Integrate Eastern Europe’s shadow economy into the formal sector, World Bank report says

Too many of Eastern Europe’s workers and firms are engaged in the “shadow economy” — doing business and work in untaxed and unregulated markets for goods and services — according to a new World Bank report “In From the Shadow: Integrating Europe’s Informal Labor.”

As the impacts of the euro crisis, population ageing, and labour force shrinkage spread to emerging economies of Eastern Europe, bringing workers and firms in from the shadow economy is critical for long-term economic growth in Eastern Europe, the World Bank said.

The report, launched on September 10 2012 in Brussels at a joint Centre for European Policy Studies (CEPS) – World Bank conference, finds that integrating the informal economies in the countries of Eastern Europe with the formal sector is crucial for the well-being of households, the growth of firms, and the advancement of society. The report provides guidelines for policy makers in the new EU member states to bring as much economic activity in from the shadow economy as possible.

The World Bank said that the report’s references to “new EU member states” were to EU countries from the Baltic region, Central Europe, and the eastern Balkans that joined the bloc in 2004 and 2007, respectively. They are Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Romania, Poland, Slovakia, and Slovenia. The report was not directed to Cyprus and Malta, but was relevant to countries such as Croatia, due to join the EU in 2013.

In her opening remarks at the September 10 conference, World Bank Senior Adviser Katarina Mathernova underscored that the current financial crisis, combined with the demographic changes ahead, make it all the more important for governments in Eastern Europe to enable firms to operate competitively in the formal sector, to provide sufficient protection to workers and their families, and increase the economy’s tax base.

“The governments of the new member states in Eastern Europe simply cannot afford a large shadow economy, neither in the short run due to fiscal concerns, nor in the long run due to the shrinking labor force,” Mathernova said.

World Bank Lead Economist and co-author of the report Truman Packard said that the informal economy creates problems on three levels.

“At the household level, workers, business owners, and their families cannot properly manage their income risks because they lack proper access to social security. At the firm level, informal companies are constrained in their growth because of lack of access to credit protection of property rights, and formal companies are overburdened due to tax revenue losses and unfair competition from informal firms.  At the societal level, a large informal sector erodes the financing of public goods and services, thereby inhibiting the government’s capacity to provide proper education and health care services and a well-functioning infrastructure,”  Packard said.

In terms of what governments in Eastern Europe can do, World Bank Senior Economist and co-author of the report Johannes Koettl said that it is not all about enforcing laws and punishing offenders, but also about making the formal sector more attractive and changing social norms for paying taxes.

Low-paying, casual, part-time jobs comprise a large part of informal jobs in the new EU member states, but these jobs are often not economically viable in the formal sector.

“Making these jobs and businesses economically viable in the formal sector means providing tax incentives for low-wage earners, like the US Earned Income Tax Credit, and designing smart safety nets that reward formal work, like the German Harz IV reforms. In addition, regulations need to strike the right balance between the protection that is afforded to workers and consumers and the flexibility that is afforded to employers,”  Koettl said.

The report argues that changing social norms about paying taxes and gaining citizens’ trust in their governments is crucially important. Time and commitment on the part of governments are critical for achieving and delivering better results.

A good starting point, the report says, is building good and trustworthy relationships between tax officials and taxpayers. Tax administrators are likely to receive a more positive response from the citizens if they construct relationships based on trust and presumption of good citizenship, and establish transparent payment procedures. Improved and sustainable high levels of tax morale can only be achieved through a successful liaison of three factors: corruption control, the quality of institutions, and the degree of citizens’ participation.

“By working with the new EU member states on this issue, the World Bank is continuing its role as a partner with the European Union in how to improve the economic performance of its newest members,”  Mathernova said.

(Photo, of an old street in Vilnius, Lithuania, by  Herman Brinkman/sxc.hu)