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Poverty and t he Underground Economy in Croatia 1990-2000 Project leader Katarina Ott

Poverty and t he Underground Economy in Croatia 1990-2000 Project leader Katarina Ott Predrag Bejaković Institute of Public Finance, Zagreb, Croatia HR-10000 Zagreb, Katančićeva 5, P.O.Box 320, Tel: +385 1 48 864 55, Fax: +385 1 48 19 365 e-mail: predrag@ijf.hr , www.ijf.hr

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Poverty and t he Underground Economy in Croatia 1990-2000 Project leader Katarina Ott

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  1. Poverty and the Underground Economy in Croatia 1990-2000 Project leader Katarina Ott Predrag Bejaković Institute of Public Finance, Zagreb, Croatia HR-10000 Zagreb, Katančićeva 5, P.O.Box 320, Tel: +385 1 48 864 55, Fax: +385 1 48 19 365 e-mail: predrag@ijf.hr, www.ijf.hr UNECE Seminar on Poverty, Geneva, 2-3 October 2003

  2. Some statements about poverty • In general, the art of government consists in taking as much money as possible from one class of citizens to give to the other. - VOLTAIRE (1694-1778),the French writer and philosopher • And distribution was made to each as had need. - ACTS 4:35 • A decent provision for the poor is the true test of civilization. - SAMUEL JOHNSON(1709-1784), English lexicographer and writer • Almight God! Thou who holdest in thy hand the minds od men, deliver us from fatal arts and science ... give us back ignorance, innocence and poverty which alone can make us happy and are precious in thy sight (Discourse on the Arts and Science, 1750:27) - ROUSSEAU, Jean Jacques (1712-1778), French philosopher, social and political theorist

  3. Project and presentation contain • Description of research into the underground economy (UE) in Croatia in the 1990 to 2000 period. • The circumstances surrounding and the reasons for the origin of the UE • Estimations of the dimensions of and changes in the UE at the level of the whole of the economy and in terms of certain industries. • The socio-cultural and institutional dimensions of the UE are analysed, including the influence of formal and informal norms, privatisation, poverty, self-employment and so on. • Influence on poverty

  4. What is the Underground Economy • The Underground economyencompasses all activities that are formally legal but ideologically are suspected; hence there is official tendency to discriminate them and give them an inferior status. It covers productive activities that are quite legal in themselves but which are concealed from public authorities to avoid taxes and similar charges. • Activities in "hidden" economy consist of undeclared legal production of goods and services, production of illegal goods and services, and concealed income in kind. • Tax evasion

  5. How to measure inmeasurable? • (1) a monetary approach; • (2) official statistics with arbitrary estimates; • (3) calculation and analysis of the structure of informal economy • (4) comparing the rates of activity in longer period or among different countries (if rates of activity are decreasing, it can be due to withdrawing from formal to informal sector); • (5) differences between income and consumption (if consumption is bigger than income this part of income can be realised in informal economy) • (6) using the data from national accounts; • (7) better control of taxpayers and tax obligations; • (8) examining the opinions of experts for particular part of economy; • (9) method of causes where the reasons that stimulate for the participation in the informal economy are analysed; • (10) electricconsumption.

  6. Various evaluation methods give different results, but according with the most applied methods (national accounting, discrepancy between income and expenditures method, labour force survey)in the Republic of Croatia the UE came on average to about 25% of GDP in the 1990-1995 period, and in 1996-2000 to an average of 10% of GDP. With reservations because of the uneven results obtained by these various methods and uncertainty whether this is a matter of a genuine reduction of the UE or of an improvement in statistics

  7. In 1996 the Institute of Public Finance did research into the UE in Croatia in the 1990-1995 period. The whole project has been published or participated in: • the journal Financijska praksa, 21 (1-2), 1997, (English Summery on http://www.ijf.hr/eng/fp/97/1-2/index.htm) • a summary in Bicanic and Ott (1997), The Unofficial Economy in Croatia: Causes, Size and Consequences. Occasional paper, 1 (3), November. Available at http://www.ijf.hr/. • an international conference on the UE in transition, works from which were also published in Financijska praksa, 21 (5-6), 1997 (English Summery on http://www.ijf.hr/eng/fp/97/5-6/index.htm) • the book of Edgar Feige and Katarina Ott, (1999) Underground Economies in Transition: Unrecorded Activity, Tax Evasion, Corruption and Organized Crime. Aldershot : Ashgate.

  8. Trends in the unofficial economy in Croatia could be influenced by • structural conditions (impoverishment, increasing inequality, unemployment, destitution of the public services), and • the institutional changes (privatisation, taxation policy, sanctioning). Reasons for UE were • the inherited tradition • the transition with its vigorous sector and institutional restructuring • the great influence of the government in the economy, particularly through paternalism and privatisation. • the high tax burden • unclear and non harmonised laws and regulations • the lack of the independence and resources of the courts • the lack of or insufficient organisation, efficacy, expertise and cooperation of state bodies. There is the obvious ambitions of the state to become large, expensive and paternalistic, to invest in economy or to subsidise it, which encourages new corrupt and illegal practices.

  9. A particular problem of the unofficial economy in Croatia is its involvement in privatisation, due to: • the quantity of the social capital included in privatisation, • the impossibility of measuring the unofficially economy in privatisation, • the attitude that privatisation auditing is a political rather than economic, legal and moral question, • the lack of transparency in regulations and the concentration of power in the hands of the state officials (lack of public accountability, appearance of the state clientelism, etc.).

  10. Detailed measures of economic policy necessary for the suppression of the UE were suggested, and particularly stressed that in attempts to reduce the UE it was more important to do away with the causes than to penalise the consequences. Most important was to: • reduce taxes and customs duties (to the extent permitted by the state budget) • reduce regulation (but selectively, without reducing, for example, regulation of the labour market, which is positive) • reduce the role of the public sector and the presence of the state in the economy while liberalising the economy • better estimate the size of the unofficial economy within the overall economy and in individual sectors

  11. New phase of the Project During 2001, the Institute of Public Finance went on with the previous research and started a new chapter in investigation of the UE in Croatia The whole project has been published or participated in: • the journal Financijska praksa, 26 (1), 2002, (English Summery on http://www.ijf.hr/eng/fp/02/1/index.htm) • IJF Occational papers - available at http://www.ijf.hr. • No. 15 Dollarisation and the Underground Economy: Accidental Partners?, Šošić & Faulend, • No. 14 Opportunism, Institutions and Moral Costs: the Socio-Cultural Dimension of the Underground Economy in Croatia 1995-1999 / Štulhofer & Rimac • No. 13 An Estimate of Tax Evasion in Croatia / Madžarević-Šujster, • No. 12 The Underground Economy in Croatia / Katarina Ott • An international conference Unofficial Activities in Transition Countries: Ten Years of Experience, on line available onhttp://www.ijf.hr/eng/index.html

  12. Various approaches to the measurement of the UE were applied: • the national accounts • monetary methods • labour force surveys • tax evasion

  13. It should be pointed out that comparisons of results obtained by different methods are very risky. The measurement of the UE via the national accounting discrepancy method always gives relatively low results, unlike monetary methods, which always give relatively high results Figure 1. Share of the underground economy in GDP according to different methods

  14. Although the discrepancy in the national accounting method has a number of drawbacks, this method does provide a general picture, and it can be considered the lower border for the share of the UE in GDP. It is a very good point of departure for complementation with alternative methods of UE estimation. • The discrepancy in the national accounting method determined that the UE in • the period 1991-1995 came to an average of 25.4% of GDP, • for the 1996-2000 period, the UE is estimated at an average 10.4%

  15. Some of the reasons and explanation • Such results seem fairly logical. In the earlier period in Croatia there was the war, hyperinflation, the beginnings of the transitions and reform, and in the second period stabilisation and the strengthening of the ethical and legal system. • Of course, one has to ask again how much this is a real reduction in the UE, and how much a better statistical coverage of the OE.

  16. Authors in Project have determined that in Croatia there is a negative correlation between the UE and GDP. Source: Madzarevic-Sujster and Mikulic (2001). Figure 2. Share of the underground economy in GDP (% of official GDP) Source: Madzarevic-Sujster and Mikulic (2001).

  17. Other methods • The results from monetary method are perhaps questionable, but are certainly indicative. The authors endeavoured to link up literature about the UE and dollarisation, suggesting this connection as a link that is missing, and which could enhance the quality of research into both areas.Since the measurement of underground dollarisation is in its infancy, this work is one of the pioneer attempts that, one can hope, will stimulate new research into the phenomenon. • According to the Eurostat method adjusted to the needs of transitional countries, employment data from official sources and labour force surveys are compared. This method covers illegal activities such as prostitution, drug dealing and so on. The difference of the officially recorded and the expected rates of activity of the population is analysed. • In Croatia the main component of the UE is work on the black, or unreported employment.

  18. Estimate of tax evasion From 1994 to 2000 the lower border of tax evasion shows a declining trend, from 8.5 to 5.5% of GDP, while the upper border up to 1998 was constant, and after that it fell from 11 to 7.5%. Figure 3. Comparison of tax evasion and the share of the UE (% of GDP)

  19. It is interesting that the upper estimate of tax evasion follows the tax burden until 1998, the rise of the tax burden in 1998 led to the rise in tax evasion, and in 1998-2000 the reduction of the costs of labour resulted in a reduction of tax evasion. Tax evasion is reducing, and we can be pleased with this. Nevertheless, 8.6 billion kuna (the lower limit) of missed revenue in 2000 is still a very large amount. The missed revenue is greater than, for example, the deficit of consolidated general government, which in 2000 came to 7.7 billion kuna.

  20. Estimates of the UE in individual industries Agriculture - for the whole of the 1990-1999 period, an average lower limit of 6.8% and an upper limit of 16.9%. Industry is a branch with a relatively low though growing UE trend, from 2.3% in 1996 to 5.2% in 1998. The growth or stagnation of the UE in industry, unlike the fall of the UE at the level of the economy as a whole, can be explained by the lagging of the transition in this activity. Trade. Although, depending on the definition, the results of estimates of the UE in trade vary a good deal, the trends are nevertheless identical – a sudden growth in 1990-1993, a sudden fall in 1993-1994, a mild decline or stagnation from 1995 on. Figure 4. The UE in agriculture, industry and trade (%) Source: Mikulic and Madzarevic (2001).

  21. The trends, however, are essentially different: the UE is reducing in trade, stagnating in agriculture, but rising in industry. The explanation might be fairly simple – the speed of the transition per sector, the development of a number of new, mainly small business units and the number of employees, the relative weakening of the importance of the big systems. In short, the transition was most rapid in trade, slowest in industry – hence this kind of result.

  22. The socio-cultural and institutional dimensions dimension of the UE The causes and dynamics of the UE cannot be understood outside the social and economic background of the area. This means that the reduction of the UE is necessarily based on the simultaneous action of social and cultural, legal and economic measures. In the theoretical assumption the dynamics of social opportunism coincides with the dynamics of the UE, since the rise in opportunism reduces moral costs. This, in turn, increases the readiness to get round or break the standards and - if it goes unpunished - sustains the expansion of opportunism.

  23. If we compare the results from 1995 and 1999, we will notice the following: • The level, in both diffusion and intensity, of opportunism has decreased. The number of those who think that tax evasion and bribe can never be justified has doubled. • The age structure of opportunism has remained unchanged – the youngest age group is still most apt to justify tax evasion and taking bribes. This gives ground for concern suggesting that the phenomenon might be long-lived. • Distrust in institutions has increased, and is once again most pronounced among the young. • Economic traditionalism has ceased to be a relevant factor; respondents are getting used to differences in wages and are, as it seems, embracing the principle of individual responsibility.

  24. In a society there are both formal and informal institutions, which are interwoven, that is the informal usually complement the formal. In the transitional countries, the formal institutions are incompletely articulated, not built up, and some do not even exist. The weakness of formal institutions contributes to the rise in the UE, crucial being an analysis of the costs and benefits of accepting (un)lawfulness.

  25. Privatization Most activities of the UE in the first half of the 90s, such as political clientelism, fictitious recapitalisation, failure to report or appropriation of the profits of firms, assets stripping, deliberate bankruptcies, corruption, bribery, abuse of official positions and so on went on in the second half of the 90s, with the new phenomena of irregularity in the privatisation of the banking sector and coupon privatisation. Because of the absence of political will, the non-existence of an effective and independent judiciary and the inefficient public control, the UE was maintained in privatisation during the whole of the decade.

  26. In analysing the poverty & unemployment, one could stress that in Croatia: • poverty is not the key generator of the UE, • the fact that the UE actually deepens inequality need not be equated with the creation of poverty, and • a certain level of the UE in every developed society is related to the poorest but this is not the segment of the UE towards which social measures need to be directed.

  27. Basic facts about poverty in Croatia (I) • Using an internationally comparable standard across transition economies (4.30 US dollars a day per person at purchasing power parity) it was found that the incidence of absolute poverty in Croatia is very low. This international standard, however, may not reflect adequately specific conditions of each society. For policy makers what matters is the extent of poverty based on nationally relevant standards. • There is no national official poverty line in Croatia. The World Bank study has estimated the level of total expenditures (including non-food items) of households in Croatia at which families, after paying for essential non-food expenditures, just attain minimal nutritional needs. • This level of expenditures represents therefore an absolute poverty line and amounts to 41,500 HRK (5,500 Euro) per year (in 1998 prices) for a couple with two children or 15,474 HRK (2,100 Euro) for an “equivalent adult”. Only around 10 percent of the Croatian population falls below this nationally specific poverty line. Poverty Rate with International Line 4.0% Poverty Rate with National Line 8.4%

  28. Basic facts about poverty in Croatia (II) • The poverty gap is 1.8% of total consumption, and that on average the consumption of a poor household is 20.7% below the poverty line. • To bring all poor above the poverty line with perfect targeting (i.e., each poor person is given a transfer exactly equal to the poverty gap) would cost 1 percent of GDP; and to give to all poor the amount equivalent to the poverty line would require 4 percent of GDP. • Therefore, it would be affordable for Croatia to completely eliminate absolute poverty.

  29. Basic facts about poverty in Croatia (III) • Those Who Have the Misfortune to be Poor are Seriously Deprived. • Life of the poor differs in many respects from the non-poor. The poor tend to live in overcrowded, poorly maintained dwellings; their diet is limited to basic staples (especially for the urban poor who can afford little beyond basic staples such as bread, potatoes or milk); and, they are poorly educated. Only few have savings; they are often immobile, and their social networks are very limited.

  30. The Poor Have Distinct Characteristics …. The poverty profile is dominated by two groups: • poorly educated individuals and the elderly. • Almost ¾ of the poor live in families where the head has primary education or less. They are likely to have bad prospects for finding employment when they are not employed, or have low earnings when they are employed. The risk of poverty is particularly high when poor education is combined with unemployment. • Low pension benefits or no pension at all in old age is the second cause of poverty: 40% of the poor live in households with a retired. In 1998 as many as 25 percent of all retirees did not receive pension benefits and about half of pension beneficiaries received pensions that were below the poverty line.

  31. In Combination With Limited Opportunities… • Poverty in Croatia has already many features of a permanent state: the poor are unlikely to escape poverty easily. This is due to two basic reasons: • there are limited economic opportunities because growth so far has not generated enough jobs. Many old jobs have been destroyed and very few new jobs have been created. Growth has benefited primarily those who kept their jobs. But for those locked outside employment, the effect was close to nil, if not negative. Furthermore, over-regulation of employment, especially constraints on layoffs, are limiting opportunities for small businesses and flexible working arrangements, both of which could constitute a viable alternative to wage employment for the poor; and

  32. … Make Them Likely to Be Stuck in Long term Poverty • The poor are at a disadvantage to benefit even from this limited set of opportunities. Once locked outside employment, unemployed and economically inactive have limited possibilities to break the circle of impoverishment. Over half of the unemployed are long-term unemployed, so analysis of labor market flows suggests that both unemployed and inactive are unlikely to find a new job. • Most of working age individuals who are not employed have either very low educational endowments (primary) or narrowly formed skills (vocational schools graduates). Those who are currently locked outside remunerative employment due to their level of education are also likely to see their limited opportunities perpetuated for their children.

  33. Almost crucial question in solving poverty is employment (im)possibility. It is most important for employment to start to rise, because then, all those who are in the UE not from their own will but because it is the only way out will start to go over from the UE to the OE. With a rise in employment, the income of the population will rise and this will have an effect on a reduction in the UE and poverty.

  34. A propensity to evasion of pension contribution will be crucially affected by an inadequate link between contributions and pensions, an unjust system with many (high) privileged pensions, without the payment of contributions, and circumstances in which a contribution is not a condition for being able to claim pension rights. According to the Croatian Pension Fund in 2000 about 82% of contributions were collected.

  35. The analysis of inefficacy of the judiciary warns of some apparent problems and possible solutions: • it is important to encourage transparency in public tenders and contracts clearly to determine authorities and responsibilities of public servants and the opportunities they have for discretional decision-making • the courts can have their load lightened by the encouragement of arbitration of disputes. • the adoption of clear intelligible, unambiguous and lasting laws, which will have an affect on the growth of the efficacy of the judiciary, greater resistance towards unlawful behaviour, the dissemination of the rule of law and democracy and, indirectly to a reduction of the UE and unlawful forms of behaviour. • Unfortunately, key factors such as the transparency and quality of public services are still not developing with adequate speed, and quite a lot of time is still required for them to be improved.

  36. THE PROJECT CONTAINS MANY RECOMMENDATIONS OF MEASURES NECESSARY FOR THE REDUCTION OF THE UE • SHORT GENERAL RECOMMENDATIONS • GENERAL INSTITUTIONAL MEASURES • MEASURES IN THE PRIVATISATION PROCESS • MEASURES IN STATISTICS • REFORM OF THE TAX SYSTEM • ENCOURAGEMENT OF EMPLOYMENT • THE JUDICIARY Better to obviate the causes than penalise the consequences. Thank you for your attention

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