Incentives Light the Path Out of the Shadow Economy

May 10, 2016

Three questions for Friedrich Schneider, economist and leading expert on shadow economies. 

The economic crisis that has plagued Greece for more than five years is a story of tragedies micro and macro. It includes the accounts of individuals who have lost their homes and livelihoods, and the struggle of successive governments to create a policy path to sustainable growth.

As The Economist reported in 2014, Greece has high self-employment, which tends to lead to larger shadow economies, damaging the ability of governments to fund services. According to Eurostat, this is largely because of the high level of agricultural employment in Greece. But it’s also come from necessity—as employers went bankrupt, people were driven to self-employment for lack of other options.

Recent research conducted by EY and commissioned by MasterCard indicates that the presence of a passive shadow economy—where one party innocently pays with cash, while the other party takes advantage of the opportunity to hide income—can shave off between 1.6% and 4.2% of GDP growth in some Central and Eastern European countries. Payments in cash have other social and economic costs. How, then, should policymakers help those who are part of a country’s shadow economy transition out to help improve their and their nation’s broader macroeconomic outlook?

To gain insights into this question, we spoke with Friedrich Schneider, professor of economics at the Johannes Kepler University of Linz in Austria, whose research on shadow economies has determined that the shadow economy of Greece accounts for nearly 24% of the country’s GDP. Schneider’s insights on the shadow economy in both the developed and developing worlds help to underscore the development challenge facing Greece and point to a way forward.

Q: To what extent can we compare shadow economies across the developed world and developing economies?

Schneider: A shadow economy in Germany, Great Britain or France is a reflex of over-burdening regulation, high taxation on labor and less freedom for craftsmen and other areas. For instance, we have quite severe regulation on what a carpenter can do and cannot do. We have a tax burden on labor—which quite often doubles labor costs. We observe these conditions, to a large extent, only in highly developed OECD countries.

In Asia or Africa, a shadow economy is a real parallel economy, driven by poor governance, corruption, high unemployment and oftentimes the large size of the agricultural sector. Quite often a number of activities in the countryside are not even measured in Africa or Latin America. No wonder, then, that we get results of the size of the shadow economy of between 30% and 50% of official GDP.

Q: What do you see as some of the adverse effects of the shadow economy?

Schneider: The interaction between the official economy and the shadow economy and the consequences of a rising shadow economy are difficult. Is a shadow economy welfare-enhancing if it fluctuates between 10% and 20%? I would say, mostly, yes. People earn additional income. That additional income is immediately spent in the official economy and the standard of living of people rises. What are the big losers? The big losers are the state, the tax authorities and the social security authorities. They lose contributions. This might end up in a vicious circle, where taxes and social security rates are increased, provoking more activities in the shadow economy. This is quite often the case in developing countries with shadow economies greater than 20%, 25% or 30%.

When we talk about developing countries, we also need to acknowledge the costs that fall on microenterprises: unfair or ruinous competition and little or no development possibilities—with workers subject to low pay and no job security.

Q: What policies have proven most effective in decreasing the shadow economy?

The most effective policy is an incentive-oriented one. If it is less worthwhile to work in the shadow economy and more attractive to work in the official economy, people will do it. There are a number of policy measures that have proven to be quite effective. One is to exempt the value-added tax on labor-intensive work for a certain time. Then, in most states, this work becomes cheaper by 15-20% and it is much more attractive to work in the official economy and get the VAT tax back.

Also the German idea of a mini-job—that everyone can have a mini-job and only pay some social security contributions—proved to be quite effective and reduced the shadow economy in Germany by 20bn euros.

Shadow economy activities are mostly undertaken with cash payments. If it is cheaper and more efficient to use debit or credit cards, shadow economy activities simply get a bit more expensive. Hence, if one would create incentives for people to use their credit and debit cards, it would have a small effect on the shadow economy, reducing it by 3-5%.

Featured Image Caption: A vendor counts cash in a market in Jakarta. (Credit: Bay Ismoyo/AFP/Getty Images)

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