The results of the “Shadow Economy Index for the Baltic Countries”, presented on May 16th, 2018, by the Stockholm School of Economics in Riga (SSE Riga), show that the shadow economy in Latvia has increased despite economic growth in 2017.

 

When expressed as a percentage of gross domestic product (GDP), the shadow economy reached 22% in Latvia and 18.2% in Lithuania and Estonia in 2017.

 

Year-on-year, the shadow economy has increased by 1.3% of GDP in Latvia, 2.8% in Estonia and 1.7% in Lithuania.

In Latvia, this increase followed a period of reduction in the shadow economy – in 2014-2016, the shadow economy decreased by approximately 1% per year. In Lithuania and Estonia, however, the share of the shadow economy has been on the rise for three years in a row.

Dr. Arnis Sauka, associate professor at SSE Riga and author of the index, stresses: “Although GDP has grown by 4.5% compared to 2016 and the general budget revenue (taxes) administrated by the State Revenue Service has increased by 7.7%, nevertheless the shadow economy in Latvia is growing.In a situation where the economy grows and overall tax income increases, such an increase of the shadow economy, instead of a reduction, is an alarming sign.”

Arnis Sauka, who studies the shadow economy, considers that there are several explanations for the current growth of the shadow economy in Latvia. In his opinion, one of the main reasons might be that the economic growth in Latvia is faster and the overall size of the economy is larger than what is shown by statistics. “In such a situation, the size of the shadow economy can increase, even if overall tax revenue is growing,” says Arnis Sauka.  Another reason given by the expert is problems related to the functioning of control mechanisms and the attitude of businesses towards taxes. Arnis Sauka explains: When the economy grows, usually the share of the shadow economy decreases. If companies don’t see a reason to pay more in taxes, even during an economic upturn, then the policymakers should ask the question – why does this happen? Sure, it is possible to strengthen the control mechanisms, but before you do that it is worth remembering that the taxpaying behaviour of businesses often is a reflection of the work of policymakers, including their trust that the money paid as taxes is spent properly. It seems that such trust is not yet widespread among Latvian businessmen.”

In 2017, the highest level of shadow economy in Latvia was in the regions of Riga and Kurzeme.In terms of sectors, the highest share of shadow economy was in the construction sector, where it was 35.2%, which is still a decrease compared to 38.5% in 2016. The results of the study show that there are no marked differences in the amount of shadow economy in larger or smaller Latvian companies – in 2017, the share was between 21% and 24% depending on company size.

In 2017, in all three Baltic countries, under-reporting of salaries (“envelope wages”) was the largest component of the shadow economy, making up 45.5% of the overall shadow economy in Latvia and 55% and 41.7% in Estonia and Lithuania, respectively. The average share of wages not reported by businesses to the state in 2017 is relatively similar in Latvia and Estonia(20.9% and 18.1%, respectively) and slightly less in Lithuania (15.2%). In turn it is precisely the under-reporting of income, which amounts to approximately 37.2% of the entire shadow economy in Latvia, is the component that causes the biggest differences in the size of the shadow economy among the three Baltic countries. Namely, although in Latvia the average percentage of income not reported by businesses to the state has decreased to 17.1% in 2017 compared to 18.5% a year earlier, it is still larger than in Estonia (9.7%) or Lithuania (12.8%).

Arnis Sauka states: “There is hope that as a result of the tax reform in Latvia the income under-reporting component will decrease in the next few years. However, a reduction of envelope wages is less likely, because the reform aimed at dealing with this problem may turn out to be insufficiently effective, but only time will tell. The component of under-reporting of employees should not be overlooked either – especially within the context of the labour shortage in the country and the related potential inflow of illegal workers, which may already  cause problems in the near future. In 2017, the level of under-reporting of employees in the Baltic countries remained similar to that of 2016, standing at 7.4% in Latvia, 6.1% in Lithuania and 6.5% in Estonia.”

The results of the study also indicate that Lithuania still has the highest level of bribery in the Baltic countries, especially regarding government procurement. According to the study, in 2017, Lithuanian companies paid an average of 10.1% of the contract amount to be awarded public procurement contracts. In Latvia and Estonia these amounts were 5.1% and 3.9% of the contract amount, respectively.

The study data shows that Baltic companies are still relatively satisfied with the work of tax authorities.In 2017, the satisfaction level slightly increased in Latvia and Lithuania, but in Estonia it decreased somewhat. In Estonia, the level of satisfaction with the government’s tax policy has also decreased, and it is lower than in Latvia or Lithuania. Furthermore, in Estonia the level of satisfaction with the quality of business legislation has decreased, in contrast to an increase in Latvia and Lithuania. Arnis Sauka says: “Estonian policymakers should pay serious attention to these indicators, because they at least partially explain the relatively big increase of the shadow economy in Estonia in 2017.”

Estimates of the effect of business environment on the performance of Baltic companies show that high tax rates are still one of the principal obstacles, particularly for Latvian businesses. “Hopefully, the tax reforms implemented in Latvia will improve the situation over the next few years, reducing the differences between the Baltic countries,” states the author of the study. Latvian businessmen are also much more dissatisfied with the uncertainty of legal regulation. As regards political instability, it is a major problem in all three Baltic countries, while corruption and unfair practices by other companies are significant problems in Lithuania.

 

About the Shadow Economy Index

The SSE Riga study “Shadow Economy Index for the Baltic Countries” is performed on an annual basis by using questionnaires filled out by entrepreneurs in the Baltic countries. 

The authors of the study are Dr. Arnis Sauka, Director of the Centre for Sustainable Business at SSE Riga, and Dr. Tālis Putniņš, who is a professor at SSE Riga.  In order to calculate the size of the shadow economy as a percentage of GDP, the index includes calculations on the under-reporting of business income, the under-reporting of workers and the under-reporting of wages. In the newest study, the main focus was on estimates of the shadow economy in 2017 and the trends covering the period 2009-2017.

The study data was presented on 16 May at the annual conference on shadow economy devoted to reducing the shadow economy in Latvia, organized for the eighth consecutive year already by the Centre for Sustainable Business at SSE Riga, in cooperation with the Latvian Chamber of Commerce and Industry and the Ministry of Finance of Latvia. The full study is available below.