In Ukraine, a considerable degree of economic activity takes place in the “shadow”, i.e. outside the formal economy. While precise estimates are difficult to obtain and thus vary widely, national experts put this number at around 30% of official GDP. This poses major economic problems: A lack of funds for the state and no level playing field for companies.
Attempts to formalise such activities are thus well-grounded. In this paper, we focus on the unreported economy, i.e. on activities that are legal in principle, but are not properly documented by economic agents in order to reduce the tax burden. This includes the wide-spread practice of underreporting employees’ incomes - paying partly officially, partly by “envelopes”.
In order to assess specific measures for reducing underreporting, one needs first a deeper understanding of its causes. In this paper, we identify three broad reasons for such underreporting. First, high social security contributions (especially pensions) provide an incentive for underreporting, which outweighs any positive effects resulting from low personal income tax rates. Second, serious administrative barriers often create an extra burden on taxpayers and lead to avoidance schemes (including corruption). Third, taxpayers often get the impression that their tax payments are poorly managed by the state, thus creating a permissive culture of tax evasion.
The causes identified above set the broad framework for improving the situation. In order to formalise economic activities previously conducted in the shadow, a sensibly designed system of economic incentives (and counterincentives) needs to be created. Simply speaking, policy makers need to strike the right balance between “sticks and carrots” to minimise shadow activities.
Regarding concrete policy recommendations, we take the following positions:
- We support the reform of the pension system that has recently passed the first reading in parliament. This reform will stabilise the first pillar of the system in the medium-term, creating room for a reduction of contributions later on. Furthermore, the link between contributions and expected benefits has to be strengthened.
- Establishing an economy-wide “indicative wage scale” is in our view not the right instrument, as a number of associated problems will likely outweigh its potential benefits. We thus do not support such plans.
- Reform of tax administration has to keep pace with the recently adopted legislative improvements as seen in the Tax Code. As long as paying taxes is a complicated and burdensome process, this overshadows improvements made in other areas.
- Boosting “tax morale” is a “soft”, albeit important issue in public revenue collection, especially in the long term. Once people get a better and direct understanding of the value of their contributions, they will be more willing to participate in the system.
While Ukraine can gain much by moving along the lines sketched above, it has to be emphasized that no quick victory over the shadow economy is possible. Policymakers can realistically expect only a gradual reduction of the problem. But given the enormous dimension of the problem, also gradual improvements count a lot.
