨assner (1994). See Section 6.5.2.2. The introduction of the solidarity contribution for East Germany was an example of this in Germany. However, keeping the set time limit once again poses a considerable problem. More than 77% of the population demand cuts in state expenditure to ﬁnance a tax reform to decrease the burden (Forschungsstelle fur ¨ empirische Sozialokonomik ¨ 1997: 35).

Figure 9.2. General economic policy recommendations

More flexibility instead of forced reduction of working time

Decreasing density of regulation, e.g., on the labour market

Allocating transfer payments according to the principle of neediness

Consolidating the public sector and making administrations more efficient

Reducing the burden of contributions by reforming the social security systems

Reducing the tax burden by systematic tax reforms

General objectives for economic and social policy

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183

theory. Cuts in corruption and the wastage of tax yield within public administration will increase loyalty to the state. A signiﬁcant correlation between the two is conﬁrmed by various surveys.14 Transfer payments should be increasingly examined with respect to the real need for them whilst, at the same time, they should also be made subject to a time limit. This adds to the motivation of the people concerned and prevents the formation of many bad habits. At the same time, the transfer payment payers regard this as being legitimate. The reduction of the density of regulation while increasing its security, especially on the labour market, is a further element of a rational economic policy. Competition would be augmented as a result of the lower market-entry barriers and could thus develop its dynamic welfare effects. To consider the preferences of employed individuals concerning working time would ensure that they would have less time to engage in illicit activities. 9.4

Strengthening the ‘voice option’

In principle, reactance can be dismantled by solidarity. In economic policy, this has been dealt with under the term ‘moral suasion’. This means that if the individual accepts the necessity of an infringement of personal freedom, he declares his solidarity with society and perceives the beneﬁts of the state as being sensible. However, state roll-calls may have a contradictory effect, as citizens willing to pay taxes up to that point will only then be informed about the extent of the shadow economy. Only then will individuals perceive the injustice of the burden and will also be encouraged to work illicitly. This negative process can be stopped successfully by the active participation of the people concerned. This leads to the conviction that the infringement is necessary. An often-cited example is that of vendors and politicians who adopt the opinions of the persons they have to represent and make them their own, even if those opinions differ from the ones they held initially.15 Transferred into the procedures of democratic decisionmaking, this means that federal elements have to be strengthened and further instruments of direct democracy (e.g., referenda and legal initiatives) have to be introduced, so that the citizens can increasingly contribute, e.g., to the design of the taxation system. Regional commitment and citizen initiatives that try to inﬂuence decisions could be a clue to the desire to keep or regain control. Increased participation will 14 15

For a recent overview, see Bardhan (1997); Rose-Ackermann (1999); Mauro (1995); Tanzi (1998). See Pelzmann (1985: 56f.).

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The shadow economy

always diminish the perception of having one’s personal freedom being subjected to unfair restrictions. At the same time, morality and loyalty are ameliorated, and this helps to combat the rise of the shadow economy.16 The government should act according to the subsidiarity principle at all levels and further centralisation should be resisted.17 The increasing shift of decision-making towards Brussels and the justiﬁcation of this with European pressure (e.g., the rise in VAT in Germany for reasons of harmonisation) does not strengthen the perception of control over spending for taxpayers. The rise in centralisation, often combined with harmonisation, is not the right way forward when considering the growing shadow economy. An increasing ﬁscal federalism would counteract the ‘detachment of state activities from the desires of the citizens’ (Pommerehne and Kirchg¨assner 1994: 860). Hence, Frey (1996, 1997a) demands a ‘new federalism for Europe’. The objective is a combination of federalism and direct democracy. The main features of his proposed new governmental units can be summarised by the term ‘functional overlapping competing jurisdictions’ ( FOCJ) (Frey 1996: 275). They are characterised by functional differences in size and geographic overlapping, resulting in a competition of regions or systems. Individuals can state their preferences in referenda or by citizen initiatives. The design and duties correspond to the subsidiarity principle. Enabling such an institutional framework, which increases inter-regional competition, would imply a trust in the citizens, but would also increase public trust in political institutions.18 The increased participation of the public raises commitment, i.e. personal contribution and interest in governmental issues and, as a consequence, the control of ‘moral hazard behaviour’. Strengthening the right of participation can reduce the ‘free-rider’ problem, as state efforts are regarded as a fair equivalent that ultimately boosts tax morality. One important reason for the limited extent of the Swiss shadow economy, as opposed to other OECD countries, is the considerable number of direct democracy elements.19 In the long run, this leads to a strengthening of social capital and sense of community, both of which contribute 16 17

18 19

The relatively small Swiss shadow economy can be attributed to the extensive voice options. See Kirchg¨assner (1999), and Weck-Hannemann and Pommerehne (1989). In public ﬁnances and social policy, this principle is regarded as the axiom of the distribution of duties between the private and the public sector as well as communal institutions. Following the subsidiarity principle, one can derive that tasks can only be delegated to a higher level, if the lower level is unable to solve the problem. The state should only assume social assignments if the individual or the family is over-burdened. For a theoretical realisation, see Pommerehne and Frey (1992). See Pommerehne, Hart, and Frey (1994) for a simulation regarding the differences in tax moral and honesty in direct and representative democracy.

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considerably to the successful survival of societies and the further supply of public goods.20 9.5

Legalising illicit work?

‘Soft forms’ of illicit work may even have to be legalised. Laws would then correspond to public opinion, for whom such forms would be legitimate and tolerated. The current regulations would be adjusted to the norms, which have been changed due to deviant behaviour. The abolition of the prosecution of offences against the crafts organisation would be a ﬁrst step towards the legalisation of illicit work in Germany. Currently, numerous forms of illicit work are already tolerated by the very vague formulations in the law against illicit work. In fact, the state concentrates on criminal forms (illegal employment, social fraud) where it intensiﬁes controls and law enforcement (e.g., higher ﬁnes). The other offences are brought into court mainly by the chambers. Work on the side should be subjected to less taxation, via higher allowances. In Germany, this would imply the reformulation of the regulations concerning the 325-EUR-jobs. However, it can only be a preliminary solution, as problems and allocation distortions for other employees are to be expected. Therefore, an extensive tax reform would be the superior solution. Immigrants should be able to take up regular work more easily. The ban is a reason for the large number of foreigners who work in the shadow economy, which increases as the level of immigration rises.21 Giving limited working permits would also reduce the exploitation of these individuals. 9.6

Combating illicit work: the perspective of public choice theory

This elaborate illustration of the effects of the shadow economy begs the question why hardly any effective effort is put into ﬁghting illicit activities. Politicians in the western democracies should be extremely interested in this topic: the state has tax deﬁcits, ﬁrms experience increased losses in sales and ﬁnd themselves in a market with unfair competition, the taxpayer has to carry a heavier burden, etc. Yet, is interest in the effective 20 21

For the importance of social capital, see, e.g., Coleman (1990: 300f.); Hirschman (1994). See Borjas (1994); Djajic (1997).

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The shadow economy

ﬁght against illicit work really this high?22 When looking at important agents in democratic economies, namely voters and taxpayers, and government and pressure groups (trade unions and employers’ associations), Hofreither and Schneider (1989) come to different conclusions in their attempt to ﬁnd a political economy explanation.23 9.6.1

The view of employees, voters, and taxpayers

Those employees/voters/taxpayers working or consuming in the black market, will have no interest in ﬁghting against the latter, if current conditions (heavy tax burden, high wage extras, increasing regulation) persist. Nevertheless, a reduction of the shadow economy may be called for in principle, as the individual may feel that the immediate costs (wage losses) are larger than the uncertain utility (tax cuts). An important factor in the ﬁght is that a reduction of illicit work is a public good. If it no longer exists and there really is a higher tax yield for the state resulting in a declining burden, this is positive for everyone. The costs of this are merely carried by those who no longer have the opportunity to work in the black market. Individuals engage in additional shadow economic activities because they desire to earn an income which seems just for them. If this income is lost, the result would be considerable economic and social crises for some households. Offering illicit work often implies receiving a considerable amount of additional income (and thus ensuring a higher standard of living). Satisfying one’s demands in the black market can often be cheaper, faster, and more ﬂexible than in the ofﬁcial economy. It is only those employees/voters/taxpayers, who neither work illicitly nor buy on the black market, who are interested in combating the shadow economy. Besides those individuals who only work ofﬁcially and who expect a slower tax progression, those unemployed people who are not engaged in hidden activities, hope for additional jobs when the size of the economy grows. These two groups are only a small part of the general public in many countries. 9.6.2

The interests of the trade unions and employers’ associations

Unions also often complain about the increase in illicit work. A closer look reveals that these statements are often made obligatorily. Smaller ﬁrms, in 22 23

For an interesting introduction into political economy, see Kirsch (1997), who explains the basics for the following considerations. In Section 8.2, a few of these considerations hinted at here are explained further. These considerations have been thoroughly discussed by Schneider (1998a) in various presentations.

The ‘two-pillar strategy’

187

particular, proﬁt from the black market while publicly complaining about it. They gain from processing some orders without invoicing, so as to save on VAT and social security contributions, but also to evade regulation. This leads to decreasing costs and thus lower prices. However, it only holds as long as other ﬁrms are not proﬁting from the supply of public goods in the same manner.24 These considerations clarify the dilemma of union representatives. It is ofﬁcially demanded that illicit work should be halted, yet a further analysis of the situation shows that is not clear whether the utility from reducing illicit activities can outweigh the costs for the representatives. 9.6.3

The situation of the government

Finally, the political decision-makers have to be taken into account. The interests of the government should be clear: it should be immensely concerned about ﬁghting illicit work, merely because of the losses in tax yield. At the same time, the government realises that a large part of the public has no real interest in restricting shadow economic activity, as they proﬁt from it (economic aspect) as well as seeing it as a tax loophole, which decreases the perception of the infringement of personal freedom (psychological aspect). For these reasons, the government has to come up with proper arguments in order to gain the necessary support and to be re-elected. One such argument would be the fact that tax deﬁcits could be compensated which might also lead to a fall in unemployment. However, at this point, the important question to be answered is whether such efforts can actually induce more jobs in the ofﬁcial economy. It is rather improbable that individuals currently engaged in the shadow economy would be able to maintain the job supply under the conditions of the ofﬁcial economy. Also, the demand for illicitly produced goods would not be the same in the regular sector, as prices would be higher. With the help of economic policy simulations, Hofreither and Schneider (1989: 66f.) have analysed the extent to which it would be proﬁtable for the government to put efforts into combating illicit work and how this would change the situation of the voters. The authors assume that the government tries to reduce the extent of the shadow economy and, at the same time, hopes to achieve better results for other economic policy objectives (e.g., reducing unemployment) as well as receiving additional taxes. The politicians have a choice between direct taxation policy 24

This situation can be deﬁned as a ‘prisoner’s dilemma’, where some proﬁt from illegal behaviour. However, when everyone is a free-rider, the situation worsens for everyone. See, e.g., Kirchg¨assner (1991).

188

The shadow economy

measures or intensifying administrative controls to combat the black market. Three ﬁnancial policy instruments have been analysed: 1. reducing the direct income tax burden 2. reducing the indirect tax burden, and 3. increasing administrative controls to ﬁght shadow economic activity. The simulations were carried out by applying an econometric model of the Austrian economy and it was assumed that the hidden economy shrinks when the ﬁrst two instruments are enforced. Yet, the third measure should also help to reduce illicit work, although this implies higher costs for the state as more personnel and funds are needed. The main results are as follows. In Austria, reducing the individual income taxes by 19% would have an extremely positive effect on the ofﬁcial added value or GDP. It could be increased considerably and the shadow economy could be reduced by a quarter. On the whole, there would be a small net increase in the ofﬁcial and unofﬁcial GDP, combined with the tax deﬁcits, as the rise in economic activity is not connected to a rise in (direct and indirect) taxes. By cutting indirect taxes, one would achieve similar results but to a lesser extent. Increasing administrative controls would have no positive effects on the economy whatsoever.25 In both the cases of tax cuts, the government would lose a considerable amount of tax yield, as the increase in economic activity would not offset the decrease in demand due to the missing illicit incomes. Indeed, neither would the positive (Keynesian) effect be large enough to compensate for the tax deﬁcit. When cutting direct taxes, the Austrian government would lose 4 billion AS per annum over a ten-year period and, in the case of indirect taxes, it would be 8 billion. Implementing the third measure does not lead to positive economic effects (e.g., an increase in the GNP or in the tax yield) other than the direct objective of decreasing shadow economic activity. Reducing the shadow economy can obviously be achieved only by extensive reforms from the government. It will enforce these only if they result in an amelioration of the economic situation of the voter (e.g., a lighter tax burden and/or less unemployment) and thus are acceptable to the public. This is not the case for all three instruments introduced, i.e., even more voters will be negatively affected (by income losses) than positively (through a higher demand) by the decline of shadow economic activity. Thus, it would be strategically sensible, to pretend to combat illicit work without obtaining substantial effects. The bureaucracy would also 25

See Section 7.6.

The ‘two-pillar strategy’

189

support such a policy, as the prosecution of illicit workers and tax evaders would demand additional resources. If, in addition, victories are not desired, there are no conﬂicts of interest between politicians and bureaucrats. On the whole, these considerations illustrate that, once the shadow economy has reached a certain level, it is very difﬁcult to motivate the respective decision-makers to bear the costs of a reduction of illicit work themselves, especially when assuming an egoistic utility–cost calculation. 9.6.4

Conclusion: little interest in combating illicit work

If they are engaged in shadow economic activities, employees, voters, and taxpayers are only interested in avoiding the black market when the loss of utility that they have, when refraining from such behaviour, is at least compensated by a decrease of the tax burden. The reduced burden, however, is regarded as a public good and hence the individual utility gains are marginal when compared with the immediate loss. The representatives of ﬁrms (employers’ associations) only partly advocate the ﬁght against illicit work, as this means lower income for some of their members. The government also does not unequivocally support this ﬁght, as even though there are negative consequences for the social security systems and tax yield, it is unclear as to whether reduced shadow economic activity would actually result in more ofﬁcial jobs or whether there would be less demand after all.26 This could limit considerably the government’s chances of re-election. Thus their objective is to suggest credible reforms without actually achieving anything. This illustrates that a reduction of an existing shadow economy is very difﬁcult. Economic policy has to enforce prevention measures that can merely keep the current situation stable for the future. 26

For the effects, see Chapter 8, and for an overview, see Merz (1997).

10

Conclusion and outlook

The size and the development of the shadow economy of seventy-six countries has been shown in order to clarify the importance of broad reforms of the tax and social security systems. For this, we have introduced several methods of measuring the extent of illicit work, even though this is a difﬁcult task.1 Not one of the applied approaches allows for exact calculations. All of these are subject to considerable ﬂaws and, therefore, can only give crude clues to the size of the black markets. However, by comparing the results, it can be shown that there is a similar tendency in all the various methods. The shadow economy has gained considerable momentum from 1970 to the end of the 1990s in many countries. In OECD countries, its size has nearly doubled and lies between 10 and 20% in the years 1990–7, whereas it was between 1 and 5% during the period from 1970 to 1980. Poll results conﬁrm that illicit activities are increasingly accepted and that willingness to take up an illegal occupation is rising. In the context of an integrated, socio-scientiﬁc approach, various theoretical methods were introduced with which the cause and effects of rising shadow economic activities can be examined. Here, the objective was to underline the possibilities and synergy effects of combining economic, socio-psychological, and sociological theories. Based on rational choice theory, these research areas can be integrated into an interdisciplinary model. Failing economic policy was conﬁrmed as the most important cause of the strong increase in shadow economic activity. Not only are the rising tax burden and regulation density important reasons for migration into the hidden economy, but also the defensive labour-market policy directed at a redistribution of working hours. In combination with a reduced tax morality and falling loyalty to the government, this potential will be exploited increasingly. This leads to the conclusion that a systematic ﬁght against the causes is necessary. 1

For an elaborate discussion of the problems of calculation, see Bhattacharyya (1999); Dixon (1999); Feinstein (1999); Giles (1999b); Tanzi (1999); and Thomas (1999).

190

Conclusion and outlook

191

A rational economic policy has to cover various areas, so that a discussion about winners or losers does not arise but, instead, an ameliorated taxation system is implemented without assumption of the status quo. The economic policy reform approaches, which we have introduced for Germany, are transferable to other industrial nations. These proposals have been developed in the context of the growing shadow economy in many countries. They have the objective of reaching a higher degree of agreement between politicians and citizens and reducing the incentives for migrating into the hidden economy. This demand is supported by the analysis of effects. Merely increasing the costs of illicit work by intensiﬁed controls and higher ﬁnes would not bring about positive effects on the overall welfare. Empirical surveys show that a fundamental tax reform was a much more appropriate way to restrict migration. Besides the allocation effects, the stabilisation effects are important for the whole economy, as the black market acts as stabiliser and economic buffer, slightly reducing cyclical ﬂuctuations. This holds especially in the current situation with its hardened labour markets and strongly regulated industries. Tax deﬁcits and evasion of social security contributions are the main arguments with which the state wishes to substantiate its ﬁght against the shadow economy. However, when taking a closer look at the further consequences, we see that the yield losses are no longer as high as generally assumed. An example clariﬁed that, not only are economic proﬁts from the black market due to higher supply and demand, but also that the state receives compensation, e.g., through increased VAT income. Nevertheless, substantial deﬁcits remain, which have been heavily lamented by politicians. Yet, as we have illustrated in a political economy context, the decisionmakers have very few incentives to combat illicit work effectively. It follows that hopes for an extensive reform of the taxation and social security systems are small. However, there are some policy approaches in a few OECD countries, which will be enforced in the course of increasing international competition. In the long run, reforms are inevitable both because of international pressure and the rising importance of the shadow economy. The agents will increasingly opt for the ‘exit option’ if the ‘voice option’ is not strengthened by more direct democratic elements such as referenda on budget decisions, etc. They will either choose to work illicitly or search for a system which corresponds to their preferences. In this context, the shadow economy can be regarded as part of an evolutionary process, making economic and societal development increasingly dynamic. On the one hand, societal pressure on deregulation and tax reduction is increased and, on the other, new innovative forms of

192

The shadow economy

living together and economising outside the restrictions are fashioned. This could be regarded as a test for the ofﬁcial sector. Conclusions derived from economics, sociology, and socio-psychology determine positive consequences for the individual, as additional freedom encourages effort and personal desires can be satisﬁed. From a societal perspective, promoting unity through bilateral interaction and strengthening networks and families is a very important and positive factor of the shadow economy in a global world. In the long run, however, a society cannot accept offences against laws and rules, as the latter form the basis of the state. The ‘common good’ is threatened by the increase of the shadow economy that, in turn, results from the withdrawal of politics from the desires and wishes of the public. Pommerehne and Kirchg¨assner (1994) fear a cumulative process that, in the extreme case, can lead to a malfunction in democracy and state institutions. This would be one of the most dangerous effects of the rise in shadow economic activity and also of pure tax evasion. Schmidt (1982) had already voiced the warning of an erosion of the economic order and institutions at the beginning of the 1980s. The shadow economy is a sign of considerable ‘disruptions in the system’ (Schmidt 1982: 16). However, the possibility of engaging in illicit activities seems to strengthen social peace rather than disrupt it. One main reason could be the compensation for decreased opportunities to evade taxes, which is considered by many when working illicitly. Firms and individuals who receive a higher income have more possibilities to avoid payments to the state. In this context, Gretschmann (1986: 125) talks about a ‘democratisation of tax resistance’.2 Yet, it is not sensible to penalise illicit work with intensiﬁed controls and higher ﬁnes. The tendency to engage in shadow economic activities should be perceived as a warning signal by politicians. There is an increased resistance to the existing norms and laws of the ofﬁcial institutions, which can only be met with substantial (tax) reforms combined with a stronger public participation in politics. Klein (1997) also states that it is important that taxation law should be designed according to the conceptions of the citizens, implying an adjustment to the societal norms, instead of a further aggravation of laws and punishments. Biedenkopf (1986) suggests using the new institution, which is formed in the shadow economy, for a further development of the ofﬁcial administration. The causes (of the rise of shadow economic activities) are an out-of-date organisation of the working and social order, and the improper taxation and regulation of labour and the economy. The current state of affairs 2

This certainly does not include (organised) economic crime, which has been explicitly excluded from the analysis in this book.

Conclusion and outlook

193

can be endured as long as it is part of an evolutionary process of transition from the old to the new situation. Old institutions will increasingly lose authority and political acceptance if the government ceases to adhere to the existing order. Spontaneous and informal institutions are required. This evolutionary process has been going on for centuries but without considerable changes. Ofﬁcial institutions have not had high public acceptance. Reforms are more important today than they have ever been. Schmolders ¨ (1980) has already pointed to approaches for a sensible economic and taxation policy, which should be directed at a debureaucratisation of state institutions as well as higher transparency: The susceptibility of the economic system towards fraudulent exploitation of its institutions becomes the higher, the more abstract and reﬁned these are; perfectionism is the enemy of loyal acceptance and fulﬁlment of civil duties, which have long lost their vitality and moral proﬁle. (Schmolders, ¨ 1980, p. 378–9)

In this context, one can still keep up one’s hopes for a rational economic policy, even though the results of the ‘new political economy’ are rather negative regarding the actual implementation of reforms. At least, our analysis illustrates the necessity of a rational economic policy with respect to the growth of the shadow economy and the rising competition of the systems and regions. On the basis of the theory, we have derived a few economic policy recommendations that, in the long run, should contribute to a reduction of illicit work, even if the reader is not currently inclined to be interested in such a reduction in the short run.

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Index

Adam, M. C. 170n agricultural subsidies 116–17 Aigner, D. 24n Alden, J. 72n Allesandrini, S. 33n Allingham, M. G. 68, 68n, 69, 155n allocation effects 155–6, 157–66 Alm, J. 77, 79 Andel, N. 103n Andersen, P. 69 Andreoni, J.10, 55n, 68n, 68n, 95n, 143n, 156n Arni, J.-L. 57n Asea, P. K. 11n asymmetric distribution of chances 168 Badelt, C. 57n Bagachwa, M. S. D. 31 Bardhan, P. 154n, 183n Bayer, R.-C. 58n, 62n, 84n, 91n, 95n, 96n Beck, U. 77n Becker, G. S. 58, 59n, 60n, 65n, 67, 68n behavioural control, see control theory behavioural economics 55 Bendelac, J. 40 beneﬁt abuse 174 Bentham, J. 54 Benton, L. A. 30n Berger-Schmitt, R. 8n, 82n Berthold, N. 125n Bhattacharyya, D. K. 6n, 20n, 171, 190n Biedenkopf, K. H. 181n, 192 black labour market 43–4 see also labour force black markets, in developing counries 30 in OECD countries 35 in transition countries 30, 33 Blades, D. 21 Blankart, C. B. 98n, 100n, 101, 103n, 106n, 167n Boeschoten, W. C. 18n, 19n

Bohlich, ¨ S. 120n, 131n, 134n Borchert, J. 103n Borjas, G. J. 185n Borsch-Supan, ¨ A. 105n Bos, ¨ D. 69n Bosch, G. 127n, 132, 133n Boss, A. 116n, 120n bounded rationality 60, 85 Bovi, M. 37n Brehm, J. 87 Brennan, G. 100, 167n Breusch-Pagan test 110n Brockmeier, T. 30n, 32n, 159, 161n Brue, S. L. 125n Brummerhoff, ¨ D. 103n Buchanan, J. M. 100, 167n Cagan, P. 19 Canadian tax rule 88 Cappiello, M. A. 43n Carlberg, M. 68n cash demand approach 17–18, 29, 36, 38, 39–41 model 26–7, 143–5; with tax reforms 144–9 Caspers, A. 6n, 7, 9 Cassel, D. 6n, 7, 9, 30n, 32n, 79n, 157n, 166n, 170 Castells, M. 30n Castelluci, L. 37n causal analysis, of deviant behaviour 63–7 Cebula, R. J. 143 Chickering, L. A. 30n, 44n citizen money 123 Clair, P.-M. 40 Clotefelter, C. T. 16n Cloward, R. A. 77n coal mining subsidies 117 cognitive control, see control theory Coleman, J. S. 55n, 185n community work 123–4, 174

215

216

Index

competition, distortion of 163 and growth 159 intensiﬁcation of 162–3 and quality 141 and welfare effects 183 complexity, of tax system 113 consultation, and policy 180 Contini, B. 17n control theory, and deviant behaviour 85–6 see also reactance theory Cook-Weisberg test 110n corrupt administration 30, 33 and tax yield 183 Cowell, F. A. 3n, 69n craftsmen/craftsmanship 139, 140, 161, 162, 163, 168 criminal sector 12 crowding-out effect 62–3 currency demand, as measure of shadow economy 19–20, 41 criticisms 20–2 Dahrendorf, R. 58n Dallago, B. 16n, 19n, 32n, 33n, 44n, 105n De Gijsel, P. 67, 68, 70n, 72n, 79n De Mandelville, B. 54 De Soto, H. 11n,30, 32n, 161n decision-making habits 61–2 of individuals 56–7 Del Boca, D. 16n, 17n, 22n demand deposits, and currency demand 21 demand effects 171 deregulation, advantages 124–5 developing countries, shadow economy labour force 44–5, 46–9 size 30–2, 37 Dickenberger, D. 87 Diewald, P. 9n disincentives to work 123 distribution effects 166–9 division of labour, and comparative advantage 161–2 Dixon, H. 6n, 190n Djajic, S. 185n Dohrn, ¨ R. 9n, 157n Donges, J. 115n, 124n dual economy categorisation 7–9 DYMIMIC model 24–5

education and training, effects of shadow economy 159 see also foreman’s certiﬁcate education, training and illicit working 82 Eekhoff, J. 106n, 117n, 122, 123n, 124n, 127n, 131n, 134n, 138n, 142 efﬁciency, and social justice 167–9 efﬁciency, of Inland Revenue 91 efﬁciency taxation 168 Eichenberger R. 57n, 61n electricity consumption method 22–4, 29 and developing countries 31–2 and OECD countries 35, 41 and transition countries 33 Elster, J. 58n, 59n, 62, 54, 84 EMU, and shadow economy 6 Enste, D. H. 1n, 3n, 4n, 6n, 7n, 10n, 13n, 15n, 18, 29n, 37, 38, 41, 57, 58n, 59n, 60, 61n, 62n, 63n, 81n, 82n, 84n, 91n, 101, 106n, 111n, 112n, 114n, 117n, 149n, 154n, 160n, 179n, 180n, 181n environmental taxes 115 equality of distribution 167–9 Erard, B. 10, 55n, 68n, 68n, 95n, 143n, 156n Esser, H. 55n, 58n, 59, 60 Essing, H. 6n Etzioni, A. 153n EU Commission employment strategy for combating illicit work 1, 3–4 standardisation of national income accounts 7 EU Parliament 1 EU shadow labour force 51–2 Eucken, W. 179 European National Accounts 6 Evers, H.-D. 76n, 83n evolutionary theory of shadow economy 97–101 of taxation 112 Ewers, H.-J. 103n, 105n, 140n, 163n exchange theory 91 exit option 2, 5, 86, 97–8, 168n, 179, 180–3, 191 Expert Commission on Housing 121–2, 151

early retirement 131–2 economic development 191–2 economic policy, effects of shadow economy 2–3 failure 104, 190 economic psychology 55, 89–93

Fase, M. M. G. 18n, 19n Federal Union of Independent Craftsmen 175n Fehn, R. 125n Feige, E. L. 2n, 4n, 7n, 15n, 16n, 18, 20n, 21, 39, 40, 41, 79n, 172n

Index

217

Feinstein, J. 10, 55n, 68n, 68n, 95n, 143n, 156n, 190n Felderer, B. 69n Fels, G. 121n Festinger, L. 83n, 91 Fetchenhauer, D. 57n, 58n, 62n, 84n, 90n, 95n Fichtenbaum, R. 170 ﬁnes, see punishment ﬁscal effects 156, 171–7 ﬁscal federalism 184 Fisher’s quantity equation 18 ﬂexibility, see part-time working; working hours Flexman, B. 81n Focus Magazine poll 81 foreman’s certiﬁcate 140, 141 Forte, F. 22n Fortin, B. 43–4, 70n, 111, 143 frames, in RREEMM model 60–1 Frank, R. H. 62, 84 Franz, W. 125n, 133n Fr´echette, P. 43–4, 70n, 111, 143 Fredebeul-Krein, M. 124n, 140n, 141 freedom of movement 163 freedom, infringement, see government regulation Frey, B. S. 2n, 4n, 7n, 15n, 17n, 19n, 21, 24n, 26n, 36n, 42n, 54n, 55, 57n, 58, 59n, 60, 61n, 62, 75, 83n, 84, 87, 91n, 98n, 99, 126, 151n, 152, 154n, 163n, 179n, 180n, 184 Friedman, E. 107n, 155 Friedrich, P. 82n, 155n Fritsch, M.103n, 105n, 140n, 163n Fuest, W. 123n Fujimori, President 30 Furnham, A. 58n, 62n Furubotn, E. 62n

government regulation 19, 20, 25, 26 and common good 192 costs 158 density 124, 126, 149, 183 in labour market 125 measurement 126–7 in OECD countries 38, 43 transparency 114 see also state intervention; tax burden Grabitz, H.-J. 87 Gretschmann, K. 6n, 155n, 157n, 163, 168, 170, 173n, Gross, P. 82n, 155n growth rate 26, 159–60 and investment 160 Gutmann, P. M. 19, 39, 41, 98 Gutmann-curve 111

Gaertner, W. 2n, 153n Garcia, G. 21 Gates, Bill 164 German Council of Economic Experts 7, 117, 134n Ghersi, E. 32n Ghosh, D. 24n Giersch 178 Giles, D. E. A. 4n, 6n, 19n, 20n, 26, 27, 35, 160n, 190n Giles, L. M. 26, 111, 143 Ginsburgh, V. 170n Glatzer, W. 8n, 82n Gniech, G. 87

illicit labour supply models 67–8, 123 illicit work 1, 12, 41, 63–4, 66 in Austria 13 and corruption 149 ﬁscal effects 172 in Germany 14, 79–82 and government 2, 187–9 legalisation 185 public perception 186–7, 189 see also developing countries; income-leisure model; labour force; OECD countries; social security; sociological factors; tax burden; tax reform; transition countries

habits, in RREEMM model 61 Hackmann, J. 69n Hartmann, N. 6n Hayek, F. A. von 54, 60n, 166n health insurance 106 and part-time working 119, 175 Heertje, A. 157n Heinz, R. G. 76n, 83n Helberger, C. 26n Henman, B. 138n Herbert, W. 77n Herkner, W. 87n Hill, R. 21, 40, 111, 143 Hippler, H. J. 77n Hirschman, A. O. 62, 168n, 179, 185n Hofreither, M. F. 17n, 55n, 68n, 79n, 98n, 156n, 186, 187 Homburg, S. 114 Homo Oeconomicus 56n, 57–8, 59, 62, 63 Homo Sociologicus 58–9, 76 Houston, J. F. 170 Hunt, J. 133n

218

Index

income and expenditure statistics 16–17, 41 income, and illicit working 83 income-leisure model 63–7, 100, 150 and illicit work and overtime 71–3, 123–4 and individual labour supply 69–71 limitations 75 reduction in working hours 73–5, 129 indicator approaches 16–24, 26 indifference curves, and preferences 64–5, 70–1 inefﬁciency, of tax system 113 inﬂation in MIMIC model 26 information control, see control theory Ingelhart, R. 77n innovation 164–5 institutional change, and habits 61–2 institutional determinants, and deviant behaviour 78–9 institutional sclerosis 2, 98 insurance contributions 106 integrative model of deviant behaviour 95–7 interdisciplinary analysis 54–97 passim invisible hand 54 irregular sector 11–14 IRS 16n Isachsen, A. J. 15n, 20, 69, 70n, 72 Jessen, J. 76n, 83n Johnson, S. 4n, 20n, 22n, 25n, 30n, 33n, 34, 35, 143 Juster, S. 55n Kabir, M. 21, 40, 111, 143 Kahneman,D. 57, 61 Kaliberda, A. 22 Karmann 105n Kaufman, D. 4n, 20n, 22, 25n, 30n, 33n, 34, 35, 143 Kaufman-Kaliberda method 22 Kelley, H. H. 91 Kirchg¨assner 9, 17n, 19n, 21n, 54n, 57n, 58, 59n, 64n, 79n, 106n, 115n, 153, 154n, 157n, 162n, 163n, 179n, 180n, 181n, 184, 187n, 192 Kirsch, G. 105n, 186n Klages, H. 77n Klein, A. 151n, 192 Klopﬂeisch, R. 120n, 123n Kloveland, J. 15n, 21 Knepel, H. 26n Koch, L. T. 59n, 61 Krause-Junk, G. 113n, 115n

Kronberger, K. 127n, 134n, 138n Krugman, P. R. 161n Kucera, G. 140n Kullmer, L. 113n, 155n labour force, ofﬁcial and actual 17, 26, 41, 43–4, 160 see also black labour market labour supply, and transfer payments 122–4 Lacko, ´ M. 22–4, 30n, 31, 33n, 35 Lacko´ method 22–4 Laffer Curve 3, 56, 98, 99, 111, 143 Lamnek, S. 76n, 79n, 81, 82, 83–4, 93, 94, 123n, 135, 150n, 151 Langfeldt, E. 18n, 106n, 124n, 157n, 165n Latin American shadow economy labour force 45, 49 size of 29, 30 law against illicit work 150 law enforcement 12 lack of trust in 33 legal regulation, increase 150–1 Lehndorff, S. 127n Lehner, G. 176 Lemieux, T. 43–4, 70n, 111, 143 Levi, M. 57n Leviathan theory on taxation 100–1 Lewin, S. B. 58n, 62n Lewis, A. 58n, 62n Lindenberg, S. 58n, 59n, 60 Lippert, O. 3n, 4n, 10, 29n, 36n, 40, 105n Little, D. 58n, 59n Lizzeri, C. 22n Loayza, N. V. 4n, 29n, 30n, 31, 44n, 55n, 153n, 160 local exchange systems 164–5 Lubell, H. 7n, 32n, 43n, 44n Luedtke, J. 76n, 150n Maastricht Treaty 36 MacAfee, K. 16n Mackscheidt, K. 90n, 91n, 170n macro-economic data 169–70 Maﬁa 33 Mankiw, N. G. 103n, 161n marginal rate of substitution 65 market distribution 102–5 market exit restrictions 125 market failure 103, 105 and labour supply 125 Mauleon, I. 35 Mauro, I. 183n McClelland, G. H. 77, 79 McConell,C. R. 125n

Index McGee, R. T. 172n McKenzie, R. B. 58 McMillan, J. 33n measurement of shadow economy 3, 4–5, 15 see also currency demand; electricity consumption method; indicator approach; labour force; model approach; surveys; transactions approach media, power 179–80 Meier, D. 9n, 63n, 164n, 165n Meinhardt, V. 119n Meisterbrief 124, 139–43, 163 Menger, Bohm-Bawerk ¨ 54 Merton 83 Merz, J. 76n, 189n methodological individualism 54–5 Mettelsiefen, B. 68n, 172n, 173n migration 98 Mill, J. 54 MIMIC model 26–7 and labour force 44 Mirus, R. 11n model approach 24–7, 29 and developing countries 31–2 and OECD countries 41 Mogensen, G. V. 15n, 16n moonlighting 1, 13, 17, 72–3, 82 moral suasion 183 Moritz, K.-H. 64n, 65n Morris, B. 24 motivation, and illicit working 83–4 motivational structure, RREEMM model 62 Muckl, ¨ W. 7, 124 Mueller, D. C. 105n, 133n Muller, ¨ K. 102 Musgrave, P. B. 113n, 155n Musgrave, R. A. 113n, 155n Myles, G. D. 76n Nasho, A. 31 national accounting 16–17 National Income Accounts 7–9 Naylor, R. A. 76n Neck, R. 55n, 68n, 79n, 98n, 112n, 143n, 146, 156n negative effects 157–60, 165–6 negative income tax 123 neoclassical model 57 network assistance 9 Neumann-Morgenstern utility function 68–9 Niessen, H.-J. 76n, 82n Noelle-Neumann, E. 180n

219 Nordhaus, W. D. 161n norms and values 58–9, 82 O’Higgins, M. 16n O’Neill, D. M. 17n objective probabilities, in neoclassical theory 57, 59 Obstfeld, M. 161n OECD countries’ shadow economy development of 37–9 labour force 51–3 size 30, 33–7 Offe, C. 76n, 83n ofﬁcial indicators, distortion 3 Ohlin, L. E. 77n Olbrich, G. 76n, 79n, 81, 82, 83–4, 93, 94, 123n, 135, 151 Ollmann, R. 76n, 82n Olson, M. 2, 133n Opp, K.-D. 58n, 76n ordinal utility theory 65 ordnungspolitik 55, 103, 179 organised crime 192n and currency demand 21n in transition economies 33 and welfare 162 Osnabrugge, ¨ G. 87 overtime working 72–3, 125 regulation 128 Park, T. 16n, 21 part-time employment, and state regulation 118–20 part-time working 129–33 Pelzmann, L. 88n, 90n, 183n pension insurance 106–7 and part-time working 119–20 pensions, and beneﬁt abuse 174 Peruvian shadow economy 30–3 Petersen, H.-G. 16n, 64n, 68n, 88n, 102 Petry, G. 2n, 11n Phillips curve 56 Pindyck, R. S. 110n Pissarides, C. 17n Poll, ¨ G. 17n, 36, 112n, 126, 143n, 145, 148, 162n Pommerehne, W. W. 2n, 4n, 7n, 9, 15n, 17n, 19n, 21, 36n, 44n, 75, 79n, 106n, 143n, 150, 151n, 152, 154n, 154n, 157n, 179n, 181n, 184, 192 Portes, A. 22n, 29n, 77n positive effects, of shadow economy 157, 161–5, 165–6 Pozo, S. 3n, 20n, 25n, 29n, 31, 40, 43n, 44n, 105n

220

Index

preferences in income-leisure model 64–7 in neoclassical theory 57 prices, and scarcity 161 Prinz, A. 174n privatization, in Peru 32 property rights 30, 33 prospect theory 57 protection, problems 163–4 public expenditure 1 and subsidies 115–18 public opinion, management 61 punishment, for illicit work 150, 158, 192 Quirk, P. J. 55n, 156n R&D subsidies 117 rational choice theory 55–9 rational economic policy 178–9, 182, 191–3 reactance theory 84–5, 87–9 and economic utility theory 88 real estate, and tax reform 121–2 real income, MIMIC model 26 reduction in working hours 73–5 regulation, avoidance of 9 see also government regulation Reichl, N. 58n, 62n, 84n, 91n, 95n, 96n relative deprivation 60n resources use of 165 waste of 158 retrospective control, see control theory Ricardo, and comparative costs 161n Richter, R. 62n Riebel, V. 64n, 72n, 74, 150n Robben, H. S. 57n Rogoff, K. 21n Rose, K. 161n Rose, M. 113n Rose-Ackermann, S. 30n, 154n, 183n Rosenschon, A. 116n Rostker, B. 68n, 70n, 72n Roth, S. 118n RREEMM model 59–60 man component 62–3 Rubinfeld, D. L. 110n rule of maximisation 57 Rurup, ¨ B. 103n, 181n Salahdine, M. 30n, 44n Samuelson, P. A. 161n Sandmo, A. 68, 68n, 69, 70n, 155n Sassen-Koob, S. 77n satisﬁcing 60, 62

Sauernheimer, K. H. 161n Sch¨afer, W. 68n, 76n, 79n, 81, 82, 83–4, 93, 94, 123n, 135, 151, 157n, 173n, 174n Schenk, M. 61n, 179n Schlenger, M. 120n Schm¨ahl, W. 174n Schmidt, K. 166n, 181n, 192 Schmolders, ¨ G. 10n, 75n, 89, 91, 154n, 193 Schnabel, R. 105n Schneider, F. 2n, 3n, 4n, 7n, 10n, 13n, 15n, 17n, 18, 20n, 21, 24n, 25n, 29n, 35, 36, 37, 38, 40, 41, 52, 55n, 63n, 68n, 79n, 81n, 82n, 89, 91n, 98n, 106n, 111n, 112, 126, 143, 145, 146, 148, 149n, 154n, 156n, 159n, 160n, 162n, 171, 176, 180n, 186, 187 Schonfelder, ¨ B. 103n Schrage, H. 6n Schulze, W. D. 77, 79 Schumpeter, J. A. 164n Schupp, J. 119n Schurfeld, ¨ A. 124n, 140n, 141 SchwArbG, BMA 12n Schwarze, J. 76n, 119n Schweers Cook, K. 57n Scitovsky 62 Second Building Law 150 secrecy 10n, 79 Seifert-Vogt, H.-G. 79n self-sufﬁcient economy 9, 11 Sendlhofer, R. 113n servants’ privilege 121 Sesselmeier, W. 120n, 123n Setzer, M. 120n, 123n Shishko, R. 68n, 70n, 72n Shleifer, A. 4n, 22n, 30n, 35, 154n, 158n Siebert, H. 123n Simon 60 Sinn, H.-W. 163n, 180n Smekal, C. 89n, 95n, 113n Smith, A. 54 Smith, P. M. 11n Smith, R. S. 11n social norms, and tax honesty 77, 79 social security burden 2, 43, 106–7 costs and beneﬁts 106–7, 175 fraud 1, 9, 12 in Germany 77–82, 106n inﬂuence of shadow economy 174–5 part-time employment 118–20, 133 reform 90, 93, 183 see also beneﬁt abuse societal development 191–2

Index socio- and ﬁnance psychology, and deviant behaviour 84–5 Socio-Economic Panel 135, 138 sociological explanation, for deviant behaviour 76–8, 82–4, 191–2 Spiro, P. S. 3n, 61n, 111, 143n, 149 Spross, K. 118n St Florian’s principle 151 stabilisation policy 169–71 Stahlberg, D. 87 St¨ahler, F. 123n state intervention 102–5 and market failure 103 and part-time working 129–33 and social injustice 102, 167, 169 see also government regulation state pressure 63 Staudt, E. 158n Steinhausen 170n Stiglitz, J. E. 103n Stratenwerth, W. 140n Streit, M. E. 60n Strom, S. 15n, 20, 69, 70n, 72 Strom, W. 6n, 9n Strumpel, ¨ B. 91n Stutzel, ¨ W. 7 subjected-expected-utility theory 58 subsidiarity principle 184 subsidies, see public expenditure Suchanek, A. 55n survey approach 15–16, 39–41, 44 Tanzi, V. 4n, 6n, 13, 19, 21, 30n, 40, 41, 43n, 154n, 183n, 190n tax auditing 15–16 tax burden 2, 19–20, 25, 143, 172, 181, 188–9 in Germany 93 and labour supply 69 in OECD countries 38, 43,107–9 primary cause of shadow economy 109–12 and reactance theory 88–9, 181, 183 and social insurance contributions 106, 109 and transfer payments 90–1 in transition economy 33 see also cash demand tax evasion 1, 9, 10, 13, 41, 57, 61n, 143, 158n, 168, 172, 192 German attitudes 79–82, 93–4, 150 models 68–9 tax mentality 93 tax morality 21n, 26, 89–90, 93–4, 97, 151–4

221 in OECD countries 38 and reactance theory 85, 89 and social norms 77, 79, 91 tax reform Austrian model 144–9, 188 in Germany: ecological taxes 115; and economic growth 114; objectives 112–13; private real estate 121–2; rate change 113–14; servants’ privilege 121; state expenditure 181n; and transfer payments 122–4; VAT 120–1 tax revenue, and underground activity 3 tax variable, use in measurement 21n, 26 tax yield 172–4, 176–7, 187 in Austria 176 and corruption 183 in Germany 175 taxation psychology 89–95, 97 Taylorism 162n Thaler, R. H. 97 theory of evolutionary taxation 89 theory of social comparison 83n, 91 Theurl, E. 89n, 95n Thibaut, J. W. 91 Thomas, J. J. 2n, 3n, 4n, 6n, 11n, 12, 15n, 16n, 17n, 19n, 20n, 21, 25n, 29n, 30n, 36n, 40, 105n, 161n, 190n Thompson, S. C. 86 Tokman, V. E. 32n trade, and manual labour 139 foreman’s certiﬁcate 140–1 legalisation 185 and quality regulation 140–2, 143–3 trade unions 186–7 transactions approach 18–19, 39–41 transition countries’ shadow economy labour force 45, 50–1 size 32–3, 34, 37 transparency, of tax policy 113 Trockel, J. 64n, 68n, 72n Tuchtfeldt, E. 7n, 105n Tullock, G. 58 Tversky, A. 57, 61 unemployment 1, 68 insurance 175 rate calculation 170 utility maximisation, income-leisure model 65, 67 value-added tax reductions 120–1 yield 173 Varian, H. R. 64n, 65 Vaubel, R. 123n

222

Index

Veit, O. 91n velocity of money, and currency demand 21, 38 Vestny, R. W. 154n, 158n voice option 2, 5, 86, 98, 168n, 179–80, 183 need for increased participation 183–5, 191 in Switzerland 184n Volkswagen AG 139 Wagner, D. 134n Walker, M. 3n, 4n, 10, 29n, 36n, 40, 105n Walwei, U. 127n, 134 W¨arneryd, K.-E. 54n Watrin, C. 103n, 141n Weber, G. 17n Webley, P. 57n, 58n, 62n Weck, H. 2n, 24n, 42n, 75, 98n, 99, 151n, 152 Weck-Hannemann, H. 21n, 24n, 26n, 36n, 55n, 126, 143n, 150, 152, 154n, 179n, 184n Wehmeier, A. 117n Weidinger, M. 127n Weigel, K. E. 57n Wein, T. 103n, 105n, 140n, 163n Weizs¨acker, C. C. von 167

welfare effects, of shadow economy 159–60 welfare system, and labour supply 43–4 see also income-leisure model welfare theory on taxation 100, 112 welfare, and state intervention 103–5 Wenig, A. 2n Werkneh, G. 26, 111, 143 Werner, C. 68n, 72n Wied-Nebbeling, S. 2n, 11n Wiegard, W. 68n Williams, C. C. 20n, 35, 36n Windebank, J. 20n, 35, 36n Windisch, R. 98n Winner, H. 113n Wiswede, G. 57n, 77n, 86n, 87, 88, 90n Wolff, K. 76n Woodruff, C. 33n working hours regulation 127–9, 133–4 ﬂexibility 138–9 preferences 134–8, 165, 183 see also early retirement, part-time working Zilberfarb, B.-Z. 21n Zimmermann, K. W. 115n Zoido-Lobaton, ´ P. 4n, 20n, 25n, 30n, 34, 35, 143