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Raphael Markelos*

In recent years, D.P. has declared to the tax authorities no more than 10% of his incomes. According to him, his competitors have done so and therefore, how may he act in another way? And in view of the crisis... He does not find unfair not to pay, after his family is not a burden to the state. He does not interfere with anyone. When he needs a doctor, he sees a private one. As for school, he has paid a bunch of money to private schools, i.e. free education is a myth too. And the family provides for the unemployed child. The roads are bad, it is not worth paying anything for them.

"What has the state done for me?", he thinks. The state is an enemy, never a friend. Even if you pay taxes, they will go for bribes, payoffs and for the debts of the others. The tax is a punishment, money for nothing. Not the mention the troubles with accountants, laws and regulations. Ultimately, the law is the right of the family.

Those who pay, however, do not find this situation unfair either.

Civil servants have the security of the easy job, secure wage and comfortable living. Large companies might pay something but surely find other ways to avoid paying taxes. In the end, all settle their affairs in some way. It is hard to be caught, it is difficult for someone to do something to you, of course.

Naturally, D.P. does not want a receipt from anyone. Conversely, he is offended when he is offered one. He is glad if he can help a fellow citizen and share the plunder, if possible. Sometimes, however, there are some strange people who want to pretend to be law-abiding, though it costs dearly to all. The truth is that eventually he and his family are proud to able to pay so little taxes. However, is his country as well as he is? Are there some who fail to cope and suffer? Why do banks lend neither to him nor to his country? Does his child want to stay in this country? After all, who is to blame?

Motives

The informal economy consists of activities that are not officially registered and therefore not taxed but that contribute to the economy. However, why does a man decide to evade taxes? Why does the same person change his behaviour depending on the country in which he is? The main scientific explanation in terms of finance suggests that the informal economy is created after the evaluation of the benefits and costs for the people. There is a clear direct monetary benefit from the activities of the informal economy (e.g. tax evasion, non-payment of social security contributions, preservation of social benefits).

But there is the advantage of unregulated flexibility offered by the informal economy (e.g. in terms of health, environmental and labour regulations). This flexibility becomes very valuable when the legal and regulatory framework is particularly complex, unclear, changeable and restrictive. Corruption at the state level further stimulates tax evasion and limits the effectiveness of control mechanisms.

The lack of rule of law means that the people and businesses operating in the informal economy have significant competitive advantages to the law-abiding businesses whose development becomes unbearable. In addition to the threat of the imposition of fines and legal consequences, the disadvantages of the informal economy may include the lack of access to certain types of state aid (e.g. hospital care, pension and social security system) and private services (e.g. banking, insurance). Another disadvantage may be the rejection on the part of the family or the social circle.

Turning inward and disrespect for institutions

However, what are the collective consequences of tax evasion for the economy of a country?

• The informal economy limits the public resources and investment. This leads to a vicious circle of increasing taxes, which in turn strengthens the incentives for tax evasion.

• The exercise of politics becomes especially difficult, as the exact state of the economy is unknown. And because the people and businesses are forced to act outside the banking sector, the interest and liquidity policy is ineffective.

• Due to the lack of bank lending, funding is limited and particularly expensive.

• The absence of healthy competition between companies leads to lower productivity, turning to the domestic market and limiting international competitiveness.

• Finally, a serious negative consequence of the informal economy is that it leads to the establishment of an atmosphere of disrespect for the state institutions and the rule of law.

In addition to the negative assessment of the informal economy as a "parasitic" activity, there is a positive "romantic" perspective. According to it, the informal economy favours the development of business when the conditions in the formal economy are not favourable (e.g. due to bureaucracy, corruption). The revenues from the informal economy and tax evasion ultimately have a positive effect as they increase consumption and saving.

The research on how the informal economy affects growth produces conflicting conclusions. In a recent study prepared by Raphael Markelos (Norwich Business School, University of East Anglia), Dimitris Psichoios (University of Piraeus) and Friedrich (Johannes Kepler University), the authors investigate the effects of tax evasion in 64 countries in the pre-crisis period.

There are major differences in the scope of the informal economy, even between the developed countries that are studied. Among the countries of the Organisation for Economic Cooperation and Development, the champions in terms of the informal economy are Greece (26.86% of GDP), Italy (26.96%), Portugal (23.12%) and Spain (22.38%). It should be noted that these countries have played a major role in the recent debt crisis in the euro zone. It is clear that the countries with a significant informal economy have a number of negative features. It should be also emphasized that the significant informal economy does not necessarily mean economic problems, as there are exceptions. For example, the share of the informal economy in the Nordic countries is close to the average for the euro area (18%).

High borrowing costs

The main conclusion from the study is that the countries with a large informal economy have higher borrowing costs through government bonds and a low credit rating. Countries such as Switzerland, the US, Luxembourg, Austria and Japan have the lowest levels of informal economy in the world (between 8% and 11% of GDP) and the lowest borrowing costs (under 4%).

In countries such as Panama, Peru, Uruguay, Honduras and Sri Lanka, where more than half of the economy pays no taxes, credit costs are in the range of 7% and 10%.

Expensive loans from the markets

The study results support the argument that limiting the tax evasion will help countries such as Greece, which have serious problems borrowing from the international bond market. In statements on the issue Raphael Markelos says, "in view of the euro zone crisis, any new conclusion about how to form the cost of credit is valuable. Tax evasion limits the ability of a country to have access to cheap financing from international markets. This in turn has adverse effects on the entire spectrum of the economy, including social payments, investments, employment, rising prices, the availability of cheap loans to businesses and households. In modern economies, everything is closely linked to the credit rating of the country in which one lives." Especially interesting is the comment of Friedrich Schneider, who is a world-recognized authority in the field of study of the informal economy, "The crisis-stricken countries in recent years have high levels of informal economy. This drives us to conclude that tax evasion is part of the problem but of the solution too. We should not ignore the likelihood of eliminating tax evasion having negative side effects on the vulnerable groups of the population and the economy, especially in times of crisis."

* Raphael Markelos is a Professor of Finance and research director at Norwich Business School, University of East Anglia.