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ISET Economist Blog

A blog about economics in the South Caucasus.

Georgia’s Underground Economy

Economic activities which are not registered (and therefore not taxed) are commonly called Shadow Economy or Underground Economy. Are there shadowy corners in Georgia’s economy? Not just corners!

According to Schneider, Buehn, and Montenegro (“Shadow Economies All over the World – New Estimates for 162 Countries from 1999 to 2007”, Policy Research Working Paper 5356, The World Bank 2010), based on estimates for 2007, Georgia has by far the largest shadow economy (as a share of GDP) among all surveyed 21 transition countries. 62.1% of all economic activity in Georgia was taking place in the underground! Places 20, 19, and 18 are taken by Ukraine, Moldova, and Russia, with 46.8%, 44.3%, and 40.6%, respectively.

But even in the global ranking of 151 countries, Georgia is only beaten by Zimbabwe (62.7% shadow) and Bolivia (63.5% shadow). At the top of the list, we find Switzerland and the United States with 8.1% and 8.4% shadow, respectively, and among the OECD countries, a group of 25 high-income economies, the average is 16.6%. According to Schneider et al., these numbers do not primarily reflect genuinely criminal activities like drug dealing and prostitution but mostly plain tax evasion. 

The huge amount of shadow in Georgia is puzzling, given that in in this country one gets a receipt even for minor purchases (which is not the case, for example, in Greece). Moreover, Georgia received a lot of praise for its efforts to fight corruption, and in particular for its reforms of the tax administration starting in 2005 (cf. “Fighting Corruption in Public Services: Chronicling Georgia’s Reforms”, The World Bank 2012). Since 2003 and 2007, Georgia’s shadow economy has indeed shrunk, but not by as much as one would have expected. The shadow rates were 65,9% (2003), 65,5% (2004), 65,1% (2005), 63.1% (2006), and 62.1% (2007). In 1999, at the pinnacle of Shevardnadze’s rule, the number stood at 68.3%, just 6 percentage points away from the 2007 level. Unfortunately, data are not available for the years after 2007, yet up to that point, the size of the underground economy remained surprisingly unaffected by the long period of government’s massive crackdown on corruption, which was starting in 2003. Apparently, classical corruption was effectively reduced, but the shadow economy was not included in this process.


THE SLIPPERY SLOPE OF TAX EVASION

Kirchler, Hoelzl, and Wahl (“Enforced versus Voluntary Tax Compliance: The ‘Slippery Slope’ Framework”, Journal of Economic Psychology 29, 2008) identify two sources of tax compliance: enforced and voluntary. Enforced tax compliance results from the fact that tax evaders fear the risk of being detected and punished. Voluntary tax compliance is promoted by the comprehension of citizens that the government fulfills important functions which need to be funded by tax payments.  

As argued by Muehlbacher and Kirchler (“Tax Compliance by Trust and Power of Authorities”, International Economic Journal 24, 2010), neither power nor trust alone can lead to the best outcome. What is called for is a balanced mix of trust and power: if tax authorities are absolutely powerful but the government lacks trustworthiness, the economy will slide down the slippery slope into shadow. Yet the same happens if the government is transparent, fair, enjoys a high degree of legitimacy etc. but has a dysfunctional revenue service. The diagram illustrates this idea.

The argument that voluntary compliance is essential at first sight seems to be somewhat “uneconomic”, as it is not based on extrinsic incentives but intrinsic motivation. It is part, however, of mainstream thinking in the economics of crime and can be applied to almost all kinds of transgressions. The most effective police cannot prevent situations where the probability to be sanctioned for a crime is low, e.g. if a perpetrator encounters a defenseless victim at a lonesome place. Everybody relies to a considerable extent on the decency of the people one interacts with, and if economic agents would cheat and deceive each other in all situations where this is possible, inspection costs would skyrocket and economic activity would be heavily impaired.


VOLUNTARY COMPLIANCE IS KEY

According to the Caucasus Barometer of the CRRC, the percentage of Georgians who express full trust in the “executive government (prime minister and ministers)”, oscillates between 30% and 40% in the last years. For comparison: in Austria, Czech Republic, and Great Britain, the trust towards tax authorities stood at 89%, 90% and 91%, respectively, while the size of the shadow economies averaged at 16% in these three countries (Muehlbacher, Kirchler and Schwarzenberger: “Voluntary versus enforced tax compliance: empirical evidence for the ‘slippery slope’ framework”, European Journal of Law and Economics 32, 2011). Hence, despite fundamental reforms, the level of trust, destroyed in the post-Soviet turmoil and the Shevardnadze era, was not yet restored.

The difficulty for Georgia is that according to conventional economic wisdom, many issues are already handled in an almost ideal way. Thus, there is no obvious way to approach the problem. The Georgian 20% flat tax is extremely simple and transparent. Public spending, as a percentage of GDP, amounts to 31.8% -- a very moderate number, compared to 41.6% in the United States, 48.5% in the United Kingdom, 56.1% in France, and 57.6% in Denmark (data from the 2014 Index of Economic Freedom of the Heritage Foundation). In most countries, special interest groups have their hands in the honey pots of the government, financing all kinds of activities with questionable benefits for the general public. For example, 3.3 percentage points of the government expenditures of the USA, 560 billion dollars, are paid on military expenditures, largely pocketed by the US weapons industry. Compared with other governments, the Georgian public sector can be considered to be parsimonious and slim.

This is not to say that things cannot be improved. Widespread nepotism is a huge problem. People find it outrageous if their tax money, for which they have worked hard, is used to provide jobs to relatives of government officials. And the snobbish cars of many government representatives, sometimes even escorted by police, evoke the impression that politicians consider their offices at least partly as opportunities to appropriate benefits to themselves. To gain legitimacy (and improve tax morals), Georgian politicians should follow the examples of European politicians: in Amsterdam, the prime minister of a country with 17 million citizens and a GDP of almost 800 billion was coming to his office by bicycle, and in Berlin one could see ministers go around by metro. The threat of Islamic terrorism and the need for bodyguards has made this more difficult for prominent politicians, but ordinary members of parliament are still moving around like all other citizens, often using public transport. In Georgia, on the other hand, even mediocre officeholders feel entitled to special privileges in the streets of Tbilisi. Such attitudes undermine beliefs among citizens that their tax payments are used reasonably. 

Transparency is achieved to a considerable degree in Georgia. Transparency International, which considers Georgia’s E-procurement platform to be “one of the most transparent in the world”, maintains a database of government tenders since 2010, allowing for comprehensive analyses of where the money of the taxpayers went (www.tendermonitor.ge).   

Yet all of this works slowly. It is a well-known finding in the debate about so-called “bridging social capital” that trust in institutions, once it is destroyed, takes long time to be rebuilt. Shevardnadze’s kleptocracy has spoiled the attitudes of Georgians towards their government, and they cannot be restored within a few years.

There are things to be done, however, to improve the tax morals within a population, relating to recent insights from behavioral economics and the ingenious ideas about nudging by Thaler and Sunstein. This, however, we will discuss in the next issue of Georgia Today.

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Friday, 15 November 2019

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