UNIVERSITY OF LATVIA
EDGARS BRĒĶIS
Summary of the Promotion Paper
LATVIA’S UNDERGROUND ECONOMY
MODELLING WITH AN EMPHASIS
ON TAX POLICY
Promotion to the Degree of Doctor of Economics (Dr. Oec.)
Branch: Economics
Subbranch: Econometrics
Scientific supervisor: Dr. math. Professor Ismena Revina
Riga, 2007
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The Doctoral thesis is developed and approved at the University of Latvia,
Faculty of Economics and Management from 2002 – 2006.
Scientific supervisor: Dr. math. Professor Ismena Revina
Reviewers:
Dr. habil. oec. Professor Ludmila Frolova
Dr. habil. oec. Ilmārs Vanags
Dr. oec. Oļegs Barānovs
Public defence of the Doctoral thesis to be held at an open session
of Doctoral Council of Economics of the University of Latvia on
September 17, 2007 Room 322, Aspazijas bulv. 5, Riga
The Doctoral thesis is available at Library of the University of Latvia,
Kalpaka bulv. 4, Riga
The opinions are to be sent to the Doctoral Council, the University of Latvia at
Raina bulv. 19, Riga, LV 1586
Chairman of the Council:
Dr. oec. Professor Ērika Šumilo
Secretary of the Council:
Dr. oec. Docent Anda Batraga
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This research work was carried out with the support of the project “Latvijas
doktoranti Norvēģijā” group.
Special thanks go to Professor Erling Eide (University of Oslo, Faculty of
Law, Department of Private Law) for invaluable guidance and comments during
the creation of this work.
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CONTENTS
Introduction ..................................................................................................... 40
1. Theoretical aspects of underground economy ............................................. 45
2. Methods to estimate the underground economy ......................................... 51
3. The underground economy in Latvia:
money demand model (1995-2003) ............................................................ 57
4. Direct – indirect tax mix change ................................................................. 63
Results ............................................................................................................. 69
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Introduction
The history of academic research in the field of underground economy is more
than thirty years old, yet to date, there has not been a common viewpoint on the
use of the term “underground economy”; furthermore, the conclusions that have
been drawn are debatable with regard to the consequences produced by underground economy, and possibly with respect to remedies proposed by public policy
for decreasing it. One of the reasons for insufficient attention to the academic research of the underground economy’s consequences is a lack of systematically and
by a single methodology collected information concerning the size and importance
of underground economy in a given economy.
Therefore, to make state’s economic policy’s implementation more effective a
more sophisticated academic research of the underground economy’s sector must
be undertaken. National policy that is set on information, where real causes of
growth of the underground economy have not been taken into account, can change
the balance of a stable economy to an unstable one, and the chief consequence of
that would be stagflation. If there is a growing underground economy’s sector,
which is not adequately reflected in statistics, incorrect interpretation of the
situation could produce political solutions that in time could bring on much more
serious economic consequences.
Similarly, theoretical conclusions on the underground economy’s effects have
not produced a common viewpoint. On the one hand, the underground economy
damages the social equality principle by redistributing income more beneficially
toward one of the smaller groups of population, thus distorting market competition; on the other hand, the underground economy sector could become the choice
of certain entrepreneurs in situations, where state blatantly interferes excessively
in the individuals’ activities.
The objective of this academic research is to evaluate the impact of direct –
indirect tax mix changes on the underground economy’s dimensions and its significance in Latvia.
In order to achieve these objectives the following tasks should be undertaken:
• To study the underground economy causes and possible effects, by
forming the underground economy’s typology.
• To analyze previous researches for choosing the most suitable methods for
estimating the amount of the underground economy.
• To form an econometric model for estimating the amount of the underground economy.
• To compare the results with other researches’ results.
• To study theoretical tax policy effects on the size and amount of the
underground economy.
• To form an econometric model for estimating the underground economy
addiction from direct – indirect tax mix changes.
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• To study the effects of possible tax policy changes with regard to the
underground economy’s size and weight in Latvia.
Based on the results of his doctorate’s research, the author defends the following thesis:
1. Decreasing direct taxes over short term gives a small or even insignifi cant direct effect on restricting the amount of the underground economy
in Latvia, and even smaller effect over the long term. Increasing indirect taxes will have an impact on the underground economy’s size in
Latvia only in short term, whereas in long term – the effect will not be
noticeable.
2. The constructed econometric models of money demand contribute to
the possibility of obtaining valid underground economy estimates and
dynamics. Obtained underground economy time series could be used in
such economic analyses.
Innovations proposed in conducting academic research are as follows:
1. By making theoretical analyses, it is possible to form underground
economy’s typology. In that way, such terms as “grey”, “illegal”, “unregistered” economy etc. are segregated, which in literature frequently
are used together to mark the same phenomenon – “underground economy”.
2. The extent of Latvia’s estimated underground economy’s size was made
by using econometric methodology. As a result of academic research, it
was possible to develop the underground economy’s dynamic time
series by annual quarters. At the present time, there is no academic
research work being carried out in Latvia, in which the underground
economy’s impact would be estimated by quarters of a given year or
would be depicted by time series.
3. The direct and indirect effects of tax revenue take place on the underground economy amount are not unequivocal, and even the conclusions
of empirical research varies, there is formed the econometric model for
evaluating possible effects in Latvia’s situation.
Through research structured models provide not only theoretical usefulness,
but also practical applications in macroeconomic analyses and in economics policy elaborations.
• Econometric models of the underground economy can be used in state
organisations and by other researchers, who deal with macroeconomic
analyses in view of the existence of an unregistered sector.
• Acquired time series of the underground economy can be used, for example, as a basis for using it in developing a model by multiple causes
and multiple indicators’ method and it would offer the possibility for
more detailed description of the structure and dynamics of underground
economy’s sector. Thereby it would provide an opportunity to form a
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more efficient economic policy for fighting the causes of underground
economy. • Econometric model on the effect of direct – indirect tax mix
change on the underground economy’s size, can be used by government,
state organisations, which work on developing economic policy and also
work on macroeconomic analyses.
Schematically the structure of the research work is as follows:
1) By using money demand model, the time series of Latvia’s underground
economy’s significance is being enhanced.
2) Acquired time series are used for simulating the correlation of direct –
in direct tax mix changes and the changes of the underground economy’s
size.
In chapter 1 of the research work, the underground economy’s typology is
examined as it relates to form of transactions and by involvement in the official
sector.. There are described reason causes, which enhance person’s participation in
the underground economy’s transactions, and there is an evaluation of the signifi cance of these causes in context of EU countries and Norway. In this chapter the
tax effect on the underground economy’s sector is being examined from the theoretical viewpoint. Also the significance of the underground economy’s research is
being substantiated.
In chapter 2, the methods which are used in researching the underground economy’s sectors are examined. An analyses and review of existing earlier research is
being carried out. A substantiation of the advantages of the of money demand
method for the evaluation of Latvia’s underground economy’s size in comparison
with other methods. Special attention is being paid to that research, which gives an
estimate of Latvia’s underground economy’s size.
Chapter 3 is devoted to Latvia’s underground economy’s econometric model,
at which base is money demand principle. Since the time series used in modelling
of Latvia’s underground economy are short, for defining deviation from equilibrium condition in short term, the econometric method for equilibrium condition’s
deviation assessment – error correction is being used. The obtained underground
economy’s assessment covers time period by quarters from 1995 to 2003 (incl.).
Chapter 4 examines the effects of direct – indirect tax mix relationship
changes. An analysis is being carried out of the possible causes of a proportionally
large underground economy’s sector in Latvia. By using the acquired Latvia’s
underground economy’s time series in Chapter 3 and by using econometric
models, the underground economy’s size and the effect of direct – indirect tax mix
changes is being analyzed. Some calculations of the underground economy’s size
changes due to tax rate changes are also being carried out.
In this research, the statistical data available from Bank of Latvia, Central
Statistical Bureau of Latvia and The Ministry of Finance of Latvia have been
utilized. Also use has been made of data available from the organization’s
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Transparency International state corruption perceived indexes, and other empirical
research performed on the underground economy.
Approbation
1. The main results of the promotion work are presented in University of
Latvia’s workshop „Academicals personnel regeneration project”
November 6, 2006.
2. In the framework of the study course „Growth theory” in mathematical
economics master study programme, in Faculty of Economics and
Management of University of Latvia.
3. In EU structural funds national programme “Labour market researches”
project “Ministry of Welfare research” – “Evaluation of Unregistered
Employment” Nr.VPD1/ESF/NVA/04/NP/3.1.5.1./ 0001/0003 Contr.Nr.
LM17.6-04/23A-2005.
4. Chapters of the promotion work are discussed during annual workshops
of the project “Latvijas doktoranti Norvēģijā”, 2003 – 2006.
Publications
1) Brēķis E. Nodokļu politikas un ēnu ekonomikas mijiedarbības modelēšana
izmantojot logit modeli.// Latvijas Universitātes raksti: Ekonomika I –
2003. – 658 .sējums – 41.-53.lpp.
2) Brēķis E. Economic Growth of Latvia, Lithuania and Estonia: The
Industrial Structures’ Comparison.// Research for Rural Development: 10
International Scientific conference proceedings – 2004. – Jelgava, LLU –
pp. 76-80
3) Brēķis E. An Econometrical Method Of Estimating The Size Of Shadow
Economy. Seminar materials International Workshop „Lithuania – Nordic
Research Networking in Social Sciences 2003-2004”, Vilnius, May 1415, 2004 – http://www.eurofakultetas.vu.lt/Nordic [Elektroniskais resurss,
uz 04.12.2006.]
4) Revina I., Brēķis E. The Indicators of Macroeconomic Policy in Baltic
Countries.// Proceedengs of International conference „Input-Output and
General Equilibrium Modeling: Data, Modeling and Policy Analysis” –
Brussels
–
September
02-04,
2004.
www.ecomod.net/
conferences/iioa2004/iioa2004_papers/456.pdf [Elektroniskais resurss,
uz 04.12.2006.]
5) Brēķis E. Ēnu ekonomikas ekonometriskā novērtēšanas metode.// Latvijas
Universitātes raksti: Ekonomika un vadības zinātne – 2004. – 677.
sējums – 113.-122.lpp.
6) Revina I., Brēķis E. Dažu ekonomikas rādītāju tendenču analīze Latvijā.//
Statistikas un pārvaldes problēmas 2005. Zinātniskie raksti – Latvijas
statistikas institūts – Rīga – 2005. – 78.-87.lpp.
7) Brēķis E. Tiešo – netiešo nodokļu ieņēmumu attiecība un ēnu ekonomikas
apjoma izmaiņas.// Tautsaimniecības attīstības iespējas un problēmas,
Starptautiskās zinātniskās konferences materiāli. 2006. gada 24.marts. –
Rēzekne – 2006. – 37.-44. lpp.
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45
8) Brēķis E. The Underground Economy in Latvia: the Currency Demand
Approach (1995-2003).// Latvijas Universitātes raksti: Ekonomika un
vadības zinātne – 2006. – 696. sējums – 73.-88.lpp.
International Conferences
1) „Tiešo – netiešo nodokļu ieņēmumu attiecība un ēnu ekonomikas apjoma
izmaiņas”: Starptautiskā zinātniskā konference „Tautsaimniecības
attīstības iespējas un problēmas”, Rēzeknes Augstskola, 2006.gada 24.
marts.
2) „The Underground Economy and the Tax Mix Changes”: 2. starptautiskā
zinātniskā konference „Information Society and Modern Business”,
Ventspils Augstskola, 2005. gada 01.-02. jūlijs.
3) „Vai iestāšanās Eiropas Savienībā sekmēs ēnu ekonomikas samazināšanos
Latvijā?”: Baltijas forums – 2005, Latvijas doktorantu konference „Tirgus
ekonomika – iedzīvotāju dzīves līmeņa uzlabošanas faktors un noturīgas
demokrātiskas attīstības pamats atbilstoši taisnīguma principiem”, Rīga,
2005. gada 16.aprīlis.
4) „The Indicators of Macroeconomic Policy in Baltic Countries”:
International Conference „Input-Output and General Equilibrium
Modeling: Data, Modeling and Policy Analysis” Brussels, September 0204, 2004.
5) „Economic Growth of Latvia, Lithuania and Estonia: The Industrial
Structures’ Comparison”: 10. LLU starptautiskajā zinātniskajā konference
„Research for Rural Development 2004”, Jelgava, 2004. gada 19.-21.
septembris.
6) „An Econometrical Method Of Estimating The Size Of Shadow
Economy”: „Lithuania – Nordic Research Networking in Social Sciences
2003-2004, Vilnius, Lithuania, May 14-15, 2004.
7) „Baltic States Tax Legislation and Entrepreneurship”: Tax Policy in EU
Candidate Countries: On the Eve of Enlargement, EuroFaculty, Riga,
September 12-14, 2003
Academic Conferences held at the University of Latvia
1) „Pēc Latvijas pievienošanās ES – vai ēnu ekonomikas apjomam
jāsamazinās?”: Latvijas Universitātes 64.konference, Baltijas reģiona
tautsaimniecības modelēšana un analīze, 2006.gada 02.februāris.
2) „The underground economy in Latvia (1995-2003)”: Latvijas Universitātes
63.konference, Modeling and analysis of national economy of Baltic
region, 2005.gada 03.februāris.
3) „Ēnu ekonomikas ekonometriskā novērtēšanas metode”: Latvijas
Universitātes 62. konference, Ekonometrijas un informācijas tehnoloģijas
uzņēmējdarbībai, 2004. gada 6.februāris.
4) „Nodokļu politikas un ēnu ekonomikas mijiedarbības modelēšana
izmantojot logit modeli” Latvijas Universitātes 61. konference,
Ekonometrijas un informācijas tehnoloģijas uzņēmējdarbībai, 2003. gada
14.februāris.
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1. Theoretical aspects of underground economy
Looking at the USA experience, in the 1970ies by utilizing economic prognoses based on macroeconomic models a marked increase in prognoses’ errors
occurred. This generated an increased interest in the influence of the unofficial
economic activities on the US economy as a whole and what portion of the
prognoses’ errors were attributable to the underground economy’s sector.
Statistics bureaus, administrations, agencies and etc. disseminated information
give signs and promote the economic analyses and the politics. The increasing and
information system avoiding underground economy sector, in circumstances, when
government policy is oriented on full – time job policy, can cause the stagflation
syndrome, that accord the changes equally turned against of unemployment rate
and inflation. On the contrary, if the policy is oriented on price stability, increasing
underground economy sector can cause budget deficit in the mentioned situation.
In the context of the fiscal economy, the observed sector refers to the amount
of income that is “reported” to the fiscal authority. Non-compliance with tax law
generates “unreported” income, i.e., the difference between the amounts of income
that have to be reported to the tax authority and the amount actually is reported. A
growth of unreported income reduces the ability of the fiscal authority to generate
revenues and, ceteris paribus, generates budget deficits. Moreover, since the
income recorded in the National Accounts system relies on the data reported to the
tax authorities, a growth of unreported income can also lead to a growth of
unrecorded income. In short, a large and growing unobserved sector reallocates
resources away from the sphere of the observation and control. It affects perception of economic reality and the reality itself. Its allocation and distribution consequences have an important implication for macroeconomic stabilisation policy
and tax policy.
The history of academic research in underground economy is more than thirty
years old, but even now, in literature there is still missing unified approach to term
use “underground economy”. For indicating the phenomenon „underground
economy” there is called such notions as “secret work economy”, “unofficial”,
“hidden”, “grey”, „black”, „parallel”, „tax free”. The use of different terms depends on context which researchers choose for accenting.
It is possible to classify the underground economy by kind of activity in two
ways. Firstly, by legal transaction: legal (it is not forbidden by law, but for concrete
individual it is much better not to declare this transaction) or illegal (those economic activities and transactions, which are in contradiction with local laws and
regulations); Secondly, is money used as exchange leverage in those transactions.
The relation of economic activity to official sector in the underground economy can be divided into three parts:
1) Parallel economy (in literature also referred to as „white collar”);
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2) grey economy („informal”);
3) Black economy („ secret work”).
Table 1
Taxonomy of underground economy relation to official sector
parallel economic
gray economic
black economic
subjects
employees in legal
sector
illegal employees
criminal
objects
income distribution
without production
production of legal
goods and services
production of illegal
and unlawful goods
and services
relatively independent
independent
relation to do not exist without
official sector
official sector
Parallel and black economy induces benefits only for narrow group of individuals, in the same time making loss to other individuals. On the contrary, grey
economy could induce benefits for all the society by being as an alternative, for
example, in economy with high bureaucracy and different restriction level. From
the society and state administration point of view, there are interesting questions
on factors, which could encourage in grey economy involved individuals to complete transition into official sector. Parallel and black economy sectors have to be
not integrated, but exterminated, and that is why those sectors are analysed separately from the grey sector.
Within National Account system, unregistered economy activities are divided
into five groups: “underground work”, illegal, unofficial, household production for
own use and production, which is not accounted as a result of incomplete data
compile program.
Obviously, the forms of underground economy typology are not eliminating
each other. For example, organized crime income from drug producing and trade
(black economy; illegal production), or collected duties from illegal producers, are
legalized by using official enterprises. It is the reason for using general definition of
the underground economy in this research work, which is mainly used also in
other research works on underground economy valuation by modelling method:
“Underground economy is the gross domestic product, which in the result of
being unreported and/ or underreported is not accounted for in the official statistics”.
Motives of individual, which encourage them to operate in underground economy transactions, could be divided into two groups: structural and economic. The
structural motives has no influence on individual’s tendency to operate in underground economy transactions in short time period, it is invariant against concrete
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government’s political decisions, but it could change individual’s attitude in medium or long time period. The economic motives influence individual’s tendency
involve into underground economy transactions in short time of period, it can
change with concrete changes in government’s policy.
Structural motives can be examined in three sections:
1) Government’s rules (restrictions);
2) Government’s ‘perception;
3) individual’s discretion.
Figure 1: Corruption perception index and underground economy (2000)
[vertical axes – underground economy size (% GDP); horizontal axes –
corruption perception index]
Source: Schneider, Klinglmair (2004)
Transparency International Releases, The Year 2000 Corruption Perceptions
Index
For estimating in cross – section of Europe Economic Area state, how close is
the connection between structural motives and underground economy segment,
there were analysed data of 22 EU countries and Norway (except Malta, Cyprus
and Luxemburg).
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As the indicator of structural motives in 2000 there were chosen Transparency
International organizations’ calculated corruption perception indexes in the crosssection of countries. After developed methodology, interviews’ and questionnaires’
results are standardized in the scale from 0 to 10. The bigger is index, the smaller
is the influence of corruption by the opinion of business leaders (the structure is
not obstructing the entrepreneurship). Data on the underground economy amount
for year 2000 are taken from the research of F. Shneider and R. Klinglmair in
which the underground economy estimation are acquired by money demand model
in the crosscut of countries (Figure 1).
From acquired correlation it is possible to make the conclusion: in the context
of Europe Economic area in effect is the statement – as the structural motives less
direct to waste recourses and promotes production, as smaller is the underground
economy amount. Consequently, for decreasing the underground economy
amount, it is necessary to improve the economics structure.
There are four economic motives which could encourage individual to operate
in underground economy:
1) friends or relatives;
2) for avoiding from tax payments;
3) for not losing any of state benefits;
4) inflation.
The motive to operate in the underground economy could be individual’s
awareness of the fact that relatives works in the underground economy. By knowing the fact that other individuals does not declare all their revenues or does not
declare it at all, and usually they avoid of control institutions, others also are motivated to involve in the underground economy operations. This motive is closely
connected to structure’s motives examined before – especially with government
regulations, but also there is necessary to remember the influence of local traditions on operations in economics.
By increasing taxes and social security payment burden, it is influenced work
– leisure option. The bigger is labour costs in official economy and disposable
income difference, the bigger is tendency to avoid this difference and to operate in
the underground economy.
However Latvia’s tax burden comparing to EU, candidate countries and
European economic area countries is rather low, separately examining tax burden
of individuals with low income, it is possible to make a conclusion that in Latvia it
is the highest among all examined countries (41.4%). On the contrary, expenses on
social protection in Latvia (by Eurostat data 15.3% of GDP in 2000) are one of the
lowest (expenses on social protection: social benefits, which includes money or
cash transfers; for households and individuals to protect from getting into definite
risk group; administrative expenses).
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Examining in the context of mentioned 23 countries united expenses on social
protection relation to individual’s tax rate with low incomes correlation with the
underground economy amount, it is possible to make a conclusion that for the decreasing the underground economy amount, there must be balanced budget of expenses on social protection and tax burden level to individuals with low income.
By increasing the high cost of living, the real tax burden can increase and
wherewith, probably, can increase motivation to operate in the underground economy. Especially, if incomes are not indexed in official economy or tax system is
not indexed at all, then, when high cost of living increases, the underground
economy incomes becomes relatively attractive in comparison with real after tax
incomes in official sector.
The relative income level in Latvia is one of the lowest in EU, but one of the
highest income level increase rate. According to economic growth theory, real
growth rate should decrease by getting closer to EU average level. One of the
ways in as long time period as it is possible to keep high real growth rate, is to
restrain and decrease inflation level. Thereby, it is possible to make a conclusion:
to decrease or at least to restrain the underground economy amount is possible by
ensuring bigger real income level increase as much as possible, or at least decreasing inflation level.
Theoretically, the effect of the underground economy is not possible to rate
unequivocally. The underground economy distorts social equality principle by
redistributing incomes in favour of one of the smaller group of population and
distorts market competition. In the same way, it distorts the standard of ethics. It
distorts state economic policy, as basing on false official statistics it is possible to
make an improper decision; for example, existing of illegal employment leads to
government’s decision to promote new work place formation, and it will not decrease supposed unemployment rate, but budget deficit will increase.
It is usually the case that the economy is better off if, ceteris paribus, an activity is done officially, than when it is carried out in the underground economy.
However, it is much less obvious, that it is better that the activity has not be rather
done at all than has be done in the underground. This presents a major difficulty to
the policy analysis, since the simple fact that we observe a large underground
economy does not reveal what there were alternatives to the underground.
The underground economic activity is combined with various negative welfare effects. The main problem is the distortion of competition between the two
sectors.
Lower capital intensity in the underground economy can be explained by the
assumption that unregistered workers cannot use credit markets, except at a high
cost. Thus, they have no incentive to use them at all. If the probability of being
detected is relatively high then it is equal to a high risk of losing the capital. As a
result, capital is relatively cheaper in the official economy and thereby firms utilise
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it more intensively than it could be sensible for scarcity reasons. The capital
coefficient in the regular sector is too high, as the labour factor is done more
expensive artificially due to state and collective agreements. This implies that
production in the unregistered sector is too labour-intensive, as this factor is
relatively cheaper than capital.
As all the accumulated knowledge that the individual has gathered in the unregistered sector becomes worthless, when this person is discovered, their training
or on-the-job education is not profitable. This slows down economic growth even
further and, in the long run, could increase long-term unemployment, as it becomes harder for unregistered workers to obtain a regular job, due to lack of education. However, unregistered workers on the side (works “underground” parallel
to official work) do not have this problem. Furthermore, weak intellectual property rights on real capital, prevents even the most innovative firms from developing new and better products or services. In the long-run scarce human resources
lead to decreased growth potential as the development and application of modern
technologies, increasingly fail due to the lack of the workers knowledge. Nor can
productivity be augmented with more capital input.
Higher labour intensity in the underground economy can be explained by increased service concentration. The service sector is more labour-intensive and unregistered work covers services in general. The effect is that labour becomes more
expensive in the official economy as result of rationalisation and capital-intensive
production.
The official economy can much deviate from perfect competition by regulations. In the underground economy, many of these state and collective agreement
interventions do not exist, resulting in a higher amount of consumer sovereignty,
individual freedom, and price fl exibility, where the latter can function as indicators
of scarcity. This is an important presupposition for the efficient input of resources.
Price equalises supply and demand, and as well coordinates the individual decisions of households and firms. Thus, the underground economy has almost ‘ideal’
conditions for an optimal resource allocation. The economy is not burdened by
over-regulation and administration, as in the official sector, which holds back economic growth considerably. From an allocation point of view, the underground
sector is cheaper alternative for small enterprises in urban surroundings, particularly in transition and developing countries.
In the long-run, the pressure from underground economic activity can help to
transform legal regulations as well as social and economic institutions. If the state
budget situation becomes poorer, market reforms are anticipated by government.
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2. Methods to estimate the underground economy
There are three kinds of methods which are most widely used to estimate the
size of the underground economy: direct approaches, indirect approaches and
modelling.
In direct approaches are used designed surveys or/and samples based on voluntary replies or fiscal auditing. The main disadvantage of surveys is that the
average precision and results depend greatly on the respondent’s willingness to
cooperate, and the results from these kinds of surveys depend on the way the questionnaire is formulated. Since fiscal auditing programs are designed to measure the
amount of undeclared taxable income, they have been effective to calculate the
underground economy. Estimates based on fiscal audits disclose only that part of
income generated in the underground economy which the tax authorities succeed
to uncover. A further disadvantage of the direct approaches is that it only leads to
point estimates, but the purpose of this study is to attain estimates of the growth of
the underground economy over the period 1995 – 2003.
The number of respondent has to be sufficient for the interpretations of regression results. Further, there have to take into account the problem of heteroscedastity.
In such open and democratic societies as in Canada and Norway, the level of
respondence is 63-74%. In other economic countries which are not so open, the
level of respondence is seemed to be much lower. It is the reason why for
acquiring valid results, from the very beginning, it is necessary to provide comparatively much bigger representative sample to population when in Canada or
Norway. And it turns to the fact, that it is necessary to provide the research budget
big enough. First of all for having the possibility to attract researchers, who could
develop qualitative questionnaire. Secondly, for the having the possibility to pay
for the social research company service – representative selection developing and
mediatising/interviewing organizing, responses’ database forming. And thirdly, for
attracting researchers to result analyses.
Because of big costs, direct methods in underground economy researches,
mainly are done by support of state institutions or society organisations.
Indirect approaches, which are also called “indicator” approaches, are mostly
macroeconomic ones and in it there are used various economic and other indicators that contain information about the development of the underground economy.
Currently there are five indicators that leave some “traces” of the underground
economy:
(1) The Discrepancy between National Expenditure and Income Statistics;
(2) The Discrepancy between the Official and Actual Labour Force;
(3) The Transactions Approach;
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53
(4) The Physical Input (Electricity Consumption) Method;
(5) The Currency Demand Approach.
All these methods are designed to estimate the size and development of the
underground economy by considering that just one indicator “must” capture all
effects of the underground economy.
It is obvious that underground economy effects are shown up simultaneously
in production, labour, and money markets. And even more important critique is
that the causes that determine the size of the underground economy are taken into
account only in some of approaches. For example, in currency demand approach
studies it is considered one cause – the burden of taxation. The most widely used
methods to get underground economy time series are currency demand method
and electricity consumption method.
In (household) electricity consumption method there are questionable two basic assumptions. Firstly, electricity is not necessary used in all economic activities,
moreover, it is possible to use alternative source of energy. Secondly, there are
economic activities which are not related to sector of households. As information
about household electricity consumption is restricted, more attention is paid for
analysing currency demand model. Money indicators are more available than electricity indicators, and linkage is clearer between underground economy and money
indicators than between underground economy and electricity indicators.
The model approach considers that multiple causes are leading to the existence and growth of the underground economy, as well as the multiple effects of
the underground economy over time. The econometric method is based on the theory of unobserved variables. The dynamic Multiple Indicators – Multiple Causes
model allows to get a time series indexes of the unrecorded vs. recorded output of
the state.
Figure 2: The size of the underground economy as unobserved variable
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54
The method is based on the factor analytic approach, where is assumed that
the underground economy is an unobserved variable over time. The unknown
coefficients are estimated in a set of structural equations within which the “unobserved” variable cannot be measured directly. The MIMIC (multiple-indicators
multiple causes) model in general consists of two parts, with the measurement
model linking the unobserved variables to observed indicators. The structural
equations model specifies causal relationships among the unobserved variables. In
this case, there is only one unobserved variable – the size of the underground
economy. There is assumed that the underground economy could be influenced by
a set of exogenous determinants (causes). The second set consists of indicators for
the underground economy, which are capturing the effects of the underground
economy. The relation between causes Di (i =1,2,...,n), the underground economy
H, and indicators Ij (j=1,2,...,m) are shown in Figure 2.
This is an inappropriate approach for estimating the size of the underground
economy in Latvia due to the time series shortage and/or absence of some “causes”
data. As further, for converting this index into percentage units there is necessary
to have a benchmark – the long-run average value of unrecorded vs. recorded output. To obtain this benchmark there could be used any of the indirect approaches.
By reposing on underground economy estimation method analyses done in
research work, it is possible to make a conclusion, that for Latvia the most suitable
is money demand method. Direct method is eliminated because of it gives assessment only for concrete time period; moreover, it is very expensive method, mainly
because of the fact that Latvia’s respondence level could be very low. To convert
by the model approach acquired indicators to ratio of unobserved and observed
sector, it is a priori necessary to have information about this relation in a long
time period. That is why more logically to begin the underground economy assessment by indirect methods – especially with developing money demand method.
A general currency – ratio model contains the following specifications:
С = Cu+Co and
(1)
D = Du + Do
(2)
where C – currency stock in circulation and D – actual stock of demand deposit are decomposed by unobserved sector (subscript u) and “observed” sector
(subscript o).
Currency and demand deposit ratios:
ko 
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Co
,
Do
(3)
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55
C
ku  u
Du
(3)
can be viewed either as functions of constants, according to assumptions of
money demand approach.
Assumes that Yo un Yu are observed and unobserved income, accordingly,
then:
o 
Yo
and
Co  Do
(5)
u 
Yu
Cu  Du
(6)
are income velocity in observed and unobserved sectors. To solve the model
for Yu, we must evaluate (6) in terms of the model’s observable variables, namely,
C, D, and Yo. Repeated substitution and rearrangement of terms yields the general
solution for unregistrered income as:
Yu 
where
1

Yo
(ku  1)(C  ko D)
,
(ko  1)( ku D  C )

(7)
o
u
Equation (7) expresses the unreported sector as a function of three observable
variables -observed income Yo, actual currency stock C, actual stock of demand
deposit D, and three parameters or functions ß, ku , un ko .
The simple Simple Currency - Ratio Method employs the following restrictive assumptions:
(1) Currency is the exclusive medium of exchange in unreported transactions
(Du > 0; ku → ∞). Assumption implies that unreported transactions are never paid by
check.
(2) The ratio of currency to demand deposits remains constant except for
changes induced by the growth of unreported income (k0 = const).
(3) The amount of unreported income produced by currency unit transacted
in the unreported sector is the same as the amount of reported income produced by
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56
currency unit transacted in the reported economy. Assumption implies that income
velocity is equal in both sectors.
Imposing these restrictions on the general model presented as (7) produce the
restrictive form (set ß =1 and examines limit when ku → ∞):
Yu  Yo
C  ko D
(ko  1) D
(8)
which represents the simple currency - ratio method.
In the model (8) retained assumption that ß =1, namely, the income velocities
for reported and unreported income are identical. If unreported income is mainly
concentrates in the service sector, which requires much few intermediate transactions, then income velocity in unoffi cial sector could be greater than in offi cial
sector, so ß<1. On the other hand, a lower propensity to consume unreported income would imply ß>1. If ß<1, the foregoing estimates of unreported income are
too low, and conversely, if ß>1, the estimates are too high.
The foregoing simulation of the currency - ratio model assumes that the
benchmark estimate for this ratio is constant (k0 = const). The currency ratio, kot
may be regarded as a stable function of other economic variables.
The currency -deposit ratio:
C Co  Cu
Co
Cu



D D o  Du Do  Du Do  Du
(9)
is assuming that Du → 0 (assumes that actual and official deposit stocks are
close D → D0) could be rewrite as follows:
C C
C
 o u,
D
Do D
if Du → 0
(10)
C
C
 ko  u if Du → 0
D
D
(11)
or if use (3).
So, for estimating currency ratio by using econometric methods, equation (11) items
could be described with two functions:
ko  f1 ( y, r , ws)

 Cu
 D  f 2 ( )
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(12)
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57
where
y – reported income;
r – rate of interests;
ws – income share of wages and salaries;
τ – average effective marginal tax rate.
First function is described by factors which have an effect on official currency
demand. To describe second function, as the most important factor which has an
effect on currency demand in unofficial sector, is used tax index.
According to these assumptions, actual currency and deposit ratio is defined
as follows:
C
 f1 ( y, r , ws)  f 2 ( )
D
(13)
Equation (13) can be estimated to obtain a forecast of currency ratio C/D.
Method based on assumption that currency demand created by unrecorded sector
exclusively is produced by taxes. So to obtine estimates of function ko, the tax
rates are set to zero in the model (13).
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3. The underground economy in Latvia: money
demand model (1995-2003)
The macroeconomic indicators’ time series mostly are not stationary. Usual
method of time series differences is used to avoid spurious regression. If time
series used in currency demand model are not stationary, then it is possible that its
first differences are stationary. If in the model are used just differenced time series
then there it is lost the possibility to estimate long term associations. Therefore is
necessary to find a regression model, which captures correction of currency demand chances in the short period of time, captures association between variables
in long period of time, and which has economic interpretation. The condition fulfils the error correction model, which belongs to the class of dynamic regression
models.
According to money demand method methodology, firstly, there was developed econometric model for money demand evaluating, secondly, by using acquired model estimates monetary amount in circulation, which is caused by underground economy sector demand.
The currency demand model is specified as follows:
Cpc = f (YD,R,P,T), where
(14)
Cpc - real currency per capita,
YD - real disposable income per capita,
R - interest rates,
P - price level,
T -tax burden
To bring the methodology of relevant macroeconomic calculations closer to
the requirements of the European System of National Accounts (ESA 95), in the
3rd quarter of 2005 the value of GDP at current and constant prices for the years
2000-2005 was changed. The recalculation is related to Regulation No.1889/2002
of the European Commission in regard of the indirectly measured financial intermediation services (FISIM). Wherewith, data for 2000-2005 are not comparable
with the data of previous periods. In the model are used GDP data calculated by
previous methodology to provide longer time series. So, in the model are used the
quarter data, which covers time period 1995:1 to 2003:4:
1) real currency per capita at 2000 prices (Cpc);
2) real disposable income at 2000 prices (YD) (GDP less total tax revenue
and divided by population);
3) interest rates paid on up to 1 month deposits of domestic enterprises and
private persons (R);
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59
4) consumer price changes to previous period (P);
5) total tax revenues as per cent of GDP (T).
6) dummy variables.
There is used following dummies K1 , K2 and K3 :
which describes particular periods in Latvia’s economy.
In August 1998 it was suspended the growth tendency of monetary indices. As
a result of Russian crisis, Latvian export reduced; the bank activity indices became
worse, unemployment increased. From the 2nd quarter of 1999, the economical
situation slowly grew better. From 2002 for stimulating investments it was begun
gradual reducing the rate of tax on corporate income (in 2002 from 25 to 22%, in
2003 till 19% and in 2004 till 15%). From January 1, 2003 the rate of social contribution was reduced from 35.09% to 33.09%. Dummy variables were introduced
to capture that currency amount in circulation which could not be explained by
ordinary transaction needs.
The quantitative measure of underground economy can be obtained as the
excess sensitive component of taxes on currency demand, as further, there is used
the Error Correction Method (ECM) to analyse short – run effect on currency demand:
If to rewrite the model (16) using vectors, then the procedure for calculating
the size of the underground economy could be described as follows. First of all it
is necessary to estimate model:
Δ(lnCpct) = Ztα + Ttß + εt, where
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(17)
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60
Z – a matrix of explanatory variables except the average tax rate,
T – a matrix of tax variables,
α and β – vectors of coefficients,
ε – error term.
To estimate currency for period t, from equation (17) express C:
where C - currency in circulation, PI – price index (2000=1) and N - population (if took logarithm of real currency per capita Cpc 
C
then obtine:
PI  N
lnCpc = ln С - ln PI - ln N).
There is assumed that “natural level” of currency estimation can be obtained in
the absence of excess sensitivity of taxes, so:
Consequently illegal currency is calculated as a difference between actual currency demand and “natural level” currency demand:
CtU  Cˆt  Cˆt0
(20)
Assuming that currency velocity is identical in both sectors, underground and
official, then currency velocity could be calculated as follows:
Vt 
Yt
, where
M 2t  CtU
(21)
Vt - velocity rate,
Yt - official GDP,
M2t - M2 money,
CtU - an estimate of all currency circulating in the underground economy at
time t.
Income contributed to economy by the underground sector YtU , could be calculated as money velocity and currency circulating in the underground economy
product:
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61
YtU = Vt • CtU
(22)
Nest (21) into (22) and taking the unobserved economy as a fraction of the
observed one, obtain:
YtU
CtU

Yt
M 2t  CtU
(23)
the underground economy expressed as per cent of GDP.
The data on prices, GDP and population was made available by Central
Statistical Bureau of Latvia. The monetary aggregates, like M2X and currency in
circulation, the data regarding to the demand and interest rates of time deposits are
provided by the Bank of Latvia. Tax revenues components are gathered from
monthly publication “Survey of State Budget” of the Ministry of Finance of the
Republic of Latvia for the period of December 1995 – November 2004.
All coefficients on variables in the model (16) have expected signs. The t –
values for coefficients on income, tax variable and dummies are significant at the
1 per cent level. Results are follows:
The coefficient on the interest rate is negative reflecting the opportunity cost
on holding currency. The coefficient on income is positive and is reflecting expectations for increase in economic growth increase and therefore corresponding
increase in the use of currency following increases in aggregate demand. The
coefficient on taxes is positive and is reflecting an increase to hoard the currency
from the tax authorities by demanding currency for the payments of goods and
services. The coefficient on price level has expected sign but is not significant on
1% and
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62
5% level. Coefficients on dummy variables are positive, and are reflecting that society was motivated hoarding the significant amount of currency beyond ordinary
transaction needs in the period 1995:1-1999:1 more than in the period 1999:22000:4, and even more than in 2001:1-2003:4. There could be given mentions that
these motives are: restrained attitude to bank sector, tax evasion including “pay in
pocket”, and simply people’s desire to conceal wealth.
The coefficient of determination is 0.9122, so it means that independent variables of the model explain approximately 91% of dependent variable changes. The
Durbin - Watson statistics is 1.9291, it is close to 2, so it is rejected hypothesis
about error autocorrelation.
From regression equation (24) is seen that coefficient to ln Срсt-1 , is -0.5564.
So 56% of deviation from the long - run currency per capita demand equilibrium
in the previous period is eliminated in the present period.
Ratio of coefficients to Δ (in Pt) and Δ (in Ydt) 0.4492/0.7790 shows that price
change effect on currency demand changes is approximately 60 per cent of income
change effect on currency demand changes in the short run. Whereas, the long run
effects are equally as ratio of coefficients to lnP, and lnYd , 0.8203/0.8186 is close
to one.
Ratio of coefficients to variables Δ (lnTt ) and Δ (lnYdt ) 0.3525/0.7790, and
ratio of coefficients to lnTt-1 and lnYdt-1 0.3635/0.8186 shows that tax burden
changes effect is approximately 45 per cent of that created by income growth
changes on currency demand changes.
Analysing coefficients to tax variables in the model (24), it shows that, if tax
burden increase by 1 per cent then currency demand change could increase by
0.35 per cent in the short period of time (as the coefficient to Δ (ln Tt) is 0.3525).
To estimate tax burden increase effect in the long period of time, it is necessary to
have a look on the ratio of coefficients to lnTt-1 and lnCt-1with opposite sign
-0.3635/(-0.5564). It follows thence - in the long time of period tax burden increase effect on currency demand changes is approximately 0.65 per cent.
The currency demand determined by taxes is calculated as follows:
1) used equations (18), (19) and (20);
2) is used model (24) estimates, but assume that do not exist currency
demand determined by taxes (coefficients to tax variables are zero, e.g.,
in equation (16) β1 =β2=0);
3) calculate currency demand changes by equation (19).
In result, there is calculated the “natural level” of currency that can be obtained in the absence of excess sensitivity of taxes.
By assuming that the velocity of currency in the underground economy is
equal to that in the official economy, the size of underground economy as per cent
of GDP is calculated from equation (23). Results are shown in Figure 3.
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63
Figure 3: The Underground Economy in Latvia, as per cent of GDP
[vertical axes – % of GDP; horizontal axes – year and quarters]
From the Figure 3 it is clear that the underground economy activity in Latvia
is a large and significant part of overall economic activity. The highest level 42%
of GDP the underground economy reached in 1996. In 1995 Latvian economy was
hit by bank crisis, so non-bank sector’s deposits reduced for a third while currency
in circulation only for 1.7%. From April 1st, 1995 a new Law on the Corporate
Income Tax came in force, and from May 1st, 1995 – a new Law on Value Added
Tax and that stimulated changes in the tax structure. Withal tax administration had
flaws. The above mentioned functioned in favour of tax evasion and stimulated the
underground economy’s rapid increase in 1995-1996.
In 1996 the tax policy became stronger, there was tightened control on tax collection and was reduced the number of wholesalers who distributed excise goods.
From the Figure 3 is conspicuous that the underground economy level gradually
declined with exception in the second half of 1998 and 1999 when Latvian economy had to manage the effect of the Russian financial crisis in August 1998.
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64
4. Direct – indirect tax mix change
There is a statement that it is possible to reduce the underground economy by
decreasing tax rates. More usually there is used direct tax rate reduce, in such way
hoping to decrease individuals’ motivation not to declare income. The statement is
based on assumption that indirect taxes are less vulnerable to evasion than direct
taxes, and that policy measures can more effectively reveal or hamper tax evasion
related to consumption than tax evasion related to income.
In other words, there exists a hypothesis that in favour of indirect taxes the tax
mix changes can reduce the underground economy.
To reach the promotion work task:
„to examine the impact of tax mix changes on the underground economic
activity in Latvia”,
there will be used this research work results as the underground economy
causes and indicators, developed econometric model and acquired underground
economy dynamic time series in Latvia.
Now it is necessary to examine direct and indirect tax content in Latvia.
Indirect taxes include Value added tax, Excise duty and Customs duty, all
other taxes and duties belong to direct taxes. As excise and customs duties to a
greater extend affect international trade, as indicator is used value added tax to
analyse the indirect effect on the underground economy. The data covers period
1995:2 – 2003:4.
Direct tax mix includes enterprise income tax, individual income, and social
security payments. All other direct taxes form just 4-5% of total tax revenues,
moreover some taxes and duties are in force shorter time than the period of analyse.
Data on taxes are gathered from Surveys’ of the State Budget by The Ministry
of Finance of Latvia, and recalculate in prices of year 2000.
As it is seen in Figure 4 real direct tax incomes, in examined time period,
increase rapidly as real indirect tax incomes. The increase of real direct tax income
is possible to explain by rapid Latvia’s economy development and increase of total
incomes. More slowly increase of indirect tax income, more particularly the
increase of real value added tax income, it is possible to explain by not all the
incomes are used for consumption, part of the incomes are allocated to savings.
Moreover, in the examined time period, real tax incomes could be decreases by the
distributed value added wangle schemes, which are connected to as it was overpay
VAT tax refund.
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Figure 4: Real direct tax1 and indirect tax2 revenues
1 Direct
tax revenues are the sum of revenues of the individual income tax, the enterprise
income tax and social security payments.
2
As indicator for indirect taxes is used the value added tax revenues.
For the data smoothing are used Hodrick – Prescott filter.
Source: Ministry of Finance of the Republic of Latvia, “Survey of the State Budget”,
1995:12-2004:11
According to hypothesis, that direct – indirect tax mix in favour of indirect
taxes, the tax mix changes can reduce or restrict the underground economy. In
chapter 3 acquired evaluation of the underground economy amount shows that
only beginning with year 2000 there is real tendency of Latvia’ s unregistered
sector to decrease (Figure 3). From data in Figure 4 it is seen that in Latvia the
biggest part of total tax incomes are direct taxes.
If look on the direct – indirect tax revenues ratio (Figure 5), then it is seen, that
direct tax revenues are almost two times bigger than indirect tax revenues. Further,
there is observable increasing trend until year 2000. By assumed that hypothesis is
true, that tax ratio changes did not favour the underground economic decrease.
From year 2000 the enterprise income tax rate was gradually diminished, but at
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66
the same time was decreased the list of goods with reduced or zero value added
tax rate. As shown in Figure 5, starting from year 2000, there is discontinuous
growth of direct – indirect tax ratio. According to hypothesis this should reflect in
the dynamic of the underground economic. So, at this moment the hypothesis can
not be rejected, but, to approve hypothesis and to estimate effects more precisely,
is used the econometric method.
Figure 5: The direct – indirect tax mix from 1995:2 until 2003:4
Source: author’s calculations
There is used a simple econometric model to analyse the tax mix changes and
its effect on the underground economy in Latvia. The Error Correction Method
(ECM) is used to analyze short-run effects.
In the model are incorporated following variables: the size of the underground
economy, direct tax share in GDP, indirect tax (VAT) share in GDP, and real GDP
per capita. The hypothesis will be approved if direct tax changes would have
significant effect on the underground economy. If assume that total tax revenues
are given, for reducing the underground economy the most appropriate policy
would be to reduce direct tax share in total tax revenues and proportionally to
increase indirect tax share. So it will be shown, that direct – indirect tax mix
decrease could reduce the size of the underground economy.
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67
If significant will be only indirect tax effect on the underground economy,
then for decreasing the underground economy have to decrease indirect tax burden. With given total tax revenues, this means that direct tax burden have to be
increased, and direct – indirect tax mix would increase. So the hypothesis has to
be rejected.
If both indirect and direct taxes have effect on the underground economy, then
hypothesis can not be rejected or accepted. In this case could be conducted survey
to evaluate if the profit form of one tax increase covers loses from other tax
decrease.
There is possible one more direct and indirect tax effect on the underground
economy, that both taxes have no effect on the underground economy. In this case,
I have to conclude, that evaluated money demand model is not usable to estimate
the size of the underground economy as it is in conflict with theory – as total tax
burden increases, the underground economy have to increase too.
The real GDP per capita is incorporated in the model as indicator for situation
in production market – the official sector economic growth should move out inputs
(especially labour) from the unofficial sector.
In econometric model are used following variables (their notions are given in
parenthesis):
• the underground economy in Latvia as per cent of GDP (Y) (author’s
calculations);
• value added tax to GDP (X1) (author’s calculations);
• sum of personal income tax, enterprise income tax and social insurance
payments to GDP (X2) (author’s calculations);
• real GDP per capita (2000=1) (X3).
Data on real GDP per capita are from the Database of the Central Statistical
Bureau of Latvia. Data on taxes are gathered from Surveys’ of the State Budget by
The Ministry of Finance of Latvia. The data on the underground economy are
from own computations based on the currency demand approach.
All data are quarterly and cover the period 1995:4 – 2003:4. Lower time frontier is determined by two considerations. Firstly, the law on value added tax came
in force in May 1, 1995, so just the third quarter could be chosen as first comparable to following quarters. Secondly, in 1995 Latvia was affected by the bank crisis
which substantially changed macroeconomic indicators in 2nd and 3rd quarters.
Indicators became stabile in 4th quarter, 1995, so it is chosen as the first period for
analysis. Upper frontier is determined by the problem mentioned above in chapter
3, involving by recalculation of GDP by Central Statistical bureaux.
The model base is the error correction model, and model specifications is follows
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 log Yt   0  1 log X 1t   2  log X 2t  1 log X 1t 1 
  2 log X 2t 1   3 log X 3t 1   4 log Yt 1
(25)
Y – the underground economy in Latvia as per cent of GDP;
X 1 - value added tax revenues to GDP;
X2 - sum of personal income tax, enterprise income tax and social insurance
payments to GDP;
X - real GDP per capita (2000=1).
All coefficients on variables α 1 ,α 2 ,ß 1 ,ß 2 in the regression model (25) have the
expected signs. Coefficients on tax variables have positive signs reflecting the
desire to evade taxes as they increase. ß3 < 0 - on income, the sign is negative and
shows the shift from undeclared to legal sector as recorded production increase.
The model estimates are obtained by the Least Square Method. Regression
results are summarized in Table 2.
Table 2:
Regression (25) results
R2
Adj.R2
D-W stat.
0.829957
0.790717
1.730783
F-statistic
Prob. (F-statistic)
21.15049
0.000000
In the model all coefficients have expected theoretical signs. Coefficient of
the determination is 0.83, which means that the model explains approximately
83% of the dependent variable deviations. From the regression (25) is possible to
infer that 64.5% of deviation from the long-run underground economy level in the
previous quarter will be eliminated in the present quarter.
According to the direct tax or VAT, a reduction by 1 per cent will reduce
present underground economy level by 0.262328 and 0.188564 per cent in the
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69
short-run. So without additional analyses can not be accepted or rejected the hypothesis about the direct – indirect tax effect on the underground economy.
The long-run effect will be significant only if the direct tax burden would
change. If the direct tax burden is reduced by 1 per cent, then the present underground economy level will reduced by 0.57 per cent (–β2 /β4 ). So in the long-run
can not be rejected the hypothesis that the direct – indirect tax mix has effect on
the underground economy. It could be possible to restrict the underground economy by decreasing direct – indirect tax mix.
Furthermore, real GDP per capita increase by 1 per cent then in the long-run
the present underground economy level will decrease by 1.14 per cents (–β3 /β4 ).
To illustrate the effect on economy, it is possible to observe following example. If in Latvia the tax rate on enterprise income decreases by 10 per cent points
(for example from 25% to 15%), then the direct tax burden in 2003 will reduce to
less than 1% (according to the Central Statistics bureau data, ceteris paribus,
enterprise income tax reduce from 1.49 per cent point of GDP to 1.35), so actual
underground economy amount in long-run could reduce just for 0.08%. As in 2003
the underground economy level is 23.9% of GDP, then direct effect of analysed
tax reduce would be the underground economy decrease just for 0.02 per cent
points.
If individual’s income tax rate in 2003 reduces by 10% points, then direct
effect will be direct tax reduction by 0.58% of GDP. As result, the underground
economy level would reduce by 0.33% of actual level or by 0.08 percent points as
on 2003.
From above could concluded that in Latvia’s present situation direct – indirect
tax mix change has a little effect to restrict underground economy. Income taxes
or VAT rate reduction in short –run and long-run have small effect on the underground economy restriction.
More effective way to restrict the underground economy is to improve economics structural motives. In the model as indicator for the structural motives is
used GDP per capita. The real GDP in 2003 increased by 7.5% and that could reduce the current underground level by 8.55%, i.e., reduce by 2.1 per cent points.
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Results
In the process of solving the intricate problems confronted while carrying out
this research work, the following conclusions have been reached:
1. Taking into the consideration the underground economy’s taxonomy, by the
kind of activity and by its relationship to the economic activity of the official
sector, and taking in to account the division of underground economy’s activities
within National Account system, the underground economy in this work is defined
as follows:
“The underground economy is the segment of gross domestic product, which
as the result of not being reported and/ or underreported is not accounted for in
the official statistics”.
Academic research of the underground economy’s sector is necessary for
making state’s implemented policy more effective. National policy that is set on
information, where the growth of the underground economy is not taken into
consideration, is liable to change stable economic balance to unstable one, and the
characteristic consequence could be stagflation. If there is ever growing underground economy sector, which is not reflected in the statistics, the fancied
problem’s seemingly sound political solution (based on incomplete information)
can transform the situation into a real economic problem.
The underground economy’s changes could be affected by the economics
structuring as a whole as well as a particular economics’ motives. As the structural
motives less direct to waste recourses (individual itself has to protect his property,
corruption, overall attitude to crime – especially economical) and promotes production, so much smaller is the underground economy amount. The size of underground economy is affected by such indicators as taxes, social security payments,
income level and inflation. For the decreasing the underground economy amount,
there must be balanced budget of expenses on social protection and tax burden
level to individuals with low income. Further, to decrease or at least to restrain the
underground economy amount is possible by ensuring bigger real income level
increase as much as possible, or at least decreasing the inflation level.
Even theoretical conclusions on the underground economy’s effect are not unequivocal. From one side the underground economy distorts social equality principle by redistributing incomes in favour of one of the certain smaller group of
population. On the other side the underground economy sector possibly is the
choice in those situations, when state immoderately interferes in individual activity. The underground economy may help to smooth structural imperfection of
official economy in both short and long period of time. Further, in the long period
of time, the pressure from the underground economy activity can help to transform
legal regulations as well as social and economic institutions.
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2. There are three kinds of methods which are most widely used to estimate
the size of the underground economy: direct approaches, indirect approaches and
modelling.
In the direct approach designed surveys or/and samples based on voluntary
replies or fiscal auditing are being used. The main disadvantage of surveys is that
the average precision and results depend greatly on the respondent’s willingness to
cooperate, that affects the level of confidence and costs, too. The main benefit
from the direct methods is detailed information about the underground economy
structure, but these results depend on the way the questionnaire is formulated.
Because of big costs, direct methods in the underground economy researches,
mainly are done by support of state institutions or society organisations.
Indirect approaches, which are also called “indicator” approaches, are mostly
macroeconomic ones and in it various economic and other indicators are being
used, that contain information about the development of the underground economy. All these methods are designed to estimate the size and development of the
underground economy by considering the fact, that just one indicator “must” capture all effects of the underground economy. It is obvious that the underground
economy effects are shown up simultaneously in production, labour, and money
markets. The causes that determine the size of the underground economy are taken
into account only in some of approaches. For example, in currency demand approach studies it is considered just one cause – the burden of taxation. The most
widely used methods to get the underground economy time series is currency demand method and electricity consumption method.
The model approach considers that multiple causes are leading to the existence and growth of the underground economy, as well as the multiple effects of
the underground economy over time. The econometric method is based on the theory of unobserved variables. The dynamic Multiple Indicators – Multiple Causes
model allows to get a time series indexes of the unrecorded vs. recorded output of
the state. For converting obtained indexes into percentage units there is necessary
to have a benchmark – the long-run average value of unrecorded vs. recorded output. To obtain this benchmark there could be used any of the indirect approaches,
withal the currency demand method.
Taking into consideration the results obtained in the research of the underground economy’s evaluation analyses, it is possible to draw the conclusion, that
for Latvia the most suitable method is the money demand method:
(1) Direct method is eliminated, because it gives assessment only for concrete time
period; moreover, it is very expensive method, mainly because of the fact that
Latvia’s respondence level could be very low.
(2) To convert by the model approach acquired indicators to ratio of unobserved
and observed sector, it is a priori necessary to have information about this
relation in a long time period.
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(3) From indirect methods are selected two – electricity consumption method and
currency demand method. Preference belongs to the currency demand method
as electricity consumption method has two discussable basic assumptions.
Firstly, electricity is not necessary used in all economic activities, moreover,
it is possible to use alternative source of energy. Secondly, there are economic
activities which are not related to the sector of households.
Therefore for further analyses of the underground economy the currency demand method has been chosen:
3. The simple Simple Currency – Ratio Method basis are the following restrictive assumptions:
(1) Currency is the exclusive medium of exchange in the underground economy.
(2) The ratio of currency to demand deposits remains constant except for changes
induced by the growth of the underground economy.
(3) The amount of unreported income produced by currency unit transacted in the
underground sector is the same as the amount of reported income produced by
currency unit transacted in the reported economy.
Latvia’s estimating underground economy amount was made by using econometric methodology. As a result of academic research work it is acquired the underground economy dynamic time series by quarters. For this moment in Latvia
there are no academic research works, in which underground economy amount
would be estimated by quarters of the year or would be acquired its time series.
The model based on the currency demand model, in which in addition to basic
variables used tax burden (as share of GDP). The method based on assumption
that currency demand created by unrecorded sector exclusively is produced by
taxes. So in the model is used tax burden as the underground economy proxy
variable.
Time series used in the model are not stationary; those are first order integrated
time series. To capture not only correction of currency demand chances in the
short period of time, but also capture association between variables in long period
of time, there is utilised the error correction model.
The estimated currency demand model fit very well to actual time series of
currency demand.
Calculated time series of the underground economy in Latvia accords a view
how could change its dynamic in a studied period. From the results it is clear that
the underground economy activity in Latvia is a large and significant part of
overall economic activity. The highest level 42% of GDP the underground economy reached in 1996. From 1996 is conspicuous that the underground economy
level gradually declined with exception in the second half of 1998 and 1999 when
Latvian economy had to manage the effect of the Russian financial crisis in August
1998.
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4. The underground economy estimates obtained with electricity
consumption method or currency demand method is higher than those which are
obtained by discrepancy method between national accounts income and
expenditure side. The estimates by Latvian Central Statistical bureaux are the
lowest as used discrepancy method allows catching just the part of underground
economy which by definition have to be declared but as result of different
situations avoids reporting.
Estimates of Latvia’s underground economy by electricity consumption
method are close to author’s estimates, but it vary as changed assumption about the
size of underground economy in some base year. Further, with electricity
consumption method the underground economy estimates are obtained in crosscountry section and that in general allows just comparing states by this indicator,
but is still open a question, how an impact on the underground economy does
estimates different growth rates of states. Advantage of the author’s chosen
method is that there is taken into account dynamic of all variable in one
economics.
5. Taking measures to increasing penalties and the likelihood of detection in
an attempt to reduce the avoidance of income tax payments are complicated,
because one must take into consideration not just the financial state of the nation
but also different social aspects. Therefore as the simplest political tool to decrease
tax evasion is viewed tax rate decrease.
Not always is appropriate the tax rate reduction, withal total tax revenues
shrink, as state has own liabilities which are financed from tax revenues. As
alternative to total tax burden reduction is analysed possibility to change direct –
indirect tax ratio.
Theoretically, assuming that there exists a proportional income tax rate and a
proportional consumption tax rate, by reducing the income tax rate and by
proportionally increasing the tax rate on consumption, in order not to change the
total tax revenues, the average tax rate for those individuals, who have savings
above average level, decreases. Whereas, for those individuals whose savings are
below the average level, while consumption tax rate increases and average tax rate
proportionally decreases, the average tax rate will increase. So, at equal pre tax
incomes, the volumes of produced goods and services will decrease, which after
proportional tax relationship changes, can buy individuals with below average
level savings. That conceivably could even stimulate the expansion of the
underground economy’s sector.
6. In Latvia, a significant direct tax net increase and an indirect tax
reduction can be ascertained. In order to evaluate the short term and long term
effect on the changes on the underground economy an econometric model has
been developed. The conclusions are as follows:
• In examined time period the hypothesis about direct – indirect tax mix
change’s effect on the underground economy, cannot be either
substantiated or rejected.
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• In the long term, the hypothesis that the direct – indirect tax mix change
has an effect on the underground economy cannot be rejected. By
reducing the direct – indirect tax mix in the long term it is possible to
reduce the size of the underground economy.
7. By applying the econometric model which was developed in order to analyze the effect of direct – indirect tax mix change on the underground economy’s
size, it can be concluded that the direct – indirect tax mix change for the present
Latvia’s economic conditions has little effect on reducing the underground economy’s size. Income tax or VAT rate reduction in short –run and long-run have
small effect on the underground economy’s size reductions. A more effective way
to restrict the underground economy is to improve the overall situation in the
economy (i.e., by improving all-encompassing economy’s structural aspects).
Therefore, from the obtained results an overall conclusion can be drawn that
the tax burden has an effect on the size of the underground economy. Therefore
the through scientific research obtained time series of the size of the underground
economy in Latvia is not in contradiction with the theoretical conclusions and can
be utilized in economic analyses.
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