Incentives for Undeclared Work Prepared for Project on Undeclared Work in Hungary Jan Svejnar December 2007

Theoretical considerations Informal (undeclared wage) sector Fallback (necessity) Need policies for acquiring capabilities (or change regulation) Simply enforcing taxes and regulations => fall in jobs and GDP, and increase in unemployment Choice (optimization) Incentives to avoid paying taxes high when taxes and benefits not tightly linked => distortions Distortions = labor supply to the taxpaying sector becomes more limited, while in the informal sector employment goes up and productivity down => may lead to slower growth of GDP

Theoretical considerations (2) If workers have incomplete information about or time-inconsistent view of social security (old age) benefits => less likely to work in formal sector => greater enforcement could increase welfare Tax morale (inverse of tolerance of tax evasion) matters => expenditure accountability, governance, and public info. campaign = important issues Watch out for unintended impacts (e.g., tiered tax system by size of business => disincentive to grow)

Empirical Approach Using October 2007 TARKI survey of individuals we estimate the determinants of % of wages the respondent thinks a typical company in his business declares for tax and social contributions whether respondent or his employer pays for unemployment insurance perceived effectiveness of reducing labor costs to employers as a measure to reduce undeclared work Since individuals/firms vary in degree to which they view taxes as prepayment of benefits, explanatory variables are characteristics of firms/jobs characteristics of workers

Empirical Estimates – Declared Wages Table 1 – OLS results on % of wages declared Respondents in more formal parts of economy think firms declare less than do respondents in less formal parts More formal = individual that has more other income qualifies for severance payments has trade union in his/her workplace has written work contract lives in central region of Hungary Exception = having a permanent contract has a positive effect on the perception of how much firms declare Respondents who have children (responsible, risk averse) think firms declare less than do respondents with no children

Estimates – Paying for Unemployment Insurance Table 2 – only few systematic determinants of whether the respondent or his employer pay for unemployment insurance = probability of paying unemployment insurance is not strongly related to observable characteristics of the individual and firm/job Workers in construction are in firms that are less likely to pay for unemployment insurance Workers with written contracts are in firms that are less likely to pay for unemployment insurance (?)

Estimates – Reduction of Labor Costs to Employers Table 3 – only few systematic determinants of whether the respondent views a reduction in costs for employers (minimum wage, severance, etc.) as an effective strategy for reducing undeclared work = probability of respondent viewing a reduction in costs for employers is not strongly related to observable characteristics of the individual and firm/job The probablilty of the strategy being viewed as effective is higher for those working in construction and in Central Hungary

Discussion Survey – uneven evidence of undeclared wage sector Only about 2% of respondents report non-payment of contributions for pensions or health insurance About 18% report non-payment of contributions for unemployment insurance Few worker or firm/job characteristics affect probability of unemployment insurance payment view that reducing labor costs to employers constitutes an effective strategy for combating undeclared work Individuals in the formal sector think undeclared wages are more of a problem than individuals in the less formal sector – Why (stereotype, truth telling)?