Swedbank Analysis 2010 27: Lithuania’s shadow economy and what’s behind it

1. Swedbank Analysis December 27, 2010
Lithuania’s shadow economy and what’s behind it
• Different estimates suggest that the shadow economy in Lithua-
nia can account for up to one-third of GDP. The biggest share of
the shadow economy is in smuggling, closely followed by unac-
counted sale of goods and services and unreported remunera-
tion.
• The reasons behind the widespread unofficial activity are persis-
tent. Economic reasons include the heavy tax burden, the com-
plicated tax system, and generally difficult economic situation.
Broader causes include the low tax morale, low risk, and favour-
able environment.
• Instead of increasing taxes or further cutting social benefits and
salaries of public servants, the government (rightly) decided to
extract one billion litas from the shadow economy – roughly 5%
of total tax income in the national budget. Although not an easy
task, this can be accomplished with the right combination of eco-
nomic and administrative instruments.
Scope of the shadow economy
30 billions in the
A recent survey of the Lithuanian economy done by the Lithuanian Free
shadow…
Market Institute (LFMI) found that in 2010 27% of all economic activity
was unaccounted for and/or illegal. In monetary terms, this amounts to
LTL 30.8 billion. The latest estimate done by the Department of Statistics
(in 2008) suggested that the officially unaccounted-for economy
amounted to 12.7% of GDP, or LTL 14 billion. However, the Department
of Statistics does not estimate smuggling or the trade of illicit goods; thus,
its result closely responds to the one reported by the LFMI.
Another market survey 1 conducted this year showed that 54% of the offi-
cially unemployed have income related to various working activities – i.e.,
about 160,000 jobless are working unofficially while claiming unemploy-
ment benefits.
One more way to estimate the size of unreported remuneration involves a
comparison of added value per employee and compensation for that in
the private and public sectors. Since in the latter sector there are no un-
official wages, the difference in compensation for value added would indi-
cate unreported wages. In 2009, the average added value per employee
in the private sector was 38% higher than in the public sector, but wages
1
Swedbank’s Institute of Private Finances and Sprinter research.
Economic Research Department.
Swedbank AB. SE-105 34 Stockholm. Phone +46-8-5859 1000
E-mail: ek.sekr@swedbank.com www.swedbank.com
Legally responsible publisher: Cecilia Hermansson, +46-8-5859 7720
Nerijus Mačiulis + 370 5 258 2237. Lina Vrubliauskienė +370 5 258 2275

2. were 8% lower. If wages in the private sector were 38% higher (like pro-
ductivity is), this would amount to LTL 6.9 billion in employee compensa-
tion. We can assume that currently this amount is unreported.
Structure of shadow economy, billions of litas
2.2
4.0 Smuggling
9.9
Provision of goods and services
without paying taxes
Unreported remuneration
Trade in illicit goods and services
7.1
Other
7.7
Source: LFMI and Swedbank calculations
Admittedly, these calculations are based on a number of assumptions--
free labour movement between the private and public sectors, similar ne-
gotiating possibilities, etc. Nevertheless, the expected amount of unre-
ported remuneration is very similar to that estimated in the aforemen-
tioned research.
If we make a further assumption that the average unreported wage is
equal to LTL 1,000 per month (a little above the minimum salary), we
would see that around 580,000 inhabitants, or 25.6% of the working-age
population, have unreported income.
All this undoubtedly causes significant losses in tax income. Some mar-
ket estimates show that 42% of the cigarettes smoked in Lithuania are
illegally smuggled across the border – this alone causes losses of LTL
0.38 billion in excise taxes. All the smuggled and unofficially sold goods
cause value-added tax (VAT) losses of approximately LTL 1.72 billion.
Another LTL 1.34 billion is lost because of the unreported provision of
services and goods produced in Lithuania. A conservative estimate2
would suggest that all unreported remuneration causes losses of LTL 2.2
billion in social taxes and LTL 0.34 billion in personal income tax.
Tax losses amount to 8
Total tax losses arising because of the shadow economy in Lithuania, billions per year.
given the expected tax burden of 37%, could amount to LTL 8.3 billion
per year.
Main reasons
The main general causes of the shadow economy can be grouped under
four main categories:
- economic reasons;
- tax morale;
- low risk; and
- environment (widespread possibilities).
2
Assuming that all currently unreported remuneration is paid out as official
minimum salary, taking full advantage of the tax break imposed on low income.
2 Swedbank Analysis • December 27, 2010

3. Fundamental economic reasons behind the shadow economy include Tax wedge on labour
the heavy tax burden, the complicated tax system, and the difficult eco- cost and labour trap is
nomic environment. The tax wedge on labour cost3 in Lithuania is wider too high.
than the EU average, and, according to the latest available data from Eu-
rostat, stands at 40.3%. Another reason behind the tendency to work un-
officially or completely opt out is the high labour trap,4 which stands at
81%. As recently as 2004, this ratio was among the lowest in Europe
(only 54.4%), but now it is among the highest. The unemployment trap
has widened in recent years because unemployment benefits have risen
much more quickly than the minimum and average wages. As the latter is
expected to increase slowly, the government will have to address this is-
sue by limiting the benefits – especially for long-term jobless.
The category of tax morale summarises the propensity of a country’s Tax evasion is not con-
economic agents to pay taxes without trying to find legal or illegal ways to sidered to be harmful or
avoid them. Three main factors have a strong influence on this in Lithua- shameful.
nia. First, perceptions of the transparency and fairness of public servants
and institutions are poor. The high level of corruption and the common
practice of bribing induce a response in the form of avoiding taxes. Sec-
ond, the willingness to pay taxes is closely related to the quality of public
services. Since the majority of public services are perceived as being of
poor quality or inherently free (e.g., education and health care), the will-
ingness to pay taxes to receive these services is muted. The third factor
is related to cultural aspects – a high tolerance for tax evasion and all
sorts of illegal activities is persistent (smuggling is often associated with a
kind of entrepreneurship). Unfortunately, these perceptions change only
very slowly.
The low risk also plays an important role. For example, the probability of
being caught paying unreported wages is fairly low because none of the
parties have incentives to disclose this kind of agreement. Even if such
activities are reported and, during a check-up, unregistered employees
are identified, often the employer manages to get away by saying that
these employees just started to work. Here is an obvious loophole be-
cause the law does not require the employer to report about new em-
ployees before their first day at work (this problem has been identified by
authorities, but the law fixing it has yet to be passed). The fines for illegal
activities in these areas are still very low and encourage risk taking (the
ratio of benefit to risk is high).
Finally, the environment offers many possibilities and even incentives to Environment is favour-
engage in unreported economic activities. First, there are still some forms able for non-observed
of business organizations that allow employees to pay a fixed income tax economy.
despite large revenues (operating under so-called business certificates).
These individuals are also not required to have cash register and usually
report only a fraction of their actual income.
3
The tax wedge is the difference between the employer's labour costs and the
employee's net take-home pay, including any cash benefits from government
welfare programmes.
4
The unemployment trap measures the percentage of gross earnings that are
"taxed away" through higher tax and social security contributions and the with-
drawal of unemployment and other benefits when an unemployed person returns
to employment.
Swedbank Analysis • December 27, 2010 3

4. Lithuania stands out among other Baltic and European countries in terms
of the relatively low number of electronic transactions and very high ratio
M0
of cash to demand deposits ( ).
M1 − M 0
Much research in this area has shown a close relationship between these
indicators and the size of the shadow economy – not surprising, since
cash is the only instrument that allows market participants to engage in
unaccounted-for activities.
Ratio of cash to demand deposits (M0 to M1-M0)
70%
60%
59%
50%
49%
40% 42%
30%
29% 28%
20%
22% 20%
10%
11%
6% 5% Lithuania stands out
0%
terms of low number of
Latvia
Euro zone
Republic
Bulgaria
Lithuania
Poland
Denmark
Kingdom
Romania
Estonia
Czech
United
electronic transactions
Source: Eurostat
and high ratio of cash to
demand deposits.
Currently, the ratio of cash to demand deposits in Lithuania is 42%, com-
pared with 29% in Latvia, 11% in Estonia, and a little more than 5% in the
Scandinavian countries and the UK. Only Bulgaria and Romania have ra-
tios that are worse than Lithuania’s – all these countries also stand out in
terms of their large shadow economies.
How to fight it
Thus, one way to fight the shadow economy is to address the issue of Fewer cash transactions
cash. Countries like Italy, Colombia, Argentina, and South Korea have means less shadow econ-
applied different measures; e.g., lower VAT ratios for electronic than for omy.
cash transactions, limitations on cash usage in different sectors or on lar-
ger transactions, requirements to have POS once the retail company ex-
ceeds a particular turnover, etc.5 Some of theses measures might seem a
bit extreme, but a good start would be in the public sector – in some insti-
tutions, wages are still paid in cash, and not everywhere for public ser-
vices one can pay with a credit card. Also, a closer look is needed at
other sectors prone to unreported activities – such as bars and restau-
rants, accommodations, and taxis. A bit strange looks the tendency in
business-to-business transactions to settle in cash, or widespread prac-
tice of paying wages in cash.
Of course, in the longer term, the fundamental causes of the shadow
economy have to be tackled. The tax wedge on labour cost should be
narrowed, especially for lower-income employed; one way to do this is to
increase the non-taxable amount of income (currently LTL 470). This
would be effective since it mostly affects people with low income – the
ones who are more likely to get unreported remuneration (for monthly
wages above LTL 3,150 this tax break is not applicable). In the short
term, this could have a negative impact on public finances and the budget
deficit. Lost income could be compensated for by broadening the tax
base – perhaps shifting some burden from labour to capital. Taxing, for
5
A.T. Kearney (2009), “The Shadow Economy in Europe: Using payment sys-
tems to combat the shadow economy.”
4 Swedbank Analysis • December 27, 2010

5. example, real estate and personal vehicles has the advantage of effi-
ciency – it is hard to hide the tax base and avoid these taxes (given that
exemptions and tax breaks wouldn’t be widespread).
Social campaigns could help highlight the harm of tax evasion and the Education is important
shadow economy. Some recent surveys have shown that a large part of too.
the population believes that a majority of tax income is used for the
wages of parliament members and other public servants. The under-
standing of the functioning of the economy and public finances is very
poor, thus education should start already in school. Social networks and
other modern media could be effective channels of communication,
through which the government could educate the younger population
about the benefits of paying taxes and the harm of purchasing illegal
goods and services.
Improving the tax morale also takes time and is hard to achieve by social
advertising and educational initiatives alone. What else can be done?
First, the government has to improve the quality of its services or simply
allow the private sector to take over. An obvious candidate is the health
services sector, where, for almost every service, a person has to pay ex-
tra (unofficially) if he wants the check-up or medical procedure done
“right” and in time. Second, some kind of tax reform is needed that would
relate social security taxes to the benefits and services the taxpayer re-
ceives. One way to do this is by transferring a small fraction of taxes to
the taxpayer’s “virtual account,” which could be drawn upon for health,
social, or other benefits. This would discourage employees from accept-
ing unreported and untaxed remuneration.
The widespread practice of unreported remuneration indicates the low Benefit-to-risk ratio is
risk of getting caught and the high benefit-to-risk ratio. This can be too high…
changed by shifting some of the penalty directly to the company man-
ager, who usually takes the decision to employ unofficially. Instructive
examples in this area include Austria, where such activities are punished
with up to two years’ imprisonment for the responsible manager.
Combating smuggling in Lithuania is focused on the apprehension of
those crossing the border with undeclared goods. Other activities – catch-
ing and fining wholesalers and retailers of smuggles goods – are mostly
overlooked.
An important measure that could help curb unofficial employment and un- Universal declaration of
reported remuneration is the universal declaration of income and assets. income and assets could
Currently, only public servants and civilians with non-work-related income help.
have to declare income. Since the technological infrastructure for this has
already been established, taking the next step should not pose significant
hurdles.
The government has clearly indicated that, in the near future, trading in
markets and bazaars without cash registers will not be permitted. Strong
lobbying activities (with weak arguments) have been set in action to post-
pone this reform. At the same time, the government is improving the
business environment – starting January 1, 2011, the rate of the personal
income tax applied to income from individual activities will be reduced
from 15 to 5%.
Clearly, in fighting a complex phenomenon such as the shadow econ- Complex approach is
omy, the most effective approach is to combine “sticks and carrots” – the needed.
government should eliminate loopholes, tighten controls, and increase
Swedbank Analysis • December 27, 2010 5

6. fines, while creating incentives for market participants to emerge from the
shadow into the daylight.
Nerijus Mačiulis
Abbreviations
LFMI – Lithuanian Free Market Institute
LTL – Lithuanian Litas
POS – Point of sale
OECD – Organization of Economic Cooperation and Development
References
A.T. Kearney (2009), “The Shadow Economy in Europe: Using payment sys-
tems to combat the shadow economy.
National Audit Office, (2008), “Comparing how some tax authorities tackle hid-
den economy”.
European Foundation for the Improvement of Living and Working Conditions,
(2008), “Measures to tackle undeclared work in the European Union”.
LFMI (2010), “A Survey of Lithuanian Economy”.
Leinonen, H. (2008), “Evolving payment habits”, Bank of Finland.
OECD (2002), “Measuring the Non-Observed Economy – A handbook”.
6 Swedbank Analysis • December 27, 2010

7. Economic Research Department
Sweden
Cecilia Hermansson +46 8 5859 7720 cecilia.hermansson@swedbank.se
Group Chief Economist
Chief Economist, Sweden
Magnus Alvesson +46 8 5859 3341 magnus.alvesson@swedbank.se
Senior Economist
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Assistant
Estonia
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Annika Paabut +372 6 135 440 annika.paabut@swedbank.ee
Senior Economist
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Chief Economist, Latvia
Dainis Stikuts +371 67 445 844 dainis.stikuts@swedbank.lv
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Lija Strašuna +371 67 445 875 lija.strasuna@swedbank.lv
Senior Economist
Lithuania
Nerijus Mačiulis +370 5 258 2237 nerijus.maciulis@swedbank.lt
Chief Economist, Lithuania
Lina Vrubliauskienė +370 5 258 2275 lina.vrubliauskiene@swedbank.lt
Senior Economist
Ieva Vyšniauskaitė +370 5 258 2156 ieva.vysniauskaite@swedbank.lt
Senior Economist
Swedbank Analysis • December 27, 2010 7

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