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Europe's Shadow Economy Problem

  • Europe's shadow economy was diminishing before 2008, but the crisis and recession halted progress.
  • Since 2011, countries have taken various measures to curb informal economic activity.
  • Sharp tax hikes along with corruption and rent-seeking tend to encourage shadow economic activity.
  • Southern Europe has seen the least reduction in shadow economic activity.

The shadow economy is conventionally defined as a set of illicit activities, including black-market transactions, undeclared work, and other market-based production that escapes detection in the official estimates of GDP. The shadow economy typically expands relative to measured GDP during economic downturns and contracts during upturns. According to Friedrich Schneider, a professor at Austria's Johannes Kepler University, Europe’s shadow economy grew an estimated 0.5 percentage point relative to GDP in the recession year 2009.

Shadow economies emerge where regulation is perceived as burdensome, lax or corrupt. A burdensome tax and social security regime, for example, may make the shadow economy more attractive. A government that is not effective at collecting taxes or a public sector characterized by lobbying and rent-seeking presents opportunities for tax evasion and illicit commerce. But a thriving underground economy can deprive government of revenue, leading to deficits and further tax hikes that in turn send more economic activity into the shadows.

Europe's shadow economies have expanded and contracted as conditions have evolved and policies have changed over the decades. But while shadow economic activity is gradually diminishing, it continues to lure workers, create competition for firms, and weigh on public revenues, making it harder for governments to manage their finances.

Sapping revenues

Approximately two-thirds of the income earned in the shadow economy is spent in the official economy, and thus has some "backdoor" positive effect on measured GDP. But undeclared activity can sap government revenues and can diminish the reliability of official data on income and consumption. This makes cross-country statistical comparisons suspect, sometimes encouraging poor policy decisions based on inaccurate data.

In a study for Visa Europe, Schneider estimated Europe’s shadow economy at more than €2.15 trillion in 2013, or approximately 18.4% of GDP. Assuming that governments collect 27% of GDP as revenue, European countries lost €567 billion that year. For comparison, France’s budget deficit in 2013 was €75 billion and Italy’s was €47 billion. The missing tax receipts in Europe mostly stem from undeclared wages, which account for about two-thirds of the shadow economy. Across Europe, undeclared work is most common in construction, agriculture and household services such as cleaning, babysitting and elder care.

The other third comes from underreporting of income by firms, mainly those that deal heavily in cash such as small shops, bars and taxis.

Slow contraction

Prior to the 2008 financial crisis, Europe had been making progress in reducing the scope of the shadow economy, which resumed after 2011. In Western Europe, a steady recovery and a long tradition of efforts to reduce the shadow economy have kept a lid on its expansion. As the official economies of these countries perform better, people have fewer incentives to participate in undeclared activities.

In Central and Eastern Europe, where GDP growth has been faster, the shadow economy has contracted somewhat, but it is still sizeable. Local tax collection remains inefficient, and along with low tax morale and corruption, this helps the underground economy thrive. Russia's shadow economy is estimated to equal 40% of its real GDP. Although this is down from the 53% estimated in 2000, tax evasion remains high due to public sector corruption and the large number of illegal immigrants employed in construction.

Southern Europe, by contrast, has experienced negligible reduction in its shadow economy relative to GDP, as the fragile recovery has kept confidence in the official economy subdued. Spain’s level of shadow activity has barely moved in five years from 18.7% of GDP in 2008 to 18.6% in 2013. Italy’s shadow economy dipped from 21.4% of GDP in 2008 to 21.1% in 2013. In Portugal, the shadow economy today is estimated at 19% of GDP, up from 18.7% in 2008.

On average, the share of shadow economic activity across Europe was smaller in 2012 and 2013 than it had been in 2008 and 2009, thanks to the region’s economic recovery.

The economic crisis forced many governments to cut spending or raise taxes. Since 2008, 16 of the 27 EU countries have raised value-added tax rates, while seven have increased personal income taxes on top earners. VAT hikes can increase shadow economic activity as small and medium-size enterprises find it profitable to underreport revenues.

The VAT increases adopted by Central and Eastern European countries such as Poland, Romania and the Baltic states have been offset by selective adjustments in personal income taxes and flat tax rates, which has helped curb the growth of their shadow economies. But in Southern Europe, where hikes have been raised more broadly, the shadow economy has contracted marginally or not at all.

Still, these tax hikes have been accompanied by stricter enforcement, including more frequent audits of tax offices, undeclared work leniency programmes, and stricter penalties. High-profile cases of tax evasion are now prosecuted more quickly. Increased tax scrutiny of high-net worth taxpayers, mandatory use of certified invoicing programs for small and medium enterprises, cross-checking VAT declarations with merchant point-of-sale transactions, tax lottery, and new bodies to oversee tax compliance have all contributed to limiting the size of the shadow economy across most of Europe. Still, it remains a considerable force, and some countries such as Spain, Italy and Russia will need to act to keep it from significantly eroding public finances.

Martin Janicko is an Economist at Moody's Analytics.

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