Tax Dodgers Multiply as ‘Underground Economy’ Cushions Job Cuts
By Emma Ross-Thomas
March 27 (Bloomberg) -- Carlos Cruz has a strategy for surviving the worst global recession in 60 years: pay less in taxes and pass the savings along to customers.
“I’m declaring half as much as I used to,” said Cruz, 29, who runs a painting business in Madrid. “Prices have fallen by 30 percent and customers will choose you for a difference of as little as 50 euros ($67.70),” said Cruz, an Ecuadorian who has lived in Spain since 2001.
Even as the U.S., Japan and Europe weather the first simultaneous recessions since World War II, some types of activity are expanding worldwide -- just below government radar. The production of goods and services that are lawful, though not declared, may grow the most as a proportion of total output since 2000,
according to Friedrich Schneider, a professor at Austria’s Johannes Kepler University of Linz.
The shift, measured by tax analysts and economists using surveys, money-supply data and anecdotal evidence, is caused by businesses going off the books to cut costs and workers taking informal jobs to survive rising unemployment.
It offers a buffer against the ravages of the crisis and may help explain why the slowdown hasn’t prompted more social unrest.
“The good news then is that the recession, as captured by the official statistics, may not be as severe as it appears,” said Edgar Feige, a professor at the University of Wisconsin- Madison who has studied the underground economy for 30 years. In past slumps, unregistered activity increased as a proportion of the official economy, he said.
Schneider defines the underground economy as “the legal production of goods and services, but withholding tax and social security payments.” It encompasses informal work on building sites for cash, and small textile and shoe workshops that trade off the books, while excluding crime.
In 21 of the 30 countries in the Organization for Economic Co-operation and Development, Schneider estimates the informal economy will equal 13.8 percent of official gross domestic product in 2009, up from 13.3 percent last year.
On that basis, its value will climb by $200 billion to $5.59 trillion in those nations from $5.39 trillion, using constant 2008 GDP because data for this year isn’t yet available.
The relative size of the market shrank each year since 2001-2002, when it amounted to 16.7 percent, Schneider’s data show.
Growth in the underground economy is depriving governments of revenue just as their countries are reeling from the effects of the recession and stimulus measures.
It’s “an unsustainable situation for the public coffers,”
said Armando Fernandez Steinko, a sociology professor at Madrid’s Complutense University.
In the good times, such activity tends to drop off as businesses avoid the risks of not paying taxes, said Jose Manuel Saiz Alvarez, a professor at Nebrija University in Madrid who’s writing a book on the issue. In recessions, they “often turn to what might be considered informal, unregulated contractual arrangements with subcontractors and labor suppliers” to cut costs and gain “flexibility,” said Sudhir Venkatesh, a professor at Columbia University in New York and author of “Gang Leader for a Day.” (Penguin Group, 320 pages, $25.95.)
Cruz, the painter in Madrid, said clients don’t ask for receipts as much as they used to, willing to trade savings for the guarantee that having a bill gives them. He couldn’t afford to operate in the current crisis paying full tax rates,
Cruz was the only contractor willing to talk openly about avoiding tax by not declaring income among more than 20 who were asked about it. Other people are also declaring half of what they once did, he said.
By contrast, at informal labor exchanges in Madrid in February, a dozen workers looking for day jobs spoke freely, and said police don’t question them at the pickup points. Their stories couldn’t be independently verified.
Milton Haro, a 37-year-old Peruvian electrician, said he is registered among Spain’s 3.5 million unemployed, while he works illegally. He sometimes earns more in a day’s work off the books than he did in a week as a salaried electrician,
“You have to take a risk,” said Haro, while waiting among about 30 men outside a roadside cafeteria for foremen to pass by in search of laborers.
While he sometimes earns as little as 50 euros a day, Haro said he had a one-day electrical job lined up that would pay 500 euros, all undeclared and in addition to unemployment benefits.
Average monthly wages in Spain were 1,897 euros, according to fourth-quarter data from the National Statistics Institute.
Men for Hire
In the good times, only newly arrived immigrants without papers or connections would come to this improvised labor exchange, Haro said. Now, men who have worked legally in Spain for years also show up before dawn.
The greater the unemployment rate, “the higher the likelihood of participation in the underground economy,” said Steinar Strom, professor of economics at the University of Turin in Italy.
Spain has the highest unemployment rate in the European Union, at 15 percent. It has one of the region’s largest and fastest-growing underground economies, along with Greece and Portugal
, Schneider said. The country’s informal economy will expand to 19.5 percent of GDP this year from 18.7 percent, he said.
The number may go even higher, to 26 percent to 29 percent of GDP this year
, after shrinking to 17 percent at the peak of the boom, said Saiz Alvarez, the Nebrija professor.
“The reason people can live here, can bear it without a social explosion, is that there’s this underground cushion that allows people to earn, to live,” said Steinko, the sociology professor. “We could call it a safety net.”
Spanish Prime Minister Jose Luis Rodriguez Zapatero started a campaign in 2005 against those who don’t pay taxes. It includes investigating businesses that may be hiring people off the books and tracking transactions made with 500-euro bills, often associated with unregistered deals.
The growth in the underground economy comes after Spain’s tax revenue fell 14 percent last year, the same decline as in Ireland. French fiscal revenue dropped 10 percent in January from a year earlier.
“When there’s a crisis, the first thing businesses stop paying is tax,”
said Jose Maria Mollinedo, head of Spanish tax inspectors union Gestha. “Some businesses have officially closed down, but they’re still providing the same services.”
For workers, the downsides of unregistered commerce can include unsafe working conditions and not being paid.
Haro, a father of two with a baby on the way, said all his colleagues have stories about not getting paid. In his case it was after working two weeks in a rat-infested plumbing system. Still, he comes to the pickup point ready for all kinds of work, his blue day-pack stuffed with overalls, pliers and other tools of his trade.
Markets without regulation are “very predatory, very exploitative and deeply injurious to people in the long term,” said Venkatesh, the Columbia professor who was the subject of a chapter in the best-selling book “Freakonomics” (HarperCollins, 242 pages, $29.95) as the sociologist who studied a crack gang.
High percentages of people employed without contracts can indicate widespread poverty, according to the International Labor Organization.
Informal work accounted for 51 percent of global employment in 2007, with the highest concentrations in developing countries, the Geneva-based ILO said in a Jan. 28 report. That may climb to as high as 53 percent this year, or 1.6 billion people, an increase of 113 million in two years, it said.
The rise in tax dodging by workers and companies coincides with efforts by the U.S. and Europe to crack down on offshore centers the rich use to avoid taxes.
Liechtenstein and Andorra, listed as uncooperative tax havens by the OECD, and Switzerland have agreed to loosen bank secrecy rules.
Locally, governments may not think it’s in their interests to clamp down on their underground economies, said Dominik Enste, an economist at the Cologne Institute for Economic Research in Germany who has been studying the subject for 14 years.
“They won’t win many votes by fighting illicit work during a recession,
a time when the shadow economy is the Switzerland or Liechtenstein of the poor,” he said.