1. Minimum Wage and Tax Evasion: Theory and Evidence Mirco Tonin University of Southampton Warsaw, 29 November 2007

2. Objective of the paper: study the interaction between minimum wage and underreporting of earnings by employed labour build a formal model test some of the implications Basic idea: minimum wage is a lower bound for declared earnings in the formal sector

3. Plan of presentation: Some evidence on underreporting Review of related literature Model Empirical evidence

4. Relevance of underreporting (I) “Envelope wages" above the officially declared minimum "exists in practically all of the Central and Eastern European countries" (European Commission, 2004.) In Eastern Europe and the Former Soviet Union “disproportionately high shares of workers cluster on declared wages at or just above the minimum wage, with evidence of additional undeclared incomes above the minimum” (World Bank, 2005.) OECD (2004) estimates a 30% shortfall in social security contributions due to undeclared incomes in Hungary, Mexico, and South Korea and 20% in Italy, Poland, Spain and Turkey.

5. Relevance of underreporting (II) “Did you know that more than half of the people nominally employed at the minimum wage earn more, and the only reason for such a declaration is to evade taxes and social security contributions?”

6. Related literature Minimum Wage: impact on employment (Card and Krueger, 1995; Neumark and Wascher, 2006), job composition (Acemoglu, 2001), fringe benefits (Simon and Kaestner, 2004), training (Booth et al., 2004), prices (Lemos, 2006), working hours (Stewart and Swaffield, 2006), profits (Draca et al., 2006); Tax Evasion / Informal Economy: models with a separate informal sector (Fugazza and Jacques, 2003; Boeri and Garibaldi, 2005), models with partial compliance (Cowell, 1985; Kolm and Nielsen, 2005); Empirical literature (microdata): surveys (Lemieux et al., 1994), comparison of income and participation data from different sources (Fiorio and D’Amuri, 2005), comparison of income and consumption data (Pissarides and Weber, 1989; Gorodnichenko and Sabirianova, 2006; Feldman and Slemrod, forthcoming);

7. Model Competitive labour market Free entry of firms Risk neutral firms Firms act as withholding agent No capital Production = labour input

8. y : worker’s productivity w : worker’s gross wage / labour cost t : proportional tax rate (PIT and SSC) Objective functions: Firms: Workers:

9. … but there is Tax Evasion! x : declared income ỹ : detected income γ : probability of auditing θ : 1 + fine on evaded taxes Equilibrium with No Tax Evasion

10. Enforcement of taxation (I) y xy-x ỹỹ fine base

11. Enforcement of taxation (II) f : expected fine in case of auditing if ỹ distributed uniformly over [0,y]:

12. Equilibrium without minimum wage (I) Declared income is chosen to maximize total income net of expected payment to fiscal authorities

13. Equilibrium without minimum wage (II) where:

14. Equilibrium without minimum wage (III) Free entryZero profit condition

15. Equilibrium with a minimum wage Declared income is given by the solution to unaffectedout of formal labour market y

16. Example α =33% Minimum Wage=80 High Productivity Worker: y = 150 => x* = 100 Intermediate Productivity Worker: y = 100 => x* = 66 Low Productivity Worker: y = 30 => x* = 20

17. Effects on distribution of declared earnings x 0 affected unaffected

18. Effects on incomes of an increase in MW Workers operating already underground Workers declaring before the minimum wage increase between the old and new minimum wage Workers declaring already more than the new minimum wage

19. An empirical test: Hungary 2000-2001 2001: MW increased from 25500 HUF (98 EUR) to 40000 HUF (156 EUR)

20. Institutional context (I) Minimum Wage: relates to gross monthly earnings net of overtime pay, shift pay and bonuses; legally binding; covers all employment contracts 1998-2002: set unilaterally by government Taxation: tax wedge on low wage earners around 46% in 2000-2001, marginal rate around 56%

21. Institutional context (II) Informal economy: 56% of households are aware of the practice of employers declaring to the tax authority the minimum wage, while paying additional wage unofficially, taking place in their neighbourhood Informal Economy around 25% of official GDP in the period 1999-2003 (Schneider, 2005) Size of Undeclared work around 18% of GDP in 1998 (Renooy et al. 2005)

22. Effects on the labour market “Despite the brutal price shock the immediate effect did not seem dramatic” Kertesi and Köllő (2003) 1.High levels of compliance with minimum wage regulation; minor spillover 2. Jobloss risk of minimum wage workers: Male, 25 years old, 5 years tenure: QQ outflow to unemployment rates: Treatment (90-110% MW 2001) : 0.243% Control (110-125% MW 2001) : 0.119% 3. Outflows from unemployment Job finding probability of low-wage unemployed relative to unskilled as a whole dropped by 7-8% in 2001

23. 2000 y: 250 € x: 98 € Net I (reported): 78 € Net I (true): 250-70 = 180 € 2001 y: 250 € x: 156 € Net I (reported): 120 € Net I (true): 250-107 = 143 € 2000/2001 ΔNet I - reported = + 42 € - true = - 37 €

24. Empirical strategy Minimum wage hike in 2001: shock to “underreporting technology” for affected group Difference-in-Difference Approach: Treatment group: households affected by MW hike Control group: “similar” but unaffected households where c i,t : food consumption for household i at time t Estimated equation:

25. The dataset – the sample Household Budget Survey: 10000 households interviewed every year One-third of the sample is rotated every year 2Y panel: around 3500 households for 1999- 2000 and 2000-2001

26. Main variables Food consumption: distinction between food bought in the market and food produced at home Income: distinction between income including or not home production Month dummies: month of diary keeping in two consecutive years Geographical dummies: 20 counties + type of settlement Employee characteristics: number of HH members employed in: Sector (60 branches) Hierarchical position (10 categories) Type of employer (4 categories)

28. Definitions of treatment “Actual Treatment” defined on characteristics in 2000 and 2001 can also account for “intensity of treatment” “Potential Treatment” defined only on the basis of characteristics in 2000 perform a “placebo test” using 1999-2000 panel

29. “Actual Treatment” - Treatment at individual level CC All employees for the whole 2001 150% (200%) MW 200190% MW 2001 Wage 2000 Wage 2001 Public SectorPrivate Sector 150% (200%) MW 2001 Wage 2000 Wage 2001 T 90% MW 2000 110% MW 2001 90% MW 2001110% MW 2001

31. TREAT i : number of HH members treated ( i.e. belonging to T ) Regression run on all households: where at least one member belongs to T or C with constant family structure with positive net income below 200,000 HUF in both years “Actual Treatment” - Treatment at household level

32. Descriptive Statistics

33. Household Total Net Income: Kernel Density Estimation

34. Results (I) -1500 HUF ≈ -5.8 EURReminder: ΔNet I (true)= - 37 €

35. Results (II)

36. Continuous Treatment - Definition 40,000 HUFWage 2000 d : ∑ j d ij Private employees in 2001 Wage in 2000: [90% MW 2000 – 100% MW 2001] Wage in 2001: [90% MW 2001 – 100% MW 2001]

37. Continuous Treatment – Results (I)

38. Continuous Treatment - Results (II)

39. Private Sector Public Sector MW 2000MW 2001150% (200%) MW 2001 T Sector 2000 Wage 2000 C “Potential Treatment” - Treatment at individual level All employees for whole period (24M) :

41. “Potential Treatment” - Treatment at household level TREAT i : number of HH members treated ( i.e. belonging to T ) Regression run on all households: where at least one member belongs to T or C with constant family structure with positive net income below 200,000 HUF in both years

42. Household Total Net Income: Kernel Density Estimation

43. Results (I)

44. Results (II)

45. Robustness checks Other controls: income change & income level, own production of food Other types of consumption “Placebo test”: replication assuming that a minimum wage in 2000 equivalent to 50,000 HUF (instead of 25,500), increasing in 2001 to 64,500 HUF (instead of 50,000) “Hand-to-mouth” households

46. Other (theoretical) results The interaction of minimum wage and underreporting transforms a nominally neutral tax system into a regressive one When underreporting is high fiscal revenues increase with the minimum wage Under some conditions, the size of the spike at minimum wage level and the size of the informal economy are positively correlated

47. Link between informal economy and size of the spike (I)

48. Link between informal economy and size of the spike (II)

49. Link between informal economy and size of the spike (III)

50. Thank you for your attention!

51. h Extension – Working Time y xy-x τ h-τ