The World Bank Wants Eastern Europeans Above-Ground and Paying Taxes

The World Bank has clued in to the fact that many Eastern Europeans prefer to work in the "shadow economy" — that is, off the books and out of sight of tax men, inspectors and other assorted bureaucrats. This has the World Bank very concerned, for a variety of reasons — some convincing, and others, not so much. Coincidentally, that's exactly how the World Bank's policy recommendations for bringing workers in from the shadows shake out — some convincing, and others, not so much. Overall, the report comes off as soft-selling some desperately needed tax-and-regulation-cutting policy changes to a primarily political audience.

In From the Shadow: Integrating Europe's Informal Labor gives us its rationale as to why we should care that people choose to work off the books. The reasons boil down to:

• Working off the books cuts people off from social insurance (not necessarily true, as the report itself outlines later) and private insurance (also not necessarily true, though it probably makes securing coverage more difficult).
• Bigger, established firms are overtaxed to make up for what's lost to the informal sector (not proven — there is likely a cap on what the state can extract without driving more firms underground or overseas) and informal firms have difficulty expanding (probably true).
• Informal workers and businesses are "free riders" on public goods and services who damage the quality of those good (almost certainly bullshit on balance, since they're often fleeing low-quality and intrusive state services).

I'll add that I think it makes sense that we'd prefer people to want to work above-ground, where they can take advantage of contracts, legal recourse and the like, and offer their customers the same. But that would place the emphasis on people, rather than the state.

In the course of a 196-page report, the World Bank study manages to cite some of the leaders in shadow economy research, but breaks up their hard-won conclusions so you have to go digging for nuggets of information that have been more clearly laid out elsewhere. I've written on this topic before, so I'll quote my column from July of this year:

Say Schneider and his associates, "the overall tax and social security contribution burdens are among the main causes for the existence of the shadow economy." They also note that "[i]ncreased intensity of regulations is another important factor that reduces the freedom of choice for individuals engaged in the official economy" and they cite research by others concluding that "every available measure of regulation is significantly correlated with the share of the unofficial economy."

Writing in a widely cited Journal of Public Economics paper in 2000, Eric Friedman, Simon Johnson, Daniel Kaufman and Pablo Zoido-Lobaton didn't quite agree. They believed that "relatively uncorrupt governments can sustain high tax rates," tolerated by business people and workers alike who appreciate being otherwise left alone, but that "when faced with onerous bureaucracy, high levels of corruption, and a weak legal system, businesses hide their activities 'underground'."

So high and intrusive taxes probably drive people into the shadows, as do bureaucracy and corruption. There, I just saved you several pages of wading through World Bank verbiage. Looking at what the economists I've cited above say, to bring people out of the shadows requires a moderate level of taxation, a tolerable level of regulations, honest officials and a trustworthy legal system.

The World Bank report kind of agrees. Sort of. It does concede:

[Q]uite apart from the size of government and the tax take, the mix of tax instruments deployed in most of the EU's new members creates strong incentives to evade taxes and to underdeclare labor. For example, the predominant means of financing social insurance—labor taxes— combined with personal income taxes pushes the tax burden disproportionately onto earnings from work.

The World Bank's take-away is that governments should consider "less-distorting and more easily enforced taxes," although it rules out the already high VAT and recommends a progressive tax on real estate. That strikes me as a bit of a head-scratcher that's likely to have some fascinating unintended consequences, though the report recovers a bit with an endorsement of flat-rate income taxes and simplified tax structures.

And, the report delves into the alleged benefits of the welfare state, pointing out that "the value of the social insurance coverage and employment protection that come with formal employment would at times have to be enormously high to offset the opportunity costs." Basically, those goodies cost a lot, not just in taxes, but in simple access to work.

The authors also address regulatory problems, including the distorting effects of minimum wages and employment protection legislation that makes hiring and firing such a pain in the ass for above-ground firms. The report points out, "[i]n the southern member countries of the EU, where EPL is the most restrictive, all but the most educated new entrants to the labor market are limited to part-time and informal work."

That the report is aimed at a primarily political audience is clear from the next section, which starts promisingly with a discussion of improving tax morale (the willingness of the people to cough up cash to the tax man) by avoiding "[s]uspicion, control, and coercion on the part of the tax administration" and by simplifying and making transparent the tax system to reduce corruption. Then, oddly, we're reading about marketing campaigns "to influence social norms to increase voluntary compliance." The World Bank's online feature story even insists, "[c]hanging social norms about paying taxes is most important." It seems to me that making your tax system comprehensible and non-confiscatory and your business regulations relatively simple and reasonable would go a long way toward that whole morale goal, and that those approaches are more important than public relations spin, but I can see how the World Bank felt obliged to throw a bone in there to government officials who want to believe their problems can be solved by public service announcements.

Economists have known for years that high taxes and burdensome regulations drive people to hide from the government, and that you have to fix those problems to get them back in the open. The World Bank takes a lot of pages to, rather gently, restate that case to Europe's cash-starved and unpopular politicians.