CER | The Black Market in Eastern Europe

The Blessings of the Informal Economy
Part II:
How to kick the habit—slowly
Sam Vaknin

Read Part I of Sam Vaknin's The Blessings of the Informal Economy series of articles first

The black economy is especially important in times of economic hardships. Countries in transition are a private case of emerging economies, which are in turn a private case of developing countries, formerly called (in less politically correct times) "third-world countries."

They suffer from all manner of acute economic illnesses. They lost their export markets, they are technologically backward, their unemployment skyrocketed, their plant and machinery are dilapidated, their infrastructure is decrepit and dysfunctional, they are lethally illiquid, they become immoral societies (obligations not honoured, crime flourishes), their trade deficits and budget deficits balloon and they are conditioned to be dependent on handouts and dictates from various international financial institutions and donor countries.

The perfect answer

Read the above list again. Isn’t the black economy a perfect solution until the dust settles?

It enhances exports (and competitiveness through imports), it encourages technology transfers, it employs people, it invests in legitimate businesses (or is practised by them), it adds to the wealth of the nation (black marketeers are big spenders, good consumers and build real estate), it injects liquidity to an otherwise dehydrated market. Mercifully, the black economy is out of the reach of zealous and ignorant missionaries such as the IMF. It goes its own way, unnoticed, unreported, unbeknownst and untamed.

It doesn't pay attention to money supply targets (it is much bigger than the official money supply figure) or to macroeconomic stability goals. It plods on: doing business and helping the country to survive the double scourges of transition and Western piousness and patronizing. As long as it is there, the countries in transition have a real safety net. Their governments are advised to turn a blind eye to it, for it is a blessing in disguise.

There is one sure medicine: eliminate the population and both unemployment and inflation will be eliminated. Without the black economy, the population of countries such as Macedonia, Yugoslavia, Belarus, Moldova, Bulgaria, Russia and Ukraine would not have survived. This lesson must be remembered as governments prepare to crack down on the only sector of the economy which is still alive and kicking.

Kicking the habit

Granted, the informal economy is an addiction to a dangerous and criminally inclined drug. Any reforms should be gradual. The informal economy is an important pressure valve for the release of social pressures, it ameliorates the social costs inherent to the period of transition and it constitutes an important part of the private sector.

The reasons for the existence of an informal economy in the countries in transition are no different to other parts of the developing world:

High taxation level (usually, high payroll taxes, a pernicious hangover from Communist times)
Onerous labour market regulations
Red tape and bureaucracy (which often leads to corruption)
Complexity and unpredictability of the tax system
Dysfunction of institutions

Some countries in transition have been more successful than others in battling the informal economy and confining it to niche activities (such as domestic help, car servicing or baby sitting). There are characteristics common to the more successful plans to wean the economy off its informal propensities in countries such as Croatia, Bulgaria, Hungary and others. Here is a survey of the more successful measures implemented by more than 20 countries from Kazakhstan to Macedonia:

Reporting requirements and transparency

All banks are obliged to report foreign exchange transactions of (usually) more than DEM 10,000 (whether in one transaction or cumulatively by the same legal entity). Daily reports are submitted to the cenrtal bank. In extreme cases, the transactions are investigated.
All account numbers of all the firms in the economy are made publicly available.
Firms are obliged by law to make a list of all their bank accounts available to clearing exchanges (such as the ZPP in the republics of former Yugoslavia), to the courts and to plaintiffs in lawsuits.
All citizens are obliged to file annual, personal tax returns (universal tax returns, like in the USA). This way, discrepancies between personal tax returns and other information can lead to investigations and discoveries of tax evasion and criminal activities.
All citizens are obliged to file bi-annual declarations of personal wealth and assets (including real estate, vehicles, movables, inventory of business owned or controlled by the individual, financial assets, income from all sources, shares in companies, etc).
All retail outlets and places of business are required to install—over a period of three years—cash registers with "fiscal brains." These are cash registers with an embedded chip. The chips are built to save a trail (detailed list) of all the transactions in the place of business. Tax inspectors can pick the chip at random, download its contents to the tax computers and use it to issue tax assessments. The information thus gathered can also be crossed with and compared to information from other sources. Experience in Bulgaria, for instance, has shown this to be a mildly effective measure. The overall effect seems to be more an increase in business costs than the prevention of cash or otherwise unreported transactions.
All taxis are equipped with taximeters, which include a printer. This is a licencing condition.
Industrial norms (for instance, the amount of sugar needed to manufacture a weight unit of chocolate, or juice) were revamped in most of these countries. Norms are no longer determined according to statements provided by the factory—but by a panel of experts. Each norm is signed by three people, of which at least one is an expert engineer or another expert in the relevant field. Thought was clearly dedicated to the possibility of employing independent laboratories to determine norms and supervise them.
Payments in wholesale markets is done through a clearing house or banking outlet in the wholesale market itself. Release of the goods and exiting the physical location of the wholesale market is allowed only against presentation of a ZPP payment slip.

Reduction of cash transactions

Cash transactions are the lifeblood of the informal economy. Their reduction and minimization is absolutely essential in the effort to contain it. One way of doing it is by issuing universal payment (debit) cards to businesses, firms and professionals. Where this was done (on a pilot basis), use of the payment cards is mandatory in certain business-to-business transactions.
All exchange offices are obliged to issue a receipt for every cash transaction above DEM 100 and to report to the central bank all transactions above DEM 1000.
Suspicious transactions (for instance, transactions which exceed the financial wherewithal of the client involved) are duly investigated.
Some governments chose to reduce payroll taxes if the salary is not paid in cash (for instance, by a transfer to the bank account of the employee). The difference between payroll taxes collected on cash salaries and lower payroll taxes collected on noncash salaries is more than recovered by imposing a levy on all cash withdrawals from banks. The banks withhold the tax and transfer it to the state coffers monthly.
Currently, in most economies in transition, checks in checkbooks issued to account-holders by banks are virtually guaranteed by the issuing banks. This transforms checks into a kind of cash and checks are used as cash in the economy. To prevent this situation, some countries made all checks payable to the beneficiary only. The account-holder is obliged to furnish the bank with a monthly list of checks he or she issued and their details (to whom, date, etc). Checks are valid for five working days only.
Businesses are obliged to effect payments only through their accounts (by wire transfer) or using debit cards. Cash withdrawals are subjected to a withholding tax deducted by the bank. The same withholding tax is usually applied to credits given against cash balances or to savings houses or credit unions. Alternatively, savings houses and credit unions are also obliged to deduct, collect and transfer the withholding tax on cash withdrawals.
In the extreme and when all other measures failed, some countries decreed that all foreign trade-related payments are to be conducted through the central bank. But this is really a highly irregular, emergency measure, which was rarely implemented and had the effect of over-burdening the central bank and transforming it into a hub of corruption.
The interest paid on cash balances and savings accounts in the banks is increased (starting with bank reserves and deposits in the central bank). The issuance of checkbooks is made easy and convenient. Every branch of every bank issues checkbooks. All the banks and the postal bank honour and accept each other's checks.
A real-time gross settlement system was established or is being implemented in most countries in transition. This has the effect of minimizing float and facilitating interbank transfers.

Government tenders

Firms competing for government tenders are obliged to obtain a certificate from the tax authorities that they owe no back taxes. Otherwise, they are barred from bidding in government tenders and RFPs (Requests for Proposals).

Sam Vaknin, 27 November 2000

Part III will appear in next week's CER

The author:

The author is General Manager of Capital Markets Institute Ltd, a consultancy firm with operations in Macedonia and Russia. He is an Economic Advisor to the Government of Macedonia.

DISCLAIMER: The views presented in this article represent only the personal opinions and judgements of the author.

Moving on:

After the Rain cover

After the Rain:
How the West Lost the East

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