Study of Incentives, Characteristics and Strategies of Firms Operating ‘in the Shadows’ Martin Dimitrov

 

IME conducted a survey of firms’ strategies and incentives to engage in informal activities and the resulting characteristics of company organization and strategy. The report is available at - link. By ‘informal’ economy we mean all the voluntary exchanges of labour, goods and services, which take place undetected by the government. IME and GfK in Bulgaria, Romania and Serbia and Montenegro did the field data collection via sociological survey (60 firms per country). 

Only part of individual’s economic life may be in the informal sector.  In all cases he or she faces the general (optimisation) problem, which involves the choice between registered and informal economy.  The government detection of a deal does not change the matter and essence of the deal itself.  However the choice between formal and informal has implications on the costs of the transaction.  Other thing equal, the parties will choose the form of transaction that implies the lowest transaction costs.

Certain economic regulations create significant disincentives to operate formally.  As a result, some entrepreneurial ideas never reach the marketplace, some start informally, some are performed by otherwise formal company but without permission to engage in the particular activity, some are not complying with taxes and/or other liabilities to state.

It is often the case that long-term strategies and market behaviour change when environment is one with proliferating informal activities.  The individual entrepreneur adjusts his/her own intentions to a situation in which his/her competitors pay no (or less) taxes, and when in most cases contracts are informal and can hardly be enforced by courts.

 

Summary of findings on incentives:

• There is a widespread perception that the informal economy is large and that it is an exogenous factor. If the share of the informal economy is substantial, then it takes somehow part in the formation of each player’s strategy. Thus it contributes to shaping the incentives that direct the effort of almost any active person and form the business strategy of any enterprise;
• Tax burden appears as the most significant factor conducive to informality; but the overall administrative burden appears to be much higher than its visible part such as taxation;
• Evasion of labour tax is the most widespread form of tax evasion;
• The rise in the tax burden diminishes incentives to engage in productive activity;
• The incentives to engage in protective (rather than productive activity) must be attributed to both the seller and the buyer of labour. Thus the motivation for informality must be ascribed to a much wider population than just the business community;
• Informal activities are one of the strategies firms choose to reduce transaction costs; the state contract enforcement mechanisms are considered unreliable by majority of firms;
• There are major implications from operating informally on the manager- labour relationship, on competitiveness and company growth;

 

The overview of the study findings, as well as numerous other studies of the topic allows us to summarize the following common business strategies for SEE:

·            In an environment of overwhelming informality firms trade with known partners and do not recourse to official contract enforcement institutions;

·            Vertical integration emerge as a mean to reduce the cost of transacting;

·            Owners usually dominate company structures and impose informal intra-organizational labor relations, thus preventing the utilization of the competitive and formal market for specialized labor;

·            In certain activities (non-specialized labor, mass commodities, etc.) staying informal and avoiding taxes is the dominant competitive strategy to reduce costs, and therefore – selling price; thus informality in these sectors is mutually-generating;

·            In markets of direct, simple and self-enforcing transactions (they prevail on the Balkans as shown by various studies of post-communist transition) a firm can grow in the shadow sector without facing the opportunity cost of lacking access to formal institutions;

·         The majority of the unreported activity takes place in the form of partial-informality, i.e. the businesses comply at least with some of the regulations, pay some of the taxes due, register their labour contracts, etc;

 

 

Policy Recommendations

Above findings could be addressed through - first of all - national policy mixes.  The tacit mission of our project, however, is to recommend policy measures that might be applied in the context of EU integration (accession, regional cooperation and stabilization and accession process). 

The recommendations below attempt to distinguish national and EU policies.  Depending on the context, the problem could stem from the fact there is inefficient EU approach to challenges in different areas.

 

 

1) Tax and quasi-tax, including administrative, burdens should be lowered and simplified.  Due to the relative ease with which economic agents can cross over to the unofficial economy and the high tax, quasi tax and administrative burden, it appears that SEE countries fall into the negative sloping segment of the Laffer curve – that is higher tax rates may be resulting in lower tax revenues.  On the contrary, more moderate and lower tax rates may result in a significant increase in the tax base.  Tax-“harmonization” comments and “requirements” referring to lower direct taxation in new (2004) members-states do not take into account above impacts and do not seem justified.

 

• Regarding taxes, the policy that helps eliminating incentives to informality is reduction and simplification of direct taxes, including mandatory social welfare contributions.  It should include, besides tax cuts, unification of national treatment, elimination of special exemptions and preferences.  Surveyed countries follow the overall 2004-accession pattern to lower and make flatter direct taxes.
• Regarding quasi-taxes (i.e. costs of dealing with the government, compliance costs and administrative entry barriers) there are principle policies related to facilitation of entry and business registration, separation of inspections/controls from commencing activities, reduction of licences and permits, depersonalisation of thus reformed administrative process – use of one stop shops and e-government.

 

 

2) Transposition of the acquis and the stabilization and association process (SAP) result in new legislation and regulations.  They should take into account the preparedness of local businesses and citizenry to comply and the capacity of national administrations to enforce new rules.  This and other studies show that a significant incentive for informal economic activities are regulations that are too restrictive or costly, and at the same time, not uniformly applied to all businesses.

• A step in this direction is the introduction of systematic Regulation Impact Analysis (RIA), be it in the form of cost efficiency and/or cost benefit analysis.  The processes of both economic transition and EU accession involve adoption and implementation of an enormous amount of new legislation and regulations.  An important option is the introduction (institutionalisation within a separate unit or within a ministry) of a RIA Unit for systematic preliminary assessments ensuring large public participation (compulsory consultation procedures) and public scrutiny (publication on Internet, other media).

EU does not have a unified approach to this challenge; the member states vary in their accountability and government-in-the-sunshine experience.  Accession countries, with a relative success, apply some version of RIA in an attempt to keep costs under control.  Similar policies of future members (Bulgaria and Romania, and SAP countries) must be welcome and encouraged.

 

 

3) Economic openness.  State policies should target openness including free movement of goods, services, capital, people and improving accountability of procedures (e.g. public procurement) as a precondition for lengthening production processes and increasing value added instead of imposing protectionist measures. Integration in international value-added chains and corporate structures leads to formalization of business activity.  Therefore, national policies should allow for free penetration and cooperation of capital in a larger economic space, thus providing opportunities for businesses to expand. Economic openness embraces liberalization.

• The argument favouring radical versus gradual/partial economic liberalization is even stronger in settings like SEE with a large unofficial economy. The liberalization effort has to be sufficiently substantial so as to lower expected official costs of doing business to a level below those of operating unofficially.

 

 

4) Accountable provision and financing of public services.  This may include two policy options: a) introduction of program-oriented budgeting in public spending and b) decentralization of spending and taxing decisions, i.e. fiscal decentralization.

• The present prevalence of centralized and historic-based public finance is both non-transparent and not focused on providing public services used and demanded by most of the business community.  Taxes, quasi-taxes and all other fees paid by citizens should therefore be closely related to specific public services in transparent and accountable manner.
• Decentralization, understood as accountability of those who collect and spend taxes, will increase the decision-making powers of individual business people who will then be able to decide how much to pay through taxes and fees and how to direct the public funds to serve their interest in the best manner.

 

 

5) Governments should put more emphasis on improving enforcement of existing regulations rather than increasing the number of laws and regulations to be enforced.

• At the same time, there is a natural tendency for bureaucrats to expand their agencies in both authority and resources. Therefore governments should specifically address this problem and restrict proliferation of administrative units and regulations.  Otherwise, the above-mentioned process of over-regulation leads to hypertrophy of laws and erosion of the rule of law curable through codification, deregulation and simplification.