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The Normality of Informality: Shadow economy out of crisis

The informal, or shadow, economy is growing in the European Union (EU) due to the economic crisis. It ranges from eight per cent of Gross Domestic Product (GDP) in Switzerland and Austria to more than 30 per cent in some Central and Eastern European countries, such as Bulgaria, Croatia or Romania. Curtailing this “other” marketplace is a challenge for both state governments and the EU, as the transformation of undeclared work into formal work can be an important step towards the fulfilment of the EU employment targets set out in the Commission strategy “Europe 2020”.

September 7, 2012 - Charlotte Guériaux - Articles and Commentary



Known under a broad variety of different names such as “grey and black”, “unrecorded”, “illegal” or “underground”, the hidden economy has as many facets and meanings as names. This recalls the French expression “system D” of “débrouillards” which depicts particularly effective and resourceful people who start doing business on their own, without registering or being monitored by the bureaucracy – a concept sculpted by the history of the former French colonies in Africa.

Informal employment refers to jobs or activities in the production and commercialisation of legal goods and services that are not registered or protected by the state. More precisely, the term hidden economy covers three economic sectors that are not reported in the official economy (GDP): the informal economy (legal, yet unreported activities such as homemade produce or domestic labour), the illegal economy (illegitimate and unreported activities) and undeclared (grey) economy (legal and not reported such as tax evasion).

This informal economy is spreading almost to everywhere in the world. It does not only affect developing countries but it is also part of the everyday life of high-income countries, such as the EU member states. Entrepreneurs operate in the unofficial economy because they want to get free from the taxes and regulations that make official transactions unprofitable or unfeasible. Thus, the farmer who sets up a roadside stall selling produce is a participant, so is a construction company that does not report its income to the government in order to avoid meeting legal standards such as minimum wage. Parts of this informal economy also include the children who sell homemade lemonade outside their houses in summer, or their private French classes paid for by adults under the table.

Informal work is not only difficult to observe, it is also a challenge to register as it can be defined differently in national legislation, which makes it difficult to obtain reliable estimates of how widespread it is across Member States. According to some known experts such as F. Schneider, the hidden economy represents one eighth the size of the EU countries’ official GDP while it is much more important in less developed Eastern European states such as Estonia or Bulgaria. For example, Poland’s shadow economy (25 per cent of its GDP) is slightly superior to the European average part of the informal economy in the GDP (around 19 per cent).  Bulgaria is a striking case, it can be used to question the reliability of the data; different sources estimate the hidden economy share at between 10 and 32 per cent. So, undeclared work is part of the economy and its importance should therefore be estimated as accurately as possible.

The EU unemployment rate reached historic highs in 2011 and the number of unemployed people in the EU eventually stood at 23.8 million in December 2011; 1.1 million more than in March 2011. Divergence remains high among EU labour markets. The financial and economic crisis that began in 2008 has far-reaching effects for employment in Europe in raising formal unemployment and making undeclared work acts as a buffer when people are laid off in the formal sector. These developments will critically affect poverty levels and income distributions because more and more people are inclined to work outside the normal legal framework as the global economy continues to struggle. Although it has various consequences in different countries, this undeclared economy always reveals existing or future problems on the public-private interface of the economy such as the lack of adequate control, lack of acceptance of formal rules or overregulation, among others.

Undeclared and illegal work has serious consequences for both individuals and society. Underground economies are unlawful, and create considerable costs at different levels. Indeed, informal workers are extremely vulnerable in times of crisis because they are the first to lose their jobs and suffer from lower wages that result from the inflow of laid-off workers from the formal sector. They are also excluded from social security benefits and the protection afforded by formal labour contracts. Beyond earning levels, informal employment makes basic rights vulnerable and difficult to defend.

These dynamics are worsened by the global economic crisis and particularly affect some vulnerable groups, such as women or young people. In the Polish economy, women are more often engaged in lower wage jobs – for example in the private service sector – and in areas of work without any social benefits such as part-time jobs or jobs in the informal sector. The Ministry of Work and Social Policy’s services dedicated to the promotion of women entrepreneurship are clearly lacking in related funding. Moreover, young people seem to be at risk of entering the informal economy as youth unemployment is still rising (at 5.5 million in the EU in December 2011, there were still 241,000 more than a year before).

Furthermore, the formal state is also affected by the shadow economy in the sense that tax authorities receive less revenue, and social security institutions do not obtain contributions – which therefore limits the funds for improving public goods and services. A high level of informality also undermines the rule of law and governance because the state is weakened if a large part of its population starts to openly ignore its laws and taxations.

On the other hand, if an increased number of entrepreneurs fall into the underground economy, it is because it is worth it; financially speaking. This happens when undeclared income outweighs the benefits accrued through registration and compliance to the rules of the formal economy. The shadow economy does not consist of social security contributions, tax payments or binding labour regulations. In fact, one should take another look at this underground society to understand this stunning source of entrepreneurialism and innovation. For some, during this global crisis, the world shadow markets are for the better; adding jobs and improving the lives of millions of people.

The question is whether to consider hidden employment as a drag on productivity or a motor for growth, even for a temporarily. Something clear is that the size and composition of informal employment influences the growth pattern of an economy. Informal employment is often perceived as reducing the competitiveness of an economy because it eventually encourages small firms that are characterised by low-productivity. For others, this shadow economy is made of innovative entrepreneurs with high levels of flexibility that can adapt to the different qualities of the economic crisis. In some ways, the growth of unofficial employment would be an entrepreneurial response to unnecessarily rigid labour markets and excess regulation. Thus, growing underground economy employment has allowed Italian and Spanish firms to expand and contract production more easily to market demands.

However, if this second version is true for emerging economies such as China, a deeper look at the market economies of Central and Eastern Europe casts doubts on this optimistic future. Engaging in the informal economy is not always an economical choice but rather a financial necessity. For instance, the Ukrainian labour market endures many structural problems that affect every social category of Ukrainians, and limit the competitiveness of the economy. As in Russia, it appears that shadow employment is more a way for unskilled persons to escape unemployment and resulting poverty, rather than to evade taxes. Young graduate employees also face problems to find and secure employment (because many jobs are obtained through connections and payment of bribes) and are thus likely to turn to the informal economy for employment.

This is one of the world’s fastest growing economies, and it is invisible. Governments should be worried about this for various reasons because it leads to potentially negative consequences for competitiveness and growth, incomplete coverage of official social programs, undermines social cohesion and law and order, fiscal losses…

These concerns generally outweigh any advantages that the informal sector offers as a source of job creation and as a safety net for the poor. Governments have thus a battery of measures, in capturing lost revenues and protecting workers, to curtail this informal economy. While increased fines and audits would certainly reduce the size of the informal economy, it would not automatically translate all activities from the underground economy into official economy. Some experts argue that easing the regulatory and tax burdens of the shadow economy entrepreneurs is the only way to make them part of the formal economy.

The EU’s economic governance is also at stake. This fast developing shadow economy legitimately questions the EU’s economic governance and cast doubts on the EU quality of control and crisis readiness. On the one hand, the informal economy does not recognize national boundaries and may grow and become a camouflage for criminal activities. On the other hand, the current rise of the shadow economy throughout the EU is a crucial issue because it shows that the EU internal market does not function properly; it favours those who are bigger, more willing and able to pay.

Charlotte Guériaux is a French student in a double masters program in European politics and studies between the Institute of Political Sciences of Strasbourg and the Jagiellonian University in Krakow. Her academic interests include Central and Eastern Europe politics, organised crime and corruption, and energy security.

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