Poverty and the Underground Economy in Croatia 1990-2000

1
Poverty and the Underground Economy in Croatia
1990-2000 Project leader Katarina Ott Predrag
Bejakovic Institute of Public Finance, Zagreb,
Croatia HR-10000 Zagreb, Katanciceva 5, P.O.Box
320, Tel [phone], Fax 385 1 48
19 365 e-mail predrag_at_ijf.hr, www.ijf.hr UNECE
Seminar on Poverty, Geneva, 2-3 October 2003
2
Some statements about poverty

• In general, the art of government consists in
  taking as much money as possible from one class
  of citizens to give to the other. - VOLTAIRE
  (1694-1778), the French writer and philosopher
• And distribution was made to each as had need. -
  ACTS 435
• A decent provision for the poor is the true test
  of civilization. - SAMUEL JOHNSON (1709-1784),
  English lexicographer and writer
• Almight God! Thou who holdest in thy hand the
  minds od men, deliver us from fatal arts and
  science ... give us back ignorance, innocence and
  poverty which alone can make us happy and are
  precious in thy sight (Discourse on the Arts and
  Science, 175027) - ROUSSEAU, Jean Jacques
  (1712-1778), French philosopher, social and
  political theorist

3
Project and presentation contain

• Description of research into the underground
  economy (UE) in Croatia in the 1990 to 2000
  period.
• The circumstances surrounding and the reasons for
  the origin of the UE
• Estimations of the dimensions of and changes in
  the UE at the level of the whole of the economy
  and in terms of certain industries.
• The socio-cultural and institutional dimensions
  of the UE are analysed, including the influence
  of formal and informal norms, privatisation,
  poverty, self-employment and so on.
• Influence on poverty

4
What is the Underground Economy

• The Underground economy encompasses all
  activities that are formally legal but
  ideologically are suspected hence there is
  official tendency to discriminate them and give
  them an inferior status. It covers productive
  activities that are quite legal in themselves but
  which are concealed from public authorities to
  avoid taxes and similar charges.
• Activities in "hidden" economy consist of
  undeclared legal production of goods and
  services, production of illegal goods and
  services, and concealed income in kind.
• Tax evasion

5
How to measure in measurable?

• (1) a monetary approach
• (2) official statistics with arbitrary
  estimates
• (3) calculation and analysis of the structure of
  informal economy
• (4) comparing the rates of activity in longer
  period or among different countries (if rates
  of activity are decreasing, it can be due to
  withdrawing from formal to informal sector)
• (5) differences between income and consumption
  (if consumption is bigger than income this part
  of income can be realised in informal economy)
• (6) using the data from national accounts
• (7) better control of taxpayers and tax
  obligations
• (8) examining the opinions of experts for
  particular part of economy
• (9) method of causes where the reasons that
  stimulate for the participation in the informal
  economy are analysed
• (10) electric consumption.

6
Various evaluation methods give different
results, but according with the most applied
methods (national accounting, discrepancy between
income and expenditures method, labour force
survey) in the Republic of Croatia the UE came
on average to about 25 of GDP in the 1990-1995
period, and in 1996-2000 to an average of 10 of
GDP. With reservations because of the uneven
results obtained by these various methods and
uncertainty whether this is a matter of a
genuine reduction of the UE or of an improvement
in statistics
7

• In 1996 the Institute of Public Finance did
  research into the UE in Croatia in the 1990-1995
  period. The whole project has been published or
  participated in
• the journal Financijska praksa, 21 (1-2), 1997,
  (English Summery on http//www.ijf.hr/eng/fp/97/1-
  2/index.htm)
• a summary in Bicanic and Ott (1997), The
  Unofficial Economy in Croatia Causes, Size and
  Consequences. Occasional paper, 1 (3), November.
  Available at http//www.ijf.hr/.
• an international conference on the UE in
  transition, works from which were also published
  in Financijska praksa, 21 (5-6), 1997 (English
  Summery on http//www.ijf.hr/eng/fp/97/5-6/index.h
  tm)
• the book of Edgar Feige and Katarina Ott, (1999)
  Underground Economies in Transition Unrecorded
  Activity, Tax Evasion, Corruption and Organized
  Crime. Aldershot Ashgate.

8

• Trends in the unofficial economy in Croatia could
  be influenced by
• structural conditions (impoverishment, increasing
  inequality, unemployment, destitution of the
  public services), and
• the institutional changes (privatisation,
  taxation policy, sanctioning).
• Reasons for UE were
• the inherited tradition
• the transition with its vigorous sector and
  institutional restructuring
• the great influence of the government in the
  economy, particularly through paternalism and
  privatisation.
• the high tax burden
• unclear and non harmonised laws and regulations
• the lack of the independence and resources of
  the courts
• the lack of or insufficient organisation,
  efficacy, expertise and cooperation of state
  bodies.
• There is the obvious ambitions of the state to
  become large, expensive and paternalistic, to
  invest in economy or to subsidise it, which
  encourages new corrupt and illegal practices.

9

• A particular problem of the unofficial economy in
  Croatia is its involvement in privatisation, due
  to
• the quantity of the social capital included in
  privatisation,
• the impossibility of measuring the unofficially
  economy in privatisation,
• the attitude that privatisation auditing is a
  political rather than economic, legal and moral
  question,
• the lack of transparency in regulations and the
  concentration of power in the hands of the state
  officials (lack of public accountability,
  appearance of the state clientelism, etc.).

10

• Detailed measures of economic policy necessary
  for the suppression of the UE were suggested,
  and particularly stressed that in attempts to
  reduce the UE it was more important to do away
  with the causes than to penalise the
  consequences. Most important was to
• reduce taxes and customs duties (to the extent
  permitted by the state budget)
• reduce regulation (but selectively, without
  reducing, for example, regulation of the labour
  market, which is positive)
• reduce the role of the public sector and the
  presence of the state in the economy while
  liberalising the economy
• better estimate the size of the unofficial
  economy within the overall economy and in
  individual sectors

11
New phase of the Project

• During 2001, the Institute of Public Finance went
  on with the previous research and started a new
  chapter in investigation of the UE in Croatia
• The whole project has been published or
  participated in
• the journal Financijska praksa, 26 (1), 2002,
  (English Summery on http//www.ijf.hr/eng/fp/02/1/
  index.htm)
• IJF Occational papers - available at
  http//www.ijf.hr.
• No. 15 Dollarisation and the Underground Economy
  Accidental Partners?, Šošic Faulend,
• No. 14 Opportunism, Institutions and Moral Costs
  the Socio-Cultural Dimension of the Underground
  Economy in Croatia 1995-1999 / Štulhofer
  Rimac
• No. 13 An Estimate of Tax Evasion in Croatia /
  Madžarevic-Šujster,
• No. 12 The Underground Economy in Croatia /
  Katarina Ott
• An international conference Unofficial Activities
  in Transition Countries Ten Years of Experience,
  on line available on http//www.ijf.hr/eng/index.h
  tml

12

• Various approaches to the measurement of the UE
  were applied
• the national accounts
• monetary methods
• labour force surveys
• tax evasion

13

• It should be pointed out that comparisons of
  results obtained by different methods are very
  risky.
• The measurement of the UE via the national
  accounting discrepancy method always gives
  relatively low results, unlike monetary methods,
  which always give relatively high results

Figure 1. Share of the underground economy in
GDP according to different methods
14

• Although the discrepancy in the national
  accounting method has a number of drawbacks, this
  method does provide a general picture, and it
  can be considered the lower border for the share
  of the UE in GDP. It is a very good point of
  departure for complementation with alternative
  methods of UE estimation.
• The discrepancy in the national accounting method
  determined that the UE in
• the period 1991-1995 came to an average of 25.4
  of GDP,
• for the 1996-2000 period, the UE is estimated at
  an average 10.4

15
Some of the reasons and explanation

• Such results seem fairly logical. In the earlier
  period in Croatia there was the war,
  hyperinflation, the beginnings of the transitions
  and reform, and in the second period
  stabilisation and the strengthening of the
  ethical and legal system.
• Of course, one has to ask again how much this is
  a real reduction in the UE, and how much a better
  statistical coverage of the OE.

16
Authors in Project have determined that in
Croatia there is a negative correlation between
the UE and GDP. Source Madzarevic-Sujster and
Mikulic (2001). Figure 2. Share of the
underground economy in GDP ( of official GDP)
Source Madzarevic-Sujster and Mikulic (2001).
17

• Other methods
• The results from monetary method are perhaps
  questionable, but are certainly indicative. The
  authors endeavoured to link up literature about
  the UE and dollarisation, suggesting this
  connection as a link that is missing, and which
  could enhance the quality of research into both
  areas. Since the measurement of underground
  dollarisation is in its infancy, this work is one
  of the pioneer attempts that, one can hope, will
  stimulate new research into the phenomenon.
• According to the Eurostat method adjusted to the
  needs of transitional countries, employment data
  from official sources and labour force surveys
  are compared. This method covers illegal
  activities such as prostitution, drug dealing and
  so on. The difference of the officially recorded
  and the expected rates of activity of the
  population is analysed.
• In Croatia the main component of the UE is work
  on the black, or unreported employment.

18
Estimate of tax evasion From 1994 to 2000 the
lower border of tax evasion shows a declining
trend, from 8.5 to 5.5 of GDP, while the upper
border up to 1998 was constant, and after that it
fell from 11 to 7.5. Figure 3. Comparison of
tax evasion and the share of the UE ( of GDP)
19
It is interesting that the upper estimate of tax
evasion follows the tax burden until 1998, the
rise of the tax burden in 1998 led to the rise in
tax evasion, and in 1998-2000 the reduction of
the costs of labour resulted in a reduction of
tax evasion. Tax evasion is reducing, and we can
be pleased with this. Nevertheless, 8.6 billion
kuna (the lower limit) of missed revenue in 2000
is still a very large amount. The missed revenue
is greater than, for example, the deficit of
consolidated general government, which in 2000
came to 7.7 billion kuna.
20
Estimates of the UE in individual
industries Agriculture - for the whole of the
1990-1999 period, an average lower limit of 6.8
and an upper limit of 16.9. Industry is a
branch with a relatively low though growing UE
trend, from 2.3 in 1996 to 5.2 in 1998. The
growth or stagnation of the UE in industry,
unlike the fall of the UE at the level of the
economy as a whole, can be explained by the
lagging of the transition in this activity.
Trade. Although, depending on the definition,
the results of estimates of the UE in trade vary
a good deal, the trends are nevertheless
identical a sudden growth in 1990-1993, a
sudden fall in 1993-1994, a mild decline or
stagnation from 1995 on. Figure 4. The UE in
agriculture, industry and trade ()
Source Mikulic and Madzarevic (2001).
21
The trends, however, are essentially different
the UE is reducing in trade, stagnating in
agriculture, but rising in industry. The
explanation might be fairly simple the speed of
the transition per sector, the development of a
number of new, mainly small business units and
the number of employees, the relative weakening
of the importance of the big systems. In short,
the transition was most rapid in trade, slowest
in industry hence this kind of result.
22
The socio-cultural and institutional dimensions
dimension of the UE The causes and dynamics of
the UE cannot be understood outside the social
and economic background of the area. This means
that the reduction of the UE is necessarily based
on the simultaneous action of social and
cultural, legal and economic measures. In the
theoretical assumption the dynamics of social
opportunism coincides with the dynamics of the
UE, since the rise in opportunism reduces moral
costs. This, in turn, increases the readiness to
get round or break the standards and - if it goes
unpunished - sustains the expansion of
opportunism.
23

• If we compare the results from 1995 and 1999, we
  will notice the following
• The level, in both diffusion and intensity, of
  opportunism has decreased. The number of those
  who think that tax evasion and bribe can never be
  justified has doubled.
• The age structure of opportunism has remained
  unchanged the youngest age group is still most
  apt to justify tax evasion and taking bribes.
  This gives ground for concern suggesting that the
  phenomenon might be long-lived.
• Distrust in institutions has increased, and is
  once again most pronounced among the young.
• Economic traditionalism has ceased to be a
  relevant factor respondents are getting used to
  differences in wages and are, as it seems,
  embracing the principle of individual
  responsibility.

24
In a society there are both formal and informal
institutions, which are interwoven, that is the
informal usually complement the formal. In the
transitional countries, the formal institutions
are incompletely articulated, not built up, and
some do not even exist. The weakness of formal
institutions contributes to the rise in the UE,
crucial being an analysis of the costs and
benefits of accepting (un)lawfulness.
25
Privatization

• Most activities of the UE in the first half of
  the 90s, such as political clientelism,
  fictitious recapitalisation, failure to report or
  appropriation of the profits of firms, assets
  stripping, deliberate bankruptcies, corruption,
  bribery, abuse of official positions and so on
  went on in the second half of the 90s, with the
  new phenomena of irregularity in the
  privatisation of the banking sector and coupon
  privatisation. Because of the absence of
  political will, the non-existence of an effective
  and independent judiciary and the inefficient
  public control, the UE was maintained in
  privatisation during the whole of the decade.

26

• In analysing the poverty unemployment, one
  could stress that in Croatia
• poverty is not the key generator of the UE,
• the fact that the UE actually deepens inequality
  need not be equated with the creation of poverty,
  and
• a certain level of the UE in every developed
  society is related to the poorest but this is not
  the segment of the UE towards which social
  measures need to be directed.

27
Basic facts about poverty in Croatia (I)

• Using an internationally comparable standard
  across transition economies (4.30 US dollars a
  day per person at purchasing power parity) it was
  found that the incidence of absolute poverty in
  Croatia is very low. This international standard,
  however, may not reflect adequately specific
  conditions of each society. For policy makers
  what matters is the extent of poverty based on
  nationally relevant standards.
• There is no national official poverty line in
  Croatia. The World Bank study has estimated the
  level of total expenditures (including non-food
  items) of households in Croatia at which
  families, after paying for essential non-food
  expenditures, just attain minimal nutritional
  needs.
• This level of expenditures represents therefore
  an absolute poverty line and amounts to 41,500
  HRK (5,500 Euro) per year (in 1998 prices) for a
  couple with two children or 15,474 HRK (2,100
  Euro) for an equivalent adult. Only around 10
  percent of the Croatian population falls below
  this nationally specific poverty line.
• Poverty Rate with International Line
  4.0
• Poverty Rate with National Line
  8.4

28
Basic facts about poverty in Croatia (II)

• The poverty gap is 1.8 of total consumption, and
  that on average the consumption of a poor
  household is 20.7 below the poverty line.
• To bring all poor above the poverty line with
  perfect targeting (i.e., each poor person is
  given a transfer exactly equal to the poverty
  gap) would cost 1 percent of GDP and to give to
  all poor the amount equivalent to the poverty
  line would require 4 percent of GDP.
• Therefore, it would be affordable for Croatia to
  completely eliminate absolute poverty.

29
Basic facts about poverty in Croatia (III)

• Those Who Have the Misfortune to be Poor are
  Seriously Deprived.
• Life of the poor differs in many respects from
  the non-poor. The poor tend to live in
  overcrowded, poorly maintained dwellings their
  diet is limited to basic staples (especially for
  the urban poor who can afford little beyond basic
  staples such as bread, potatoes or milk) and,
  they are poorly educated. Only few have savings
  they are often immobile, and their social
  networks are very limited.

30
The Poor Have Distinct Characteristics .

• The poverty profile is dominated by two groups
• poorly educated individuals and the elderly.
• Almost ¾ of the poor live in families where the
  head has primary education or less. They are
  likely to have bad prospects for finding
  employment when they are not employed, or have
  low earnings when they are employed. The risk of
  poverty is particularly high when poor education
  is combined with unemployment.
• Low pension benefits or no pension at all in old
  age is the second cause of poverty 40 of the
  poor live in households with a retired. In 1998
  as many as 25 percent of all retirees did not
  receive pension benefits and about half of
  pension beneficiaries received pensions that were
  below the poverty line.

31
In Combination With Limited Opportunities

• Poverty in Croatia has already many features of a
  permanent state the poor are unlikely to escape
  poverty easily. This is due to two basic reasons
  
• there are limited economic opportunities because
  growth so far has not generated enough jobs. Many
  old jobs have been destroyed and very few new
  jobs have been created. Growth has benefited
  primarily those who kept their jobs. But for
  those locked outside employment, the effect was
  close to nil, if not negative. Furthermore,
  over-regulation of employment, especially
  constraints on layoffs, are limiting
  opportunities for small businesses and flexible
  working arrangements, both of which could
  constitute a viable alternative to wage
  employment for the poor and

32
Make Them Likely to Be Stuck in Long term
Poverty

• The poor are at a disadvantage to benefit even
  from this limited set of opportunities. Once
  locked outside employment, unemployed and
  economically inactive have limited possibilities
  to break the circle of impoverishment. Over half
  of the unemployed are long-term unemployed, so
  analysis of labor market flows suggests that both
  unemployed and inactive are unlikely to find a
  new job.
• Most of working age individuals who are not
  employed have either very low educational
  endowments (primary) or narrowly formed skills
  (vocational schools graduates). Those who are
  currently locked outside remunerative employment
  due to their level of education are also likely
  to see their limited opportunities perpetuated
  for their children.

33
Almost crucial question in solving poverty is
employment (im)possibility. It is most important
for employment to start to rise, because then,
all those who are in the UE not from their own
will but because it is the only way out will
start to go over from the UE to the OE. With a
rise in employment, the income of the population
will rise and this will have an effect on a
reduction in the UE and poverty.
34
A propensity to evasion of pension contribution
will be crucially affected by an inadequate link
between contributions and pensions, an unjust
system with many (high) privileged pensions,
without the payment of contributions, and
circumstances in which a contribution is not a
condition for being able to claim pension rights.
According to the Croatian Pension Fund in 2000
about 82 of contributions were collected.
35

• The analysis of inefficacy of the judiciary warns
  of some apparent problems and possible solutions
  
• it is important to encourage transparency in
  public tenders and contracts clearly to determine
  authorities and responsibilities of public
  servants and the opportunities they have for
  discretional decision-making
• the courts can have their load lightened by the
  encouragement of arbitration of disputes.
• the adoption of clear intelligible, unambiguous
  and lasting laws, which will have an affect on
  the growth of the efficacy of the judiciary,
  greater resistance towards unlawful behaviour,
  the dissemination of the rule of law and
  democracy and, indirectly to a reduction of the
  UE and unlawful forms of behaviour.
• Unfortunately, key factors such as the
  transparency and quality of public services are
  still not developing with adequate speed, and
  quite a lot of time is still required for them to
  be improved.

36

• THE PROJECT CONTAINS MANY RECOMMENDATIONS OF
  MEASURES NECESSARY FOR THE REDUCTION OF THE UE
• SHORT GENERAL RECOMMENDATIONS
• GENERAL INSTITUTIONAL MEASURES
• MEASURES IN THE PRIVATISATION PROCESS
• MEASURES IN STATISTICS
• REFORM OF THE TAX SYSTEM
• ENCOURAGEMENT OF EMPLOYMENT
• THE JUDICIARY
• Better to obviate the causes than penalise the
  consequences.
• Thank you for your attention