The Shadow Economy
Economists sometimes refer to the economy as being like an iceberg: split into two parts, with one visible above the “water line” and the other “hidden” below the surface. The ‘hidden’ part of the economy is basically any economic activity which is not reported to the authorities, is not included in statistics, and on which tax is not paid. Economists have many other names for this “hidden” part of the economy, such as:
- the shadow economy;
- the black economy;
- the grey economy;
- the non-observed economy;
- the unofficial economy;
- the illicit economy and
- the informal economy
There are almost as many definitions as there are different scholars … but most centre on the concept of economic activities which go unreported to the authorities. As well as some people/enterprises simply working unofficially and not declaring their income, there are also enterprises which do report – but under report their activity, usually with the aim of evading tax.
It is important to realise that there are both legal and illegal forms of the Hidden Economy.
In poor countries, where unemployment is high, then many people will accept jobs without any ‘paperwork’. They not only do not pay income tax and social security payments, they lack the basic fundamental rights and protections of labour legislation. Even where they are ‘officially’ employed, there is a common practice to only record part of their salary in the company accounts – thus reducing the amount of income tax and social security payments payable.
Many people may work for themselves – are self employed – on an ad-hoc basis, and as such never register with the authorities. Examples might include local taxi drivers, people working from home in the textile industry, or craft industries making souvenirs, or who set up stall on the street selling fruit and vegetables. It’s a cash business, no-one is required to keep records and so there is nothing to ‘report’ to the authorities.
Some companies that are registered obviously have to file reports with the tax and statistical authorities. Many, however, operate two sets of accounts: one which is ‘official’‘ and is reported to the authorities – and another which is ‘unofficial‘ – again cash based – which is not.
One of the main reasons for not reporting economic activity to the authorities seems to be to avoid tax, but there are others. For example, certain activities (such as smuggling, prostitution, the trade in narcotics) are illegal – and by their very nature will not be reported.
Another aspect of the Hidden Economy is corruption – especially, but not exclusively, the payment of bribes. Money changes hands, so it counts as economic activity – but as it is illegal, it is not recorded, and goes unreported.
By it’s very nature, it is difficult to be sure just how large the Hidden Economy is – and how important it is to the economic swell-being and sustainability of a country. It is assumed that it is smaller in most developed countries than in developing countries or countries ‘in transition‘ (like the Kyrgyz Republic). The National Statistics committee has estimated that the Hidden economy was equal to about 25% of the country’s GDP in the late 1990′s, but other estimates are that it is equal to, or even exceeds, the official economy.
In fact the very tax system in the Kyrgyz Republic assists, encourages and possibly even institutionalises the hidden aspect of the economy in some ways. Especially by the patent system.
There are several different forms of company, each with legislation which governs their activities, and several distinct tax regimes. A company can be floated on the local (or an international) stock market and shares in it can be traded, (an AO). A Limited Liability Company (an OcOO) can be established by a group of individuals. An individual entrepreneur can register themselves as self-employed, which allows them also to employ others. Then there is the ‘patent‘ system.
Under the tax legislation of the Kyrgyz Republic there are several different forms of taxation. The regime under which someone works is mainly regulated by the size of their turnover, although a small company can, if they wish, elect to work under a more complex system. For example, there is the full tax regime with Value Added Tax (VAT); the full tax regime without VAT; the simplified tax regime – with just one unified form of tax; the Free Economic Zones – which are basically exempt from tax; … and there is the ‘patent‘ system.
The idea of the patent system is that an individual can make a single, ‘one-off’, payment to buy a patent (which is a permit, or license) which allows them to undertake a particular form of economic activity for a given period. A patent is grated for a particular activity … driving a taxi, trading on a market stall, providing accommodation in a homestay … and so on. The fee paid for the patent is calculated by making assumption about how much they are likely to earn in the given period. Once purchased, the individual can then work legally, without having to keep records of income, or to report this to the authorities. In other words – their scale of their economic activity is ‘hidden‘ from the authorities and this is built as a feature into the system.
Indirect checks are made by the tax authorities, however, to see if the individual’s earnings have exceeded the VAT threshold.
There have been several attempts to try and estimate the real size of the Hidden Economy and to try to bring people ‘out of the shadow’. For example, until recently the textiles industry was mainly unreported. Many of the people working in this sphere did so at home and were technically unemployed. In 2005, following an initiative from the industry itself, new legislation was passed to allow the workers to work under the patent system – thus bring them from the ‘illegal’ ‘shadow’ economy into the ‘daylight’ of the ‘legal’ framework.
Bishkek