The Strategist

IMF finds a way to fight shadow economy

12/24/2019 - 09:47

Although the size of shadow economies in European countries declined during the post-crisis years, it remains significant, especially in Eastern Europe. Since the size of the informal sector in local developing economies directly depends on the quality of regulation, government efficiency and the level of development of human capital, it is possible to deal with it only in a comprehensive way, selecting a reform package for specific conditions, the IMF study says.

Kenneth Allen
Kenneth Allen
Although the average size of shadow economies in Europe remains at the level of the mid-2000s, its dynamics, drivers and possible methods of fight in different countries are very different, says the IMF working paper “Explaining the shadow economy in Europe: size, causes and policy options.” Researchers estimated the size of the shadow sector using a model that takes into account both preconditions for its growth (labor productivity, government efficiency, tax revenue, trade volume and value added in the agricultural sector), their impact on GDP growth and the level of economic activity of the population. According to them, since the beginning of the 2000s, the growth of the shadow sector has been observed in Croatia, Serbia, Greece and Cyprus, while the Czech Republic and Macedonia managed to downsize it.

In more developed countries, the size of the sector is much smaller - both in relation to GDP and to formal employment. According to researchers, in developed countries in Europe it averages 10–20% of GDP, in emerging economies –– 30–35%. The lowest indicators in 2016 were observed in Austria (9.6%) and Luxembourg (9.7%), the highest - in Kosovo (38.8%), Montenegro (38.2%) and Bulgaria (37.8%). The IMF explains vitality of the shadow sector with a variety of reasons: in addition to the benefits of tax evasion and social security contributions or labor and market regulation, in some cases the “shadow” creates jobs and provides income in the absence of them in the formal sector; sometimes it even forms an alternative to the social security system during a crisis.

The size of the shadow economy not only stably negatively correlates with per capita incomes; its structure is different in rich and poor countries, researchers say. In developed economies, most of the informal sector is associated with tax optimization and shadow employment in formally registered companies, while in developing economies the percentage of employees employed is significantly higher. The key prerequisites for determining the size of the shadow sector in Europe are the quality of regulation and tax administration, combined with labor productivity and free trade (as well as development of human capital for the countries of Eastern Europe). The volume of migrant remittances corresponds with informal employment as migration and participation in the shadow economy are de facto alternatives.

Reform packages for the successful fight against the “shadow” should be based on drivers that are most influential for a particular economy, the IMF said. For European developing economies, the standard set includes removing regulatory and administrative barriers, increasing transparency and efficiency of public administration, as well as tax discipline, automating procedures and developing electronic payments. In addition, it is necessary to create incentives for the formalization of shadow employment, especially in countries that depend on remittances from migrants, where the shadow economy is a kind of social support system.