Swedbank Analysis Lithuania

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Swedbank Analysis 2010 27: Lithuania’s shadow economy and what’s behind it

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Swedbank Analysis Lithuania

  1. 1. Swedbank Analysis December 27, 2010Lithuania’s shadow economy and what’s behind it • Different estimates suggest that the shadow economy in Lithua- nia can account for up to one-third of GDP. The biggest share of the shadow economy is in smuggling, closely followed by unac- counted sale of goods and services and unreported remunera- tion. • The reasons behind the widespread unofficial activity are persis- tent. Economic reasons include the heavy tax burden, the com- plicated tax system, and generally difficult economic situation. Broader causes include the low tax morale, low risk, and favour- able environment. • Instead of increasing taxes or further cutting social benefits and salaries of public servants, the government (rightly) decided to extract one billion litas from the shadow economy – roughly 5% of total tax income in the national budget. Although not an easy task, this can be accomplished with the right combination of eco- nomic and administrative instruments.Scope of the shadow economy 30 billions in theA recent survey of the Lithuanian economy done by the Lithuanian Free shadow…Market Institute (LFMI) found that in 2010 27% of all economic activitywas unaccounted for and/or illegal. In monetary terms, this amounts toLTL 30.8 billion. The latest estimate done by the Department of Statistics(in 2008) suggested that the officially unaccounted-for economyamounted to 12.7% of GDP, or LTL 14 billion. However, the Departmentof Statistics does not estimate smuggling or the trade of illicit goods; thus,its result closely responds to the one reported by the LFMI.Another market survey 1 conducted this year showed that 54% of the offi-cially unemployed have income related to various working activities – i.e.,about 160,000 jobless are working unofficially while claiming unemploy-ment benefits.One more way to estimate the size of unreported remuneration involves acomparison of added value per employee and compensation for that inthe private and public sectors. Since in the latter sector there are no un-official wages, the difference in compensation for value added would indi-cate unreported wages. In 2009, the average added value per employeein the private sector was 38% higher than in the public sector, but wages1 Swedbank’s Institute of Private Finances and Sprinter research. Economic Research Department. Swedbank AB. SE-105 34 Stockholm. Phone +46-8-5859 1000 E-mail: ek.sekr@swedbank.com www.swedbank.com Legally responsible publisher: Cecilia Hermansson, +46-8-5859 7720 Nerijus Mačiulis + 370 5 258 2237. Lina Vrubliauskienė +370 5 258 2275
  2. 2. were 8% lower. If wages in the private sector were 38% higher (like pro-ductivity is), this would amount to LTL 6.9 billion in employee compensa-tion. We can assume that currently this amount is unreported. Structure of shadow economy, billions of litas 2.2 4.0 Smuggling 9.9 Provision of goods and services without paying taxes Unreported remuneration Trade in illicit goods and services 7.1 Other 7.7 Source: LFMI and Swedbank calculationsAdmittedly, these calculations are based on a number of assumptions--free labour movement between the private and public sectors, similar ne-gotiating possibilities, etc. Nevertheless, the expected amount of unre-ported remuneration is very similar to that estimated in the aforemen-tioned research.If we make a further assumption that the average unreported wage isequal to LTL 1,000 per month (a little above the minimum salary), wewould see that around 580,000 inhabitants, or 25.6% of the working-agepopulation, have unreported income.All this undoubtedly causes significant losses in tax income. Some mar-ket estimates show that 42% of the cigarettes smoked in Lithuania areillegally smuggled across the border – this alone causes losses of LTL0.38 billion in excise taxes. All the smuggled and unofficially sold goodscause value-added tax (VAT) losses of approximately LTL 1.72 billion.Another LTL 1.34 billion is lost because of the unreported provision ofservices and goods produced in Lithuania. A conservative estimate2would suggest that all unreported remuneration causes losses of LTL 2.2billion in social taxes and LTL 0.34 billion in personal income tax. Tax losses amount to 8Total tax losses arising because of the shadow economy in Lithuania, billions per year.given the expected tax burden of 37%, could amount to LTL 8.3 billionper year.Main reasonsThe main general causes of the shadow economy can be grouped underfour main categories: - economic reasons; - tax morale; - low risk; and - environment (widespread possibilities).2 Assuming that all currently unreported remuneration is paid out as officialminimum salary, taking full advantage of the tax break imposed on low income.2 Swedbank Analysis • December 27, 2010
  3. 3. Fundamental economic reasons behind the shadow economy include Tax wedge on labourthe heavy tax burden, the complicated tax system, and the difficult eco- cost and labour trap isnomic environment. The tax wedge on labour cost3 in Lithuania is wider too high.than the EU average, and, according to the latest available data from Eu-rostat, stands at 40.3%. Another reason behind the tendency to work un-officially or completely opt out is the high labour trap,4 which stands at81%. As recently as 2004, this ratio was among the lowest in Europe(only 54.4%), but now it is among the highest. The unemployment traphas widened in recent years because unemployment benefits have risenmuch more quickly than the minimum and average wages. As the latter isexpected to increase slowly, the government will have to address this is-sue by limiting the benefits – especially for long-term jobless.The category of tax morale summarises the propensity of a country’s Tax evasion is not con-economic agents to pay taxes without trying to find legal or illegal ways to sidered to be harmful oravoid them. Three main factors have a strong influence on this in Lithua- shameful.nia. First, perceptions of the transparency and fairness of public servantsand institutions are poor. The high level of corruption and the commonpractice of bribing induce a response in the form of avoiding taxes. Sec-ond, the willingness to pay taxes is closely related to the quality of publicservices. Since the majority of public services are perceived as being ofpoor quality or inherently free (e.g., education and health care), the will-ingness to pay taxes to receive these services is muted. The third factoris related to cultural aspects – a high tolerance for tax evasion and allsorts of illegal activities is persistent (smuggling is often associated with akind of entrepreneurship). Unfortunately, these perceptions change onlyvery slowly.The low risk also plays an important role. For example, the probability ofbeing caught paying unreported wages is fairly low because none of theparties have incentives to disclose this kind of agreement. Even if suchactivities are reported and, during a check-up, unregistered employeesare identified, often the employer manages to get away by saying thatthese employees just started to work. Here is an obvious loophole be-cause the law does not require the employer to report about new em-ployees before their first day at work (this problem has been identified byauthorities, but the law fixing it has yet to be passed). The fines for illegalactivities in these areas are still very low and encourage risk taking (theratio of benefit to risk is high).Finally, the environment offers many possibilities and even incentives to Environment is favour-engage in unreported economic activities. First, there are still some forms able for non-observedof business organizations that allow employees to pay a fixed income tax economy.despite large revenues (operating under so-called business certificates).These individuals are also not required to have cash register and usuallyreport only a fraction of their actual income.3 The tax wedge is the difference between the employers labour costs and theemployees net take-home pay, including any cash benefits from governmentwelfare programmes.4 The unemployment trap measures the percentage of gross earnings that are"taxed away" through higher tax and social security contributions and the with-drawal of unemployment and other benefits when an unemployed person returnsto employment.Swedbank Analysis • December 27, 2010 3
  4. 4. Lithuania stands out among other Baltic and European countries in termsof the relatively low number of electronic transactions and very high ratio M0of cash to demand deposits ( ). M1 − M 0Much research in this area has shown a close relationship between theseindicators and the size of the shadow economy – not surprising, sincecash is the only instrument that allows market participants to engage inunaccounted-for activities. Ratio of cash to demand deposits (M0 to M1-M0) 70% 60% 59% 50% 49% 40% 42% 30% 29% 28% 20% 22% 20% 10% 11% 6% 5% Lithuania stands out 0% terms of low number of Latvia Euro zone Republic Bulgaria Lithuania Poland Denmark Kingdom Romania Estonia Czech United electronic transactions Source: Eurostat and high ratio of cash to demand deposits.Currently, the ratio of cash to demand deposits in Lithuania is 42%, com-pared with 29% in Latvia, 11% in Estonia, and a little more than 5% in theScandinavian countries and the UK. Only Bulgaria and Romania have ra-tios that are worse than Lithuania’s – all these countries also stand out interms of their large shadow economies.How to fight itThus, one way to fight the shadow economy is to address the issue of Fewer cash transactionscash. Countries like Italy, Colombia, Argentina, and South Korea have means less shadow econ-applied different measures; e.g., lower VAT ratios for electronic than for omy.cash transactions, limitations on cash usage in different sectors or on lar-ger transactions, requirements to have POS once the retail company ex-ceeds a particular turnover, etc.5 Some of theses measures might seem abit extreme, but a good start would be in the public sector – in some insti-tutions, wages are still paid in cash, and not everywhere for public ser-vices one can pay with a credit card. Also, a closer look is needed atother sectors prone to unreported activities – such as bars and restau-rants, accommodations, and taxis. A bit strange looks the tendency inbusiness-to-business transactions to settle in cash, or widespread prac-tice of paying wages in cash.Of course, in the longer term, the fundamental causes of the shadoweconomy have to be tackled. The tax wedge on labour cost should benarrowed, especially for lower-income employed; one way to do this is toincrease the non-taxable amount of income (currently LTL 470). Thiswould be effective since it mostly affects people with low income – theones who are more likely to get unreported remuneration (for monthlywages above LTL 3,150 this tax break is not applicable). In the shortterm, this could have a negative impact on public finances and the budgetdeficit. Lost income could be compensated for by broadening the taxbase – perhaps shifting some burden from labour to capital. Taxing, for5 A.T. Kearney (2009), “The Shadow Economy in Europe: Using payment sys-tems to combat the shadow economy.”4 Swedbank Analysis • December 27, 2010
  5. 5. example, real estate and personal vehicles has the advantage of effi-ciency – it is hard to hide the tax base and avoid these taxes (given thatexemptions and tax breaks wouldn’t be widespread).Social campaigns could help highlight the harm of tax evasion and the Education is importantshadow economy. Some recent surveys have shown that a large part of too.the population believes that a majority of tax income is used for thewages of parliament members and other public servants. The under-standing of the functioning of the economy and public finances is verypoor, thus education should start already in school. Social networks andother modern media could be effective channels of communication,through which the government could educate the younger populationabout the benefits of paying taxes and the harm of purchasing illegalgoods and services.Improving the tax morale also takes time and is hard to achieve by socialadvertising and educational initiatives alone. What else can be done?First, the government has to improve the quality of its services or simplyallow the private sector to take over. An obvious candidate is the healthservices sector, where, for almost every service, a person has to pay ex-tra (unofficially) if he wants the check-up or medical procedure done“right” and in time. Second, some kind of tax reform is needed that wouldrelate social security taxes to the benefits and services the taxpayer re-ceives. One way to do this is by transferring a small fraction of taxes tothe taxpayer’s “virtual account,” which could be drawn upon for health,social, or other benefits. This would discourage employees from accept-ing unreported and untaxed remuneration.The widespread practice of unreported remuneration indicates the low Benefit-to-risk ratio isrisk of getting caught and the high benefit-to-risk ratio. This can be too high…changed by shifting some of the penalty directly to the company man-ager, who usually takes the decision to employ unofficially. Instructiveexamples in this area include Austria, where such activities are punishedwith up to two years’ imprisonment for the responsible manager.Combating smuggling in Lithuania is focused on the apprehension ofthose crossing the border with undeclared goods. Other activities – catch-ing and fining wholesalers and retailers of smuggles goods – are mostlyoverlooked.An important measure that could help curb unofficial employment and un- Universal declaration ofreported remuneration is the universal declaration of income and assets. income and assets couldCurrently, only public servants and civilians with non-work-related income help.have to declare income. Since the technological infrastructure for this hasalready been established, taking the next step should not pose significanthurdles.The government has clearly indicated that, in the near future, trading inmarkets and bazaars without cash registers will not be permitted. Stronglobbying activities (with weak arguments) have been set in action to post-pone this reform. At the same time, the government is improving thebusiness environment – starting January 1, 2011, the rate of the personalincome tax applied to income from individual activities will be reducedfrom 15 to 5%.Clearly, in fighting a complex phenomenon such as the shadow econ- Complex approach isomy, the most effective approach is to combine “sticks and carrots” – the needed.government should eliminate loopholes, tighten controls, and increaseSwedbank Analysis • December 27, 2010 5
  6. 6. fines, while creating incentives for market participants to emerge from theshadow into the daylight. Nerijus MačiulisAbbreviationsLFMI – Lithuanian Free Market InstituteLTL – Lithuanian LitasPOS – Point of saleOECD – Organization of Economic Cooperation and DevelopmentReferencesA.T. Kearney (2009), “The Shadow Economy in Europe: Using payment sys-tems to combat the shadow economy.National Audit Office, (2008), “Comparing how some tax authorities tackle hid-den economy”.European Foundation for the Improvement of Living and Working Conditions,(2008), “Measures to tackle undeclared work in the European Union”.LFMI (2010), “A Survey of Lithuanian Economy”.Leinonen, H. (2008), “Evolving payment habits”, Bank of Finland.OECD (2002), “Measuring the Non-Observed Economy – A handbook”.6 Swedbank Analysis • December 27, 2010
  7. 7. Economic Research DepartmentSwedenCecilia Hermansson +46 8 5859 7720 cecilia.hermansson@swedbank.seGroup Chief EconomistChief Economist, SwedenMagnus Alvesson +46 8 5859 3341 magnus.alvesson@swedbank.seSenior EconomistJörgen Kennemar +46 8 5859 7730 jorgen.kennemar@swedbank.seSenior EconomistMarie-Anne Larsson +46 8 5859 7740 marie-anne.larsson@swedbank.seAssistantEstoniaMaris Lauri +372 6 131 202 maris.lauri@swedbank.eeChief Economist, EstoniaElina Allikalt +372 6 131 989 elina.allikalt@swedbank.eeSenior EconomistAnnika Paabut +372 6 135 440 annika.paabut@swedbank.eeSenior EconomistLatviaMārtiņš Kazāks +371 67 445 859 martins.kazaks@swedbank.lvDeputy Group Chief EconomistChief Economist, LatviaDainis Stikuts +371 67 445 844 dainis.stikuts@swedbank.lvSenior EconomistLija Strašuna +371 67 445 875 lija.strasuna@swedbank.lvSenior EconomistLithuaniaNerijus Mačiulis +370 5 258 2237 nerijus.maciulis@swedbank.ltChief Economist, LithuaniaLina Vrubliauskienė +370 5 258 2275 lina.vrubliauskiene@swedbank.ltSenior EconomistIeva Vyšniauskaitė +370 5 258 2156 ieva.vysniauskaite@swedbank.ltSenior EconomistSwedbank Analysis • December 27, 2010 7
  8. 8. DisclaimerThis research report has been prepared by economists of Swedbank’s Economic Research Depart-ment. The Economic Research Department consists of research units in Estonia, Latvia, Lithuania,and Sweden, is independent of other departments of Swedbank AB (publ) (“Swedbank”) and respon-sible for preparing reports on global and home market economic developments. The activities of thisresearch department differ from the activities of other departments of Swedbank, and therefore theopinions expressed in the reports are independent from interests and opinions that might be expressedby other employees of Swedbank.This report is based on information available to the public, which is deemed to be reliable, and re-flects the economists’ personal and professional opinions of such information. It reflects the econo-mists’ best understanding of the information at the moment the research was prepared and due tochange of circumstances such understanding might change accordingly.This report has been prepared pursuant to the best skills of the economists and with respect to theirbest knowledge this report is correct and accurate, however neither Swedbank nor any enterprise be-longing to Swedbank or Swedbank directors, officers, or other employees or affiliates shall be liablefor any loss or damage, direct or indirect, based on any flaws or faults within this report.Enterprises belonging to Swedbank might have holdings in the enterprises mentioned in this reportand provide financial services (issue loans, among others) to them. Aforementioned circumstancesmight influence the economic activities of such companies and the prices of securities issued by them.The research presented to you is of an informative nature. This report should in no way be interpretedas a promise or confirmation of Swedbank or any of its directors, officers, or employees that theevents described in the report shall take place or that the forecasts turn out to be accurate. This reportis not a recommendation to invest into securities or in any other way enter into any financial transac-tions based on the report. Swedbank and its directors, officers, or employees shall not be liable forany loss that you may suffer as a result of relying on this report.We stress that forecasting the developments of the economic environment is somewhat speculative innature, and the real situation might turn out different from what this report presumes.IF YOU DECIDE TO OPERATE ON THE BASIS OF THIS REPORT, THEN YOU ACT SOLELYON YOUR OWN RISK AND ARE OBLIGED TO VERIFY AND ESTIMATE THE ECONOMICREASONABILITY AND THE RISKS OF SUCH ACTION INDEPENDENTLY.8 Swedbank Analysis • December 27, 2010

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