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EKONOMIKA IR VADYBA: 2010. 15 ECONOMICS AND MANAGEMENT: 2010. 15

CAUSES AND CONSEQUENCES OF NON OBSERVED ECONOMY

Graina Startien1, Karolis Trimonis2

1Kaunas University of Technology, Lithuania, [email protected],2Kaunas University of Technology, Lithuania, [email protected]

Abstract

This paper analyse the non observed economy, its causes and consequences for economy on thewhole. There are a lot of scientific works written until now about non - observed economy, but now we mustdevelop the methodology how systemically to define and evaluate the shadow economy and how to control it.The topic of this paper is to generalize and systematize the opinion of scientists about shadow economy andfind out the causes and consequences of non - observed economy. The paper systemically defines the non -observed economy and gives the various definitions based on opinion of scientists and internationalorganizations. This article also analyse what makes the influence for shadow economy and whatconsequences does the non - observed economy for national economy and society, and find out if there is a possibility to control and do the influence for the size of the shadow economy and the non observedeconomy on the whole.

Keywords: non observed economy, shadow economy.

Introduction

Non - observed economy exists whole over the world and depended form it is size does the influencefor national economy of a country, social society and politicians. The law base and taxation can beineffective if the size of shadow economy in the country is great. The bigger tax rate can stimulate thegrowth of the non-observed economy. So honest people and enterprises will pay more taxes then theyshould, because the taxation system, in such counties, does not evaluate those who are in the shadow. Size ofmanufactures, incomes and expenses, made in non - observed economy, does not let exactly to evaluate theeconomic conditions of a country. So politicians can not form the reasonable strategy of countrydevelopment and regulation in national economy. An official statistic becomes worthless because it does notevaluate the real situation in the country. The economic strategy of a country grounded by such statistics isirrational, because the data is far away from the real situations. Situation like that stops the economic growth

so all the countries are trying to limit the size of non-observed economy.Scientific problem: there are a lot of scientific works written until now about non - observed economy,

but now we must develop the methodology how systemically to define and evaluate the shadow economyand how to control it.

Objective: generalize and systematize the opinion of scientists about shadow economy and find out thecauses and consequences of non - observed economy.

Goals: Systemically define the non observed economy and give the various definitions of non-observed

economy based on opinion of scientists and international organizations. Analyse what makes the influence for shadow economy. Except what consequences does the non - observed economy for national economy and society. Find out if there is a possibility to control and do the influence for the size of the shadow

economy and the non observed economy on the whole.Research methodology: methodical analysis and comparative method of study.

Keywords: non - observed economy, shadow economy.

Definition of Non Observed Economy

More then last three decades from 1982 a lot of scientists, such as V. Tanzi, E. L. Feige, F. Schneider,B. S. Frey and W. W. Pommerehne, P. Smith, N. Brooks, O. Lippert, M. Walker, F. A. Cowell, D. Enste,C. C. Williams, H. JAE, M. T. Seevers, J. B. Gassenheimer analysed the non-observed economy and the

problems becoming from shadow economy. In the literature we can find definitions ofshadow economy ornon - observed economy from various points of view - economical, legitimate, juridical, social and other, butno exact definition, which is used by many scientists. Some times, in the literature, we can find the

underground economy definition.

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By summarizing the opinion of E. L. Feige (1989, 1994), F. Schneider (1994, 2003, 2005), B. S. Frey(1984) and W. W. Pommerehne (1984) we can define the non observed economy as all counted butcurrently unregistered economic activities that contribute to the officially calculated (or observed) grossnational product.

P. Smith (1994) describes the non observed economy as market based production of goods andservices, whether legal or illegal, that escapes detection in the official estimates of gross domestic product.

An other scientist R. DelAnno (2003) presumes that the shadow economy is those economic activitiesand the income derived from them that circumvent or other wise government regulation, taxation orobservation.

N. Brooks (2001) defines the shadow economy as the value of economic activities which would betaxed if they were declared for institutions of taxation.

Organisation for Economic Co Operation and Development (2002) the term of non observedeconomy refers to those economic activities which should be included in the GDP but which, for one reasonor another, are not covered in the statistical surveys or administrative records from which the nationalaccounts are constructed.

We can summarize that all definitions of non observed economy has one and the same feature created but unregistered valuables. To non observed economy we can assign any economic activity whichincreases the total value of national product, but it is not included in national account or shown in gross

domestic product.We think that non observed economy is the secondary market with trade deals that would bepossible in official economy but were taxed or would not be possible at all because of law.

Figure 1. Equilibrium of official and non observed economiesSource: G. Startien, K. Trimonis (2009)

Non observed economy expand market from EE to EE+Non. As we can see in the figure 1, EE showsthe equilibrium of official economy, but nearby we have non observed economy with it is supply (SNon),where the prices are lower because of non-taxation, and demand (DNon), where the non taxed money can bespend.

That is why we need to go deeper into causes and consequences of the shadow economy, because itcould help us unanimously and systemically to estimate the size of the shadow economy, to define and tofind the tools how to control the non - observed economy and its consequences.

Causes of non observed economy

Non observed economy is more flexible then official economy. The main reason why is there are

no entrance or exit barriers. The same reason influences more aggressive competition in the market of non

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observed economy. Because of that, if there is any gape for expand of shadow economy, it will growinstantly.

The research of F. Schneider (2006) show the main causes for the increase of shadow economicactivities. In figure 2 we can see, that the tax and social security contribution burdens makes the numerousinfluence for non observed economy. R. J. Cebula (1997) has counted, that the rise of tax in 1 percentexpands the non observed economy by 1.4 percent. Individuals are always very sensitive if talk about

money and their income. People want to see and to feel what they are paying for, that is why they want to getextra value and good social transfers. Only if there will be equilibrium between tax and welfare of people,individuals will not hide in the shadow. But still one thing is left it is man value judgement. The greaterdifference between total cost of labour in the official economy and after tax income from work, the greater isthe intention to work in the non observed economy.

36%

9%

6%6%

6%

24%

13%

Increase of tax and social

sec. contribution burdens

Intensity of state regulations

Social transfers

Specific labour market

regulations

Public sector services

Tax morale

Other influances

Figure 2. Main causes for the increase of shadow economic activitiesSource: F. Schneider (2006)

Empirical studies made by F. Schneider (2002, 2005), H. Wagner (1984) and D. H. Enste (2002, 2005)show that labour market regulations for employees and workers protection gives the positive effects in thelong term. Nevertheless, in short term people think that state regulations restricts personal freedom and thatis the beginning of non observed economy. F. Schneider thinks that fulfilling laws normally causessupplementary cost and may have a negative influence on production possibilities and competitiveness ofindividuals and firms. A higher scope of regulation leads in most cases to higher bureaucratic expendituresfor individuals and firms as well as for public authorities and may be the reason for corruption. The findingsof Colesca, S. E. (2009) indicated that citizen's higher perception of technological and organisationaltrustworthiness, the quality and usefulness of e-Government services, the Internet experience and propensity

to trust, directly enhanced the trust in Government. So, that should decrease the level of shadow economy.In conclusion we can say that increasing the intensity of regulation leads to a growth of the non observedeconomy.

Any regulation in labour market makes the influence for the size of non observed economy. Forexample increasing of maximum working hours or age for retirement, on the one hand, will reduce the sizeof the shadow economy, because the people will not have time for activities in the shadow economy, on theother hand, they would like to work in the shadow, because of freedom from such laws. Higher benefitsreduce the incentive to work in the official economy, because people can take the benefit and work in thenon observed economy.

Higher non observed economy can lead to the deficit of the state budget and the quality and quantityof public goods and services will be reduced. That can lead to an increase in the tax rates for getting morerevenue to the state budget. While having higher taxes and worse social welfare the growth of non observed economy is certified. Studies made by J. Kaufmann and Z. Lobaton (1998) find that smallershadow economies appear in countries with lower tax rates, fewer law and regulations, and less corruption.

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Undergroundeconomy shrinks

Undergroundeconomy expands

100 (%)Tax rate

Tax

collection

Figure 3. Laffers curve and the underground economySource: M. E. Sharpe (2007)

Higher tax means bigger shadow. A. Laffer hypothesis (Figure 3) say that the national income growuntil particular level of tax. That is because people in some point do not feel the significant difference insocial security and they lose the point to pay more tax, than they think they need to. Piligrimiene, Z., &Buciuniene, I. (2008) made the conclusion, while analysed quality of health care: every person understandand describe health care service quality in different ways. That is why it is very hard to find the equilibrium

point in taxation system.Cekanavicius, L. and G. Kasnauskiene (2009) think that emigration influences the shrinkage of

shadow economy in donor country, because of demand reduction in welfare payments and remittance flows.Non observed economy is like buffer during economical crisis, because shadow economy createsmoney in the market and after crises such enterprises legalizes if conditions in the market are friendly. Inspite of that non observed economy makes a lot of negative consequences for economy.

Consequences of Non Observed Economy

Non observed economy makes the influence not only for state and its economy but society too.Officially working people needs to pay taxes for those who are working in the shadow. We can say the sameabout enterprises. Those who hold on the law mast pay bigger tax then they deserved. That is how the deficitof the budget is compensated.

Theoretical and empirical studies show that negative consequences non observed economy makesfor official economy:

Budget deficit Economic crisis Political instability Inefficient policy of country Corruption in country Cumulative structural economic deviation Moral degradation of society

No one can predict what size of shadow economy will be in the future and how many companies andindividuals will leave an official market to be in the non observed economy. Such movements givenegative influence for budget and make the deficit bigger. That leads to economical crises. The corruptionlevel and politics are closely related. If the size of shadow economy in the county is high, that means that

subjects from non observed economy makes the impact for politics. And on the contrary, if the corruptionin the country is high, that is the best environment for those, who are in the shadow. In such countries

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politics are in the hands of those who have money and no one cares if that money is from non observedeconomy or from official economy. That shows political instability.

Moral degradation of society let people not to pay tax and hold that as a norm. Non observedeconomy divide economy in two big groups: those who are paying tax and those who do not. So, one havemore money then the others, because they hide their incomes from the government. We know that moneymakes money, so the gape between those groups will be bigger and bigger.

Despite that, non observed economy has socially unmoral, but not bad influence for economy on thewhole. Non observed economy stimulates the economy Non observed economy helps to solve the unemployment Non observed economy increases the efficiency of the economic system over the long termGaidelys, V. and G. Buciunas (2008) think that shadow economy let easier make the money

laundering.Takashi Kadokura (2007) states, that the money from underground economy are spent in official

economy and that is stimulates the aboveground economy through ordinary spending. The expansion of thenon observed economy gives job opportunities to people who are out of work and helps to solveunemployment. The non observed economy increases the efficiency of the economic system over the longterm. The main reason is that economic activities expand underground because of the existence of

unreasonable regulations in the official economy and that restrict efficient economic activity. If we couldfind loopholes in the regulation system which went too far we could provide an impulse for makingimprovements to inefficient economic systems.

F. Schneider and D. H. Enste (2002) in work Hiding in the Shadow the Growth of the UndergroundEconomy write that competition in the non observed economy is much more aggressive then in officialeconomy, that is why non observed economy is more effective. The growth of the shadow means thegrowth of total income. Empirical studies in Germany and Austria show, that two thirds of money from theshadow are instantly spent in official market. Another interesting fact is that two thirds of production madein the shadow economy would not be made at all.

Conclusions

We can summarize that all definitions of non observed economy has one and the same feature created but unregistered valuables. We define non observed economy as the secondary market with tradedeals that would be possible in official economy but were taxed or would not be possible at all because oflaw.

The non observed economy mainly forms because of the gapes in the tax system, social morality,law that regulates the market and corruption level.

Non observed economy is very flexible and it can easily adapt to the government regulations, socialmorality and market on the whole. Because of flexibility shadow economy instantly change form, size andtechnique. Every new restriction in the official market expands the size of non observed economy.

Non observed economy has not only negative consequences for the official economy, butnevertheless countries must limit the size of the shadow if they want to have the economical, social and

political stability in the countries.

If we want to avoid the expansion of non observed economy, first of all we must find the loopholesin the law that regulates the market.

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