A number of European countries – Portugal, Italy, Greece, Spain, and, most recently, Ireland – face public debt sustainability problems (Cabral 2010). They also share a problem of significant tax evasion.
This connection between public debt and underground sectors is a problem that deserves attention. High debt-to-GDP and high grey-versus-white economy ratios are closely intertwined and a major problem for the indebted countries’ policymakers.
Public debt and the underground economy
The interaction between the underground economy and government actions is complex and inherently dynamic. The presence of hard-to-manage public debt exacerbates the problem of fighting tax evasion. The stock of debt necessitates fiscal adjustments, but higher tax rates are usually associated with a “quit” option to the underground sector. Further tax increases could set off adverse debt dynamics that undermine future tax bases.
As happened ten years ago in Argentina, a “mass escape” from the regular sector can dramatically worsen the public budget situation. By the same token, lower tax rates may lessen the incentive to evade. But if the evolution of the expenditure side of public budget is out of control, dodgers may anticipate future tax increases and decide to quit now.
Public outlays are also part of the political dilemma. Indeed, apart from their obvious links with the public debt, specific spending items may also have non-trivial effects on the underground sector.
The government is an important employer (sometimes it acts as the employer of last resort, and Europe’s highly indebted countries are certainly not among the exceptions) and hence it influences the conditions of both regular and irregular labour markets. One may well think of policies on some public outlays as a “tax” that directly affects both public debt and tax evasion. A reduction in public wages, which shifts the tax burden from private agents to civil servants, is one example.
Finally, a situation where government revenues are insufficient to offer public services may push citizens to buy these services from underground agents may yield a “bad” equilibrium with both large debt and tax evasion.
A dramatic shift in policy is required
All in all, it is likely that the shift from these bad equilibria to a good steady state requires a dramatic shift in policies. The budget constraint forces the government to choose between paying off public debt and curbing spending or increasing taxation. The “shadow constraint” forces the government to carefully select the better fiscal items to manoeuvre, even considering those with deeper impacts on social consensus. Empirical analyses are paramount in this “Treasury vs dodgers” game.
Unfortunately, a lack of reliable time series data on tax evasion usually hampers the empirical analysis of these feedback effects. Taking advantage of a unique dataset on the Italian underground economy (released by the Italian Institute of Statistics), my coauthor and I have examined a dynamic system of both the hidden sector and fiscal variables (Bovi and Claeys 2008). Figure 1 and 2 show the links between public finance stance and the share of the underground economy in Italy over the last three decades.
Figure 1. Public debt vs shadow economy in Italy (as % of GDP)
Note: Public debt is depicted by the dashed line and corresponds with the right-hand-side axis. The shadow economy is the share of irregular workers compared to total full-time-equivalent units. In 2002 and 2003 there was a mass legalisation of illegal immigrants that reduced by about 200 basis points the irregular share. Italian official GDP includes both regular and irregular activities.
Figure 2. Fiscal revenues and outlays vs shadow economy in Italy (as % of GDP)
Note: Fiscal revenues are depicted by … Outlays depicted by --. Shadow economy and GDP defined as above.
Figure 1 suggests that public debt and the shadow economy go hand in hand. Figure 2 shows the huge increase in tax-to-GDP ratio up to almost 50%, which seems to be the maximum socially sustainable level (the tax burden on honest taxpayers, i.e. on regular GDP, is obviously larger than that reported in Figure 2). Starting from the early 1990s, public outlays decrease, possibly suggesting that they had reached the maximum economically sustainable level. In the last years both revenues and expenditure have maintained their (high) level on GDP.
We have studied the sustainability of public debt through spending and tax rules (e.g. a positive reaction of the surplus to an increase in the public debt) more formally using a dynamic stochastic general equilibrium (DSGE) model.
- Our results show that the underground economy reacts to changes in the tax burden as well as to variations in government spending.
- We also find a positive effect of fiscal surpluses on the black economy. For every 1% increase in the surplus, shadow activities significantly rise by slightly more than 1%.
- The main insight is that higher taxes lead to a shift to the underground sector. Tax increases cause significant substitution into irregular activity. A 1% tax increase implies a more than proportional growth of the underground economy. This shift into the black economy implies a gradual erosion of the tax base.
- At the current level of spending and taxes in Italy (nearly 50% of GDP, see Figure 2), only half of the planned additional revenues actually flow to the Treasury. The other half is foregone due to tax evasion.
Although this additional tax pressure on honest taxpayers turns some into dodgers, at the current level of underground activity there is no danger of unstable revenue dynamics. This does not exclude that increasingly higher tax burdens on less and less honest taxpayers may eventually imply perverse revenue dynamics. On the other hand, being on the increasing part of the Laffer curve implies that tax cuts to combat underground activities would make debt even more of an emergency. It turns out that tackling both fiscal consolidation and tax evasion requires an analysis of the impact of spending on the underground economy.
We have studied wage spending, consumption, investment, subsidies, and interest payments. We find that increased government spending requires future tax rises to keep the budget in balance and therefore has an indirect impact on the underground economy. As before, the magnitude of the response still implies that about half of any additional tax revenue is foregone due to evasion. Hence, the data suggest that a careful two-handed approach is necessary to keep both public debt and the underground economy in check. On the positive side, while some spending variables have a limited direct impact on the underground sector, evidence shows that the government can afford to use some items to face both hidden and financial markets. Specifically, we find that higher public wages reduce underground activities (possibly because higher public wages reduce bribe taking). In contrast, the number of public employees has a strongly positive effect on the level of underground activity. Thus, the government could manoeuvre wage spending either along the intensive margin, i.e. by raising wages, or the extensive margin, i.e. by reducing staff. Although the overall effect of fewer, better paid public workers on total spending could be balanced, such a measure would be complementary to tax cuts in fighting tax evasion.
We are strongly tempted to speculate that targeting unproductive sectors may increase the overall effects on hidden and financial markets. Our findings add support to the current fiscal adjustments implemented in some of Europe’s highly indebted countries and are in line with the call for deep spending cuts outlined by Wyplosz (2009) in his Vox column “Greece: The party is over”.
Disclaimer: The views expressed do not necessarily reflect those of the ISAE. I am indebted with Peter Claeys for his helpful comments.
Bovi, Maurizio and Peter Claeys (2008), “Treasury V Dodgers. A Tale of Fiscal Consolidation and Tax Evasion”, ISAE Working Papers 93, Institute for Studies and Economic Analyses.
Cabral, Ricardo (2010), “The PIGS’ external debt problem”, VoxEU.org, 8 May.
Wyplosz, Charles (2009), “Greece: The party is over”, VoxEU.org, 14 December.