engleski

Underground Economies in Transition, Unrecorded activity, tax evasion, corruption and organized crime

The underground or 'second' economy was a critical component of the pre-transformation planned systems of Central and Eastern Europe (CEE) and of the Former Soviet Union (FSU). Consisting of prohibited economic activities involving arbitrage, speculation, and private production and distribution employing public resources, the second economy functioned in a salutary manner to circumvent many of the inefficiencies and incentive incompatibilities that plagued centrally planned economies. It was thought that liberalization and privatization would eventually legitimate and absorb most of these economic activities into the official market system of the emerging post-transition states. It is now apparent that underground or unofficial economic activities continue to play an essential, albeit, transformed role in many post transition economies. Unrecorded economic activity, tax evasion, corruption and organized crime represent forms of non-compliant behavior that have important and primarily negative consequences for many of the transition countries. Many newly legalized economic activities continue to seek invisibility in order to evade explicit taxation and regulation, just as illegal corrupt and coercive activities substitute for the enforcement and property adjudication services that were traditionally provided by agencies of the state. What exactly are the roles and consequences of these underground activities in transition economies? How do they effect the transitions and how, in turn, have the transitions affected the nature of underground activities? These are among the issues addressed by this volume. Although interest in underground economic activities has spanned developed and developing countries, the process of transition focused a special renewed interest on the topic. In Croatia, a group of young economists associated with the Institute of Public Finance in Zagreb became concerned with the economic, political and social aspects of various types of unofficial activity. Croatia was faced with the difficulties attendant on the establishment of an independent nation ; recovery from a devastating war and a radical transformation from socialism toward a market economy. Casual observation revealed that markets were flooded with goods smuggled in from neighboring countries, workers were unregistered, employers were not paying contributions or taxes, foreign exchange dealers were found at every corner, and politically well connected individuals suddenly appeared to be displaying new found wealth. In short, there appeared to be a flourishing underground economy comprising a variety of unofficial economic activities. As a first step, Croatian researchers attempted to assess the magnitude of this underground economy. Employing rough measurement methods that had been used in other countries, (Section 3 of this volume) they concluded that at least 25% of overall economic activity was unrecorded in the newly established Croatian National Income and Product Accounts. This stimulated a number of other scholars to examine both the causes and implications of underground activities during transitions. These findings, along with comparable studies from other transition countries, were presented at an International Conference on Unofficial Economies in Transition in May 1997 in Zagreb. The present volume is an offshoot of that conference. Among the themes raised in this volume, perhaps the most important is the concern that underground activity on a large scale can fundamentally undermine the success of the transition process. The first set of papers place underground economic activity in the broader context of institutional economics and examine the complex causal interrelationships between noncompliant behavior and the economic transition to a market economy. The papers question whether unofficial activities are the natural legacy of pre-transition behavior or a phenomenon largely resulting from the uncertainty and institutional disintegration of the transition itself. The second set of papers examines both the theory and practice of economic policy in the context of transition as well as the consequences of policy failures. The final section is concerned with the difficult problems of measuring the size and growth of underground activity. As developed in the first set of essays on general issues, the causes and consequences of post-transition unofficial economic activities can best be understood in the context of the New Institutional Economics (NIE). The NIE is concerned with the costs and benefits that accrue to individuals and societies from the establishment of rules, both formal and informal, that constrain behavior. Underground economics, (UE) is concerned with the costs and benefits that accrue to individuals and societies when rules are evaded, avoided, circumscribed, or corrupted, in short, with the consequences of noncompliance with institutional rules. These two analytic frameworks are entirely complementary, opposite sides of the same intellectual coin. Institutional economics examines the consequences of compliance with institutional rules - underground economics analyses the consequences of noncompliance with those rules. Both institutional economics and underground economics have taken on a new importance in our efforts to understand the historic transition taking place in CEE and the FSU. A decade has passed since the world witnessed the extraordinary collapse of the socialist/communist experiment. As these countries began their unprecedented efforts to transform their economies from central planing to market mechanisms, few correctly anticipated the extraordinary importance that institutions, and institutional failures, would play in the process. Western economists, whose training and experience focused on solving incremental problems, suddenly encountered regime shifts involving fundamental changes in political, social and economic institutions and processes. The very institutions, which were taken as given in most previous economic inquiry, suddenly became the salient variables in the analysis. Policy prescriptions that called for stabilization, liberalization and privatization required implementation in a context of radical institutional change accompanied by massive uncertainty. Institutions were increasingly confronted with noncompliance, evasion, avoidance, abuse, corruption and criminality. Underground economic activities flourished, obfuscating true economic performance, undermining government revenue sources and hence the quantity and quality of government services, redistributing income and wealth, and unraveling the rule of law. Just as institutional economics addresses the issue of what types of institutions are required to reduce transaction costs and thereby improve economic development and performance, underground economics must distinguish between various types of noncompliant behavior in order to analyze their short and long-term consequences for efficiency, equity, and stability. As economic activities move underground, firms and individuals increasingly seek to conceal their behavior. Concealment increases transaction costs and monitoring costs. Noncompliance with reporting conventions increases the relative growth of the unrecorded or unofficial sector of the economy, making it increasingly difficult to observe and monitor the true macroeconomic course of the transition. Some countries appear to have made great strides toward a successful transition to a market economy, while others appear to suffer from massive unemployment, declines in output and the collapse of their social capital. Assessing the actual progress of each economy during the transition requires measures of the size, growth and composition of its unrecorded economy. Noncompliance with fiscal codes takes the form of failure to report income and evasion of taxes. Tax evasion places great strains on government revenues in many transition countries. Revenue shortfalls create budget deficits as governments struggle to maintain levels of social expenditures. Budget deficits, in turn, are met with reduced expenditures and/or inflationary finance. These measures tend to increase uncertainty, public dissatisfaction with government and further tax evasion, thereby sparking a vicious cycle. Investment from abroad is discouraged, economic performance suffers and the deteriorating situation increases incentives for even greater shifts to the underground economy with resulting dynamic instability. The shifts toward underground activities during transition are qualitative as well as quantitative. Pre-transition second economy activities often involved survival strategies that circumvented inefficient rules and regulations, that is, 'bad rules'. The circumvention of high transaction costs and other inefficiencies not only served as survival mechanisms for individuals, they actually enhanced the overall efficiency of resource allocation under socialism (Grossman, 1977). However, during transition, when legalization, liberalization and stabilization attempt to improve the institutional framework, evasion and noncompliance with the new 'better rules', renders them ineffective. As old institutions crumble and new institutions encounter noncompliance, uncertainty increases, property rights become more fragile, and the rule of law becomes more tenuous. Without the rule of law, privatization efforts that attempt to transform limited value, de facto use and income rights into more valuable de jure alienable rights fail to capture potential public gains. In countries where a weakened state loses its ability to enforce property rights or adjudicate property right disputes, these critical functions are usurped by criminal elements willing and able to employ coercion for their own ends. Resources previously devoted to the creation of new wealth are reallocated to efforts to redistribute the existing stock of wealth. And as the interface between public and private resources grows, so do the opportunities for corruption and criminalization. Edgar Feige’s introductory paper adopts the framework of the NIE (North, 1990) to emphasize that a nation’s limited resources must be allocated between activities involving production, protection or predation. During radical transition with weakened institutions, the incentive structure becomes skewed toward protective and predatory activity at the expense of production. Noncompliant behavior creates conflicts between formal and informal rules, suggesting that 'path dependence' may be the result of the pervasive noncompliant behavior that defined informal norms in some pre- transition economies. Feige identifies the legacy of distrust and noncompliance that was inherited from the pre-transition Soviet regime as a major source of the failure of reforms in the present FSU. The papers of Katarina Ott and Aleksandar Štulhofer take issue with the view that unofficial activity in transitions is the result of path dependence. Citing the important differences that exist among pre-transition countries, they claim that for countries like Croatia, it is the economic policy of the state and the uncertainty brought on by radical transition that is the major source of underground activity. They focus on the detrimental aspects of the noncompliance and opportunism that not only threaten the success of reforms, but the very stability of the social, political and economic system. Ott focuses attention on the nexus between economic policy and underground activity, and argues the case that credible economic policy requires informed policy makers, transparency and the equitable application of the rules. Štulhofer’s empirical findings reinforce Ott’s concerns, and reveal that it is the younger survey respondents in Croatia who admit to the greatest tolerance for tax evasion, bribery and opportunism and exhibit the greatest distrust of institutions. Both authors stress the dynamic danger that corruption and opportunism represent to the success of the transition process. The paper by Roger Bowles formalizes some of these concerns by extending the typical model of tax evasion to incorporate administrative corruption on the part of the tax collector. The transition creates both uncertainties and opportunities that can be exploited by the unscrupulous. The institutions in charge of collecting taxes are given strong power and the temptation for bureaucrats and politicians to abuse these powers for personal gain may be very great. This is potentially a very destabilizing force because abuse on the part of those inside the system may well lead citizens to become disenchanted with the activities of the state and weaken their own will to support it and pay the taxes on which it depends. By modeling the propensity of the taxpayer to evade and the tax official to behave corruptly, Bowles demonstrates the linkages between administrative corruption, the choice of tax policy and the citizen's decisions about tax evasion. By investigating the interactions between tax rates, the penalty structure, social attitudes and efforts by the tax administration to control corruption, the model demonstrates that a policy that appears to be tough on corruption may not be particularly effective and can even be counterproductive. In a similar vein, Cedric Sandford analyses the problem of tax evasion from the perspective of the design of tax policy. First, policy makers must decide on the appropriate amount of resources to devote to tax administration. They must also determine how tax evasion can be minimized for any given level of administrative resources. Sandford describes the practical steps required to minimize evasion by creating a simplified and honest administrative structure and the perception of tax equity and non-wasteful public expenditures. Svetlana Glinkina paper graphically describes how the criminalization of Russia’s economy poses a national crisis with international ramifications. With the collapse of the state, and the absence of the rule of law, criminal organizations have taken on the role of contract enforcement and adjudication of disputes about property rights. Given the huge share of property that remains in the public domain, Russia offers broad opportunities to acquire wealth by influencing redistribution, as all claims to property and income are now contestable. The society loses the resources used in attempts to influence the distribution of income, resources that could have been used in productive activity to add to national income. The rent-seeking society experiences lower growth. Rather than accumulating capital, it dissipates resources in contesting and defending redistribution. Vojmir Franičević’s contribution focuses on the political economy of underground activities, namely the role of the state and regulation. Basing his analysis on the Croatian experience, Franičević identifies the state itself as a significant source of underground activity due to its size, inefficiency and inclination to paternalism. He therefore stresses the importance of institutional reforms including the professionalization of state services, judicial independence, greater transparency of regulations and procedures, improved public access and public sector services. His analysis suggests that while underground activity will remain a permanent feature of the Croatian economy, its dynamics will depend both on the character of the developing regulatory regime, on the character of the state itself and on its capability to increase the credibility of its sanctions. The third set of papers deals with the complex issues of measuring the underground economy and determining its composition. It is widely understood that any effort to access the macroeconomic implications of the transition requires estimates of the size and growth of unreported income. However, all attempts to quantify the magnitude of underground activity are constrained by serious methodological issues. Most important among these is the effort to observe activities that economic agents have a strong incentive to conceal. It is therefore unlikely that direct observation or reliable self-reporting is an option. Typically, measurement requires a variety of indirect approaches. Attempts to use popular monetary approaches for measuring the underground economy were precluded by the short time-span of the transition and the radical changes in financial institutions. The most common indirect measurement approach therefore relied upon changing patterns in electrical consumption as a proxy for changes in overall production. Maria Lacko’s paper addresses the electrical consumption approach and points out its shortcomings. Lacko demonstrates that the variations of electricity intensity in transition countries are not necessarily reflections of the growth of the underground economy. Statistical and econometric analysis of data for eighteen transition countries reveals that measured and registered structural changes are sufficient to explain the differences in the changes of electricity intensity. Her work suggests that using aggregate electricity consumption data and the assumption of constant electricity intensity is not the proper way to calculate the size or growth of unrecorded income in either mature market economies or in transition countries. Other indices such as residential electricity consumption and other assumptions appear to lead to more satisfactory estimates. Three papers attempt to estimate the amount of unrecorded income in Croatia using different approaches. Sanja Madžarević and Davor Mikulić undertake the difficult task of measuring the size and growth of unrecorded income in Croatia by employing the national accounting discrepancy method between income and expenditures. To the extent that households are more likely to falsely understate their true incomes than their true expenditures, the discrepancy between GDP as measured by the income approach as compared with the expenditure approach yields a lower bound estimate of unreported income. Madžarević and Mikulić find that total GDP expenditures are indeed higher than total GDP income. The difference between the two is the basis for estimating the size of unrecorded income. Since their calculations require various assumptions, the authors carefully provide a sensitivity analysis, which provides a range of lower bound estimates rather than a single estimate of underground activity In a similar manner Saša Madžarević and Davor Mikulić examine all available sectoral data to estimate the amount of unreported income arising specifically in the agriculture, industry and trade sectors of the Croatian economy. . Sanja Crnković-Pozaić attempts to estimate underground activity in Croatia by using data on employment, unemployment, the activity rate of the population and data from a pilot survey of the workforce. She finds that at its peak, underground activity may involve as much as 26 % the total workforce. Given that the Croatian national income and product accounts are still in the early stages of construction and that some data inputs are of questionable reliability, it is encouraging that the three independent approaches arrived at estimates of unrecorded activity that are of similar orders of magnitude. The two final papers attempt to estimate underground and informal activities in Poland and Hungary. Malgorzata Kalaska and Janusz Witkowski try to measure the widespread unregistered employment in Poland. As the phenomenon is not directly statistically observable they employ indirect methods based on labor force surveys. They also present survey- based estimates of the supply and demand sides of underground economy participation rates and income. Their study is rich in detailing the age, education and urban/rural distribution of unregistered workers, as well as the frequency of unregistered employment in different types of jobs. They find that both full-time and part-time employment in the underground economy amounts to roughly 16 % of the total number of persons officially employed in Poland. Endre Sik presents evidence on the nature, composition and spatial distribution of two types of informal marketplaces in Hungary. The first type of market is essentially a market for daily causal labor in which neither the employer or the employee pays taxes or social security contributions. Such markets typically involve the employment of construction workers or agricultural laborers. The second type of informal market is for goods, typically a flea market or a bazaar. Sik examines the extent to which these markets involve foreign workers or traders. The underground or 'second' economy was a critical component of the pre- transformation planned systems of Central and Eastern Europe (CEE) and of the Former Soviet Union (FSU). Consisting of prohibited economic activities involving arbitrage, speculation, and private production and distribution employing public resources, the second economy functioned in a salutary manner to circumvent many of the inefficiencies and incentive incompatibilities that plagued centrally planned economies. It was thought that liberalization and privatization would eventually legitimate and absorb most of these economic activities into the official market system of the emerging post-transition states. It is now apparent that underground or unofficial economic activities continue to play an essential, albeit, transformed role in many post transition economies. Unrecorded economic activity, tax evasion, corruption and organized crime represent forms of non-compliant behavior that have important and primarily negative consequences for many of the transition countries. Many newly legalized economic activities continue to seek invisibility in order to evade explicit taxation and regulation, just as illegal corrupt and coercive activities substitute for the enforcement and property adjudication services that were traditionally provided by agencies of the state. What exactly are the roles and consequences of these underground activities in transition economies? How do they effect the transitions and how, in turn, have the transitions affected the nature of underground activities? These are among the issues addressed by this volume. Although interest in underground economic activities has spanned developed and developing countries, the process of transition focused a special renewed interest on the topic. In Croatia, a group of young economists associated with the Institute of Public Finance in Zagreb became concerned with the economic, political and social aspects of various types of unofficial activity. Croatia was faced with the difficulties attendant on the establishment of an independent nation ; recovery from a devastating war and a radical transformation from socialism toward a market economy. Casual observation revealed that markets were flooded with goods smuggled in from neighboring countries, workers were unregistered, employers were not paying contributions or taxes, foreign exchange dealers were found at every corner, and politically well connected individuals suddenly appeared to be displaying new found wealth. In short, there appeared to be a flourishing underground economy comprising a variety of unofficial economic activities. As a first step, Croatian researchers attempted to assess the magnitude of this underground economy. Employing rough measurement methods that had been used in other countries, (Section 3 of this volume) they concluded that at least 25% of overall economic activity was unrecorded in the newly established Croatian National Income and Product Accounts. This stimulated a number of other scholars to examine both the causes and implications of underground activities during transitions. These findings, along with comparable studies from other transition countries, were presented at an International Conference on Unofficial Economies in Transition in May 1997 in Zagreb. The present volume is an offshoot of that conference. Among the themes raised in this volume, perhaps the most important is the concern that underground activity on a large scale can fundamentally undermine the success of the transition process. The first set of papers place underground economic activity in the broader context of institutional economics and examine the complex causal interrelationships between noncompliant behavior and the economic transition to a market economy. The papers question whether unofficial activities are the natural legacy of pre-transition behavior or a phenomenon largely resulting from the uncertainty and institutional disintegration of the transition itself. The second set of papers examines both the theory and practice of economic policy in the context of transition as well as the consequences of policy failures. The final section is concerned with the difficult problems of measuring the size and growth of underground activity. As developed in the first set of essays on general issues, the causes and consequences of post-transition unofficial economic activities can best be understood in the context of the New Institutional Economics (NIE). The NIE is concerned with the costs and benefits that accrue to individuals and societies from the establishment of rules, both formal and informal, that constrain behavior. Underground economics, (UE) is concerned with the costs and benefits that accrue to individuals and societies when rules are evaded, avoided, circumscribed, or corrupted, in short, with the consequences of noncompliance with institutional rules. These two analytic frameworks are entirely complementary, opposite sides of the same intellectual coin. Institutional economics examines the consequences of compliance with institutional rules - underground economics analyses the consequences of noncompliance with those rules. Both institutional economics and underground economics have taken on a new importance in our efforts to understand the historic transition taking place in CEE and the FSU. A decade has passed since the world witnessed the extraordinary collapse of the socialist/communist experiment. As these countries began their unprecedented efforts to transform their economies from central planing to market mechanisms, few correctly anticipated the extraordinary importance that institutions, and institutional failures, would play in the process. Western economists, whose training and experience focused on solving incremental problems, suddenly encountered regime shifts involving fundamental changes in political, social and economic institutions and processes. The very institutions, which were taken as given in most previous economic inquiry, suddenly became the salient variables in the analysis. Policy prescriptions that called for stabilization, liberalization and privatization required implementation in a context of radical institutional change accompanied by massive uncertainty. Institutions were increasingly confronted with noncompliance, evasion, avoidance, abuse, corruption and criminality. Underground economic activities flourished, obfuscating true economic performance, undermining government revenue sources and hence the quantity and quality of government services, redistributing income and wealth, and unraveling the rule of law. Just as institutional economics addresses the issue of what types of institutions are required to reduce transaction costs and thereby improve economic development and performance, underground economics must distinguish between various types of noncompliant behavior in order to analyze their short and long-term consequences for efficiency, equity, and stability. As economic activities move underground, firms and individuals increasingly seek to conceal their behavior. Concealment increases transaction costs and monitoring costs. Noncompliance with reporting conventions increases the relative growth of the unrecorded or unofficial sector of the economy, making it increasingly difficult to observe and monitor the true macroeconomic course of the transition. Some countries appear to have made great strides toward a successful transition to a market economy, while others appear to suffer from massive unemployment, declines in output and the collapse of their social capital. Assessing the actual progress of each economy during the transition requires measures of the size, growth and composition of its unrecorded economy. Noncompliance with fiscal codes takes the form of failure to report income and evasion of taxes. Tax evasion places great strains on government revenues in many transition countries. Revenue shortfalls create budget deficits as governments struggle to maintain levels of social expenditures. Budget deficits, in turn, are met with reduced expenditures and/or inflationary finance. These measures tend to increase uncertainty, public dissatisfaction with government

underground economy ; transition ; unrecorded economy ; tax evasion ; corruption ; organized crime

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