Nobody wins with the grey economy

(Michael Fleshman, CC BY-SA)

Every new Polish government promises to reduce the size of the grey economy by closing loopholes in the tax system. Some less informed ministers even claim that the informal economy could be completely eliminated.


The experience of other countries shows that reducing the size of the underground economy is only possible if systemic actions are taken; administrative repression is much less effective.

By far the most important cause of the grey economy is regulations many entrepreneurs are unable or unwilling to meet. They include fiscal burdens, social security contributions, environmental protection regulations, labour code provisions, working time regulations, and systems for obtaining licenses and permits, etc. Other causes include low tax morality, greed, propensity to violate the law and the fact that the so-called marginal labour force (immigrants, pensioners, the unemployed, students) remains outside the official labour market.

The shadow economy operates amid fairly widespread social acceptance for activities violating the fiscal interest of the state. That is because transactions in the underground economy benefit both parties: the buyers of goods and services usually pay a below market price, while sellers avoid taxes.

Hidden, informal and illegal activities

The grey economy is included in the national accounts and estimates of its size are part of the gross domestic product. As a result, it is possible to compare grey economies across countries, which reduces the weight of experimental estimates. The definition used in national accounts breaks the informal economy into three elements.

The first is hidden activity that is not prohibited by law, but is concealed from the authorities by entrepreneurs. This involves both the under-reporting of turnover by registered companies as well as the activities of unregistered companies, which are however relatively rare.

The second is informal earnings, or in other words “working under the table”.

The third involves illegal activities, whose estimates in accordance with the guidelines of Eurostat are based on the income from cigarette smuggling, production and trafficking of drugs and prostitution. It is possible that other forms of illegal economic activity will be included in future statistics.

All of those elements of the grey economy share common features.

First, their products and services are market-based, and the transactions are voluntary. That means they are part of general economic circulation. In other words, they are supplied with money from the legal economy and, consequently, incomes from these activities enter into the legal economy.

Second, transactions in the grey economy almost always use cash.

Third, all transactions are concealed from the authorities, mainly to avoid taxes.

The grey economy also includes activities that create added value, i.e. obtaining income from the sale of products and services on the market. This means that it does not include subsistence household activities as well as theft. Theft is interpreted as a change in the distribution of income, rather than the creation of new value.

A well-thought-out plan of government influence on the economic system may limit the size of the grey economy more effectively than administrative repression. Participants in the grey economy, regardless of whether they entered it by choice or were forced by circumstances, exhibit flexibility and the ability to move to other areas of activity. In addition, because their activities are concealed, they know the methods of administrative controls very well and can successfully avoid them.

Inaccurate estimates

Estimates of the size of the grey economy are difficult to prepare and are mainly based on the observation of the traces left by concealed economic activity. In the official estimate of the Polish Central Statistical Office (GUS) for 2013, the grey economy accounts for 14.5 per cent of GDP. GUS estimates for 2014 will only be published in the third quarter of 2016. According to many experts, GUS, which has to base its data on inspected and verified sources, is underestimating the true size of the grey economy. The Institute for Market Economics (Instytut Badań nad Gospodarką Rynkową) estimates this share at 19.9 per cent in 2013, 19.5 per cent in 2014, and predicts 19.2 per cent in 2015.

The most effective way of limiting the size of the grey economy is by influencing its cause, that is by tackling regulations which businesses are unable to meet.  That means fiscal burdens should be addressed. Taxes and levies, especially those imposed on small and micro-sized companies, either hamper their ability to generate surpluses or are considered to be excessive.

There have been cases where the reduction of the tax burden resulted in higher collection rates. This was the case in Russia following the introduction of a flat tax for entrepreneurs. The well-known American economist Arthur Laffer argues that as an adviser to President Reagan he brought about the reduction of the tax rate for Americans with the highest incomes from about 90 per cent to about 30 per cent, which contributed to an increase in collected tax revenues.

High excise duties also encourage black market purchases. A large part of the cigarette market in Poland is cigarettes smuggled across the eastern border, as is also the case with the liquid fuels market. When the excise duty on alcohol in Poland was reduced by 30 per cent in October 2002, budget revenues from this tax actually increased. The noticeable decline in prices encouraged people to buy alcohol in stores, instead of buying moonshine or vodka illegally sold on street markets, as the benefits of buying on the black market had significantly shrunk. In general, however, tax authorities are unwilling to reduce tax rates, fearing the negative empirical verification of the mechanism of higher tax revenues at lower tax rates.

What can be done?

In addition to reducing the fiscal burden, simplifying the tax system and introducing uniform interpretation of tax rulings for the entire country would also help reduce the size of the grey economy. It would also be worth considering imposing differing burdens depending on the size of the company. That, however, would require ground-breaking legislation and in some cases also changes in the constitution.

Other steps include reducing non-tax costs of business activities and limiting the impact of permits, licenses, accreditations, etc. Further down the road, the number of fiscal controls and the level of inconvenience in companies should be limited to the necessary minimum.

Making cash registers mandatory proved to be a relatively effective tool for curbing the grey economy. Entrepreneurs avoiding this type of registration of turnover are subjected to severe administrative consequences. In Poland, a receipt lottery was organized to promote issuing cash register ​​receipts.

Some governments try to restrict cash turnover in transactions between companies under the banner of combating money laundering. This involves a legal ban on cash transactions above a certain size. In the European Union 12 countries have a limit ranging from EUR1,000 (in Italy, France and Portugal) up to EUR15,000 (in Croatia, Poland and Slovakia). Some non-EU countries (Colombia, Argentina, South Korea), give tax reductions to businesses or consumers using cashless transactions.

The described methods for limiting the size and scope of the grey economy are certainly effective, but are incapable of completely eliminating it.

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