Preliminary conclusions and tentative policy options

Hidden Economy WorkshopBudapest December 5-6, 2007

Preliminary and for discussion only

Notes (1)

Informality only part of fiscal problem Hungary already collects high % of GDP in

taxes. Expenditures very high. Fiscal only part of informality problem

Concerns should also include competitiveness, social welfare

Tradeoffs in combatting informality Slow down economic growth? Price people

out of economy?

Preliminary and for discussion only

Notes (2)

Terms of reference for study emphasize concrete recommendations …

But need for underlying analysis Scale and composition of informal sector Understanding incentives, motivations Attitudes

As well as analysis of specific areas for potential interventions

Weak evidence base internationally on what works in terms of specific interventions

Preliminary and for discussion only

Simple model of informality and needed responses Informal economy due to

Requires

Exclusion because of regulatory and other barriersExit when entrepreneurs and workers choose to operate informally

Removal of barriers to operate formallyReducing the costs and increasing the benefits of operating formally (Carrots)andIncreasing the costs and reducing the benefits of operating informally (Sticks)

Preliminary and for discussion only

Potential areas for reforms

Tax and benefit systems Business and labor market regulations Enforcement and sanctions Public information and education

Note that following policy ideas are preliminary and incomplete

Preliminary and for discussion only

Tax and benefit systems (1) Most important area for addressing

undeclared economic activity/employment

Taxes create disincentives for formalization But they are also not competitive with tax

regimes in neighboring countries So tax reform needs to be based on

overall efficiency and competitiveness (within framework of fiscal consolidation) and not just “whitening” the economy

Preliminary and for discussion only

Tax and benefit systems (2) Labor taxes (PIT, social contributions) are

high and discourage formal employment, especially low-wage labor

Favorable tax treatment of non-labor income encourages underreporting of employment earnings

Further disincentives created by serious spikes (e.g., employment income tax credit)

Design of social benefits and programs likely encourages undeclared work

Preliminary and for discussion only

Tax and benefit systems (3) To extent feasible, employer social

insurance contributions should be reduced Targeted reductions for workers

overrepresented in low-wage employment have biggest impact on formalization

Compensate for reductions in revenues with other taxes (e.g., dividend, VAT, real estate) Set revenue target and allocate any added

revenues due to better compliance to tax rate cuts in next year

More comprehensive reform -- Flat tax with high personal exemption and comparable rates for earnings and profits?

Preliminary and for discussion only

Tax and benefit systems (4) Employment tax credit – encourages

formalization but more gradual phasing out Assess minimum contribution base as

double minimum wage – do added receipts justify decreases in formal employment?

Consider other options to tie social contribution/tax bases to assumed productivity E.g., Bulgarian example of differentiated

minimum thresholds determined by social partners

E.g., Presumptive taxation of self-employed and small companiesPreliminary and for discussion only

Tax and benefit systems (5) Evidence suggest prevalence of combining

undeclared work with receiving public beenfits For unemployment benefit (and some social

assistance) recipients Implement “activation” policies – closer monitoring

and stricter job search requirements, combined with subsidies for hiring employers; and/or

Allow some earned income while collecting benefits High proportion of older workers are

undeclared Are reforms in pension/disability provisions

needed?

Preliminary and for discussion only

Business and labor market regulation (1)

Assessment that regulation is not a major factor

Business regulation reforms in recent years have reduced costs of compliance

Further steps Complete planned reforms for business

start-ups Simplify licensing procedures

Preliminary and for discussion only

Business and labor market regulation (2) Although some employers cite labor

market regulation as a problem, review suggests that it is not a serious barrier to formal employment

Minimum wages should be kept relatively low

Involve social partners in fight against undeclared work E.g., commitment to fight undeclared work

in collective agreementsPreliminary and for discussion only

Enforcement and sanctions

Tax collection efficiency lower than in other EU countries

Consider further consolidation of various institutions

Should APEH be restructured (by taxpayer, not function)?

Labor inspectorate – investment in training and exposure to latest international practices

Preliminary and for discussion only

Public information and education Segmented communication plan Position tax evaders as minorities and

underline criminal nature of evasion Address fairness issue by highlighting

sanctions on rich and powerful Link tax paying with publicly provided

services and benefits

Preliminary and for discussion only