1. Preliminary conclusions and tentative policy options Hidden Economy Workshop Budapest December 5-6, 2007 Preliminary and for discussion only

2. Notes (1) Informality only part of fiscal problem  Hungary already collects high % of GDP in taxes. Expenditures very high. Fiscal only part of informality problem  Concerns should also include competitiveness, social welfare Tradeoffs in combatting informality  Slow down economic growth? Price people out of economy? Preliminary and for discussion only

3. Notes (2) Terms of reference for study emphasize concrete recommendations … But need for underlying analysis  Scale and composition of informal sector  Understanding incentives, motivations  Attitudes As well as analysis of specific areas for potential interventions Weak evidence base internationally on what works in terms of specific interventions Preliminary and for discussion only

4. Simple model of informality and needed responses Informal economy due to Requires Exclusion because of regulatory and other barriers Exit when entrepreneurs and workers choose to operate informally Removal of barriers to operate formally Reducing the costs and increasing the benefits of operating formally (Carrots) and Increasing the costs and reducing the benefits of operating informally (Sticks) Preliminary and for discussion only

5. Potential areas for reforms Tax and benefit systems Business and labor market regulations Enforcement and sanctions Public information and education Note that following policy ideas are preliminary and incomplete Preliminary and for discussion only

6. Tax and benefit systems (1) Most important area for addressing undeclared economic activity/employment Taxes create disincentives for formalization  But they are also not competitive with tax regimes in neighboring countries So tax reform needs to be based on overall efficiency and competitiveness (within framework of fiscal consolidation) and not just “whitening” the economy Preliminary and for discussion only

7. Tax and benefit systems (2) Labor taxes (PIT, social contributions) are high and discourage formal employment, especially low-wage labor Favorable tax treatment of non-labor income encourages underreporting of employment earnings Further disincentives created by serious spikes (e.g., employment income tax credit) Design of social benefits and programs likely encourages undeclared work Preliminary and for discussion only

8. Tax and benefit systems (3) To extent feasible, employer social insurance contributions should be reduced  Targeted reductions for workers overrepresented in low- wage employment have biggest impact on formalization Compensate for reductions in revenues with other taxes (e.g., dividend, VAT, real estate)  Set revenue target and allocate any added revenues due to better compliance to tax rate cuts in next year More comprehensive reform -- Flat tax with high personal exemption and comparable rates for earnings and profits? Preliminary and for discussion only

9. Tax and benefit systems (4) Employment tax credit – encourages formalization but more gradual phasing out Assess minimum contribution base as double minimum wage – do added receipts justify decreases in formal employment? Consider other options to tie social contribution/tax bases to assumed productivity  E.g., Bulgarian example of differentiated minimum thresholds determined by social partners  E.g., Presumptive taxation of self-employed and small companies Preliminary and for discussion only

10. Tax and benefit systems (5) Evidence suggest prevalence of combining undeclared work with receiving public beenfits For unemployment benefit (and some social assistance) recipients  Implement “activation” policies – closer monitoring and stricter job search requirements, combined with subsidies for hiring employers; and/or  Allow some earned income while collecting benefits High proportion of older workers are undeclared  Are reforms in pension/disability provisions needed? Preliminary and for discussion only

11. Business and labor market regulation (1) Assessment that regulation is not a major factor Business regulation reforms in recent years have reduced costs of compliance Further steps  Complete planned reforms for business start-ups  Simplify licensing procedures Preliminary and for discussion only

12. Business and labor market regulation (2) Although some employers cite labor market regulation as a problem, review suggests that it is not a serious barrier to formal employment Minimum wages should be kept relatively low Involve social partners in fight against undeclared work  E.g., commitment to fight undeclared work in collective agreements Preliminary and for discussion only

13. Enforcement and sanctions Tax collection efficiency lower than in other EU countries Consider further consolidation of various institutions Should APEH be restructured (by taxpayer, not function)? Labor inspectorate – investment in training and exposure to latest international practices Preliminary and for discussion only

14. Public information and education Segmented communication plan Position tax evaders as minorities and underline criminal nature of evasion Address fairness issue by highlighting sanctions on rich and powerful Link tax paying with publicly provided services and benefits Preliminary and for discussion only