DETERRENCE, TAX MORALE AND UNDECLARED WORK – SOME LESSONS FROM CROATIA Colin C Williams, The University of Sheffield Josip Franic, The University of Sheffield

Overview: Definition and terminology Typology of policy strategies to tackle undeclared economic activities Case study – Croatia Discussion and conclusion

Definition and terminology No universally adopted definition No common name to describe the phenomenon “any paid activities that are lawful as regards their nature but not declared to the public authorities, taking into account differences in the regulatory system of Member States” Off-the-books work Undeclared work Informal Economy Cash-in-hand work Grey Economy Irregular Economy Shadow Economy Non-official Economy

Typology of policy strategies No standard recipe to tackle the phenomenon Range of possible strategies, which vary according to: APPROACH TARGET POPULATION Rough categorization of available measures to tackle undeclared work: INDIRECT CONTROLSDIRECT CONTROLS

Direct controls seek to change cost-benefit ratio of unregistered work a)by trying to improve detection or introducing harsher penalties. Main rationale is to deter people from evasion – DETERRENCE MEASURES or STICKS or b) by rewarding compliant behaviour (i.e. increasing benefits of declared work) - CARROTS. Here we distinguish between two categories: Preventative measures – seek to intercept noncompliance in the beginning Curative measures – target those already operating in the undeclared economy

Indirect controls strive to reduce institutional incongruence Their goal is to improve the psychological contract that exists between the state and citizens and foster voluntary tax compliance. The key factor of interest is ‘tax morale’ – individual’s intrinsic willingness to pay taxes. How to improve the psychological contract and tax morale? a)CHANGE THE INFORMAL INSTITUTIONS – tax education, awareness raising campaigns, normative appeals b)REFORM THE FORMAL INSTITUTIONS via improvement of procedural justice, procedural fairness and redistributive justice

Data and methodology Data from 1,000 Croatians surveyed during 2013 as part of the Special Eurobarometer 402 Logistic regression – 2 models (labour supply side & demand side) Dependent variables : 1) dummy variable indicating whether a respondent carried out undeclared work during 12 months preceding the survey 2) dummy variable indicating whether a respondent acquired undeclared goods and/or services during 12 months preceding the survey

Logistic regression

EXPLANATORY variables - deterrence Detection risk: Expected sanctions: very smallfairly smallfairly highvery high normal tax or social security contributions due normal tax or social security contributions due, plus a fine prison

EXPLANATORY variables – Tolerance of undeclared activities Attitudes towards four types of unregistered practices: 1)Undeclared work by individual for private household 2)Undeclared work by firm for private household 3)Firm hires a worker on an undeclared basis 4)Someone partially or completely conceals their income Factor analysis applied to reduce the dimensionality -> a single latent factor measuring one’s level of tolerance

Control variables

Participation in undeclared work Purchase of undeclared goods and services Detection risk (RC: Very small) - Fairly small0.609 (0.474) (0.224) - Fairly high (0.580) (0.267) - Very high (1.119)-0.963* (0.415) Expected sanctions (RC: Tax or social security contributions) - Tax or social security contributions plus a fine0.887 (0.525)0.401 (0.226) - Prison1.148 (0.838)0.205 (0.495) Tolerance0.463*** (0.112)0.156** (0.053) Female-1.508*** (0.401)0.106 (0.181) Age-0.025* (0.014)-0.015* (0.007) Occupation (RC: Unemployed ) - Self-employed (0.761)0.795 (0.519) - Employed (0.491)0.493 (0.285) - Inactive (house persons, students, etc.) (0.662) (0.357) - Retired (0.698)0.419 (0.367) Financial problems (RC: Most of the time) - From time to time-1.458*** (0.457)0.202 (0.251) - Almost never/never-1.255** (0.444)0.143 (0.248) Urban area-1.691*** (0.409)0.266 (0.205) Region (RC: Zagreb) - North Croatia-3.611*** (1.125) (0.304) - Slavonia-1.227* (0.543) (0.296) - Lika and Banovina-2.292* (1.057) (0.461) - Istra, Rijeka and Gorski Kotar (0.593) (0.305) - Dalmatia-1.168* (0.543)0.194 (0.273) Cons1.421 (1.205)-2.070**(0.655) Number of observations1,000 Number of imputations50 Prob > F Area Under ROC Table 1 Determinants of undeclared work in Croatia, logistic regression

Figure 1 Predicted probability of participation in undeclared economy of a ‘representative’ Croatian citizen: by tax morale and age The representative citizen - an unemployed woman who lives in an urban area of Slavonia, faces financial problems from time to time, perceives the risk of being detected as fairly small and expects to pay a financial fine alongside the tax or social security contributions due when detected participating in the undeclared economy. Tolerance

Figure 2 Predicted probability of participation in undeclared work of a ‘fearful’ Croatian prone to undeclared work: by tax morale and age The ‘fearful’ citizen – a self-employed male living in the capital who regularly struggles to pay his bills, perceives the risk of being detected as very high and expects imprisonment in the case of detection.

Conclusion Weak psychological contract between the state and its citizens is a significant driver of undeclared practices in Croatia No significant association between participation in undeclared work and deterrence Weak rule of law in Croatia Need for a change in policy approach – from direct to indirect controls