Georgia’s underground economy – Georgia Today on the web


From the ISET Economist blog (www.iset.ge/blog)
Economic activities that are not recorded (and therefore not taxed) are commonly referred to as Shadow economy Where Underground economy. Are there dark corners in the Georgian economy? Not just corners!

According to Schneider, Buehn and Montenegro (“Shadow Economies All over the World – New Estimates for 162 Countries from 1999 to 2007”, Policy Research Working Paper 5356, The World Bank 2010), based on estimates for 2007, Georgia has by far the the biggest underground economy (as a percentage of GDP) among the 21 transition countries studied. 62.1% of all economic activity in Georgia took place in the subway! Places 20, 19 and 18 are occupied by Ukraine, Moldova and Russia, with 46.8%, 44.3% and 40.6% respectively.

But even in the world ranking of 151 countries, Georgia is only beaten by Zimbabwe (62.7% shadow) and Bolivia (63.5% shadow). Topping the list are Switzerland and the United States with 8.1% and 8.4% shadow respectively, and among OECD countries, a group of 25 high-income economies, the average is 16 , 6%. According to Schneider et al., These figures do not primarily reflect genuinely criminal activities such as drug trafficking and prostitution, but above all simple tax evasion.

The huge amount of shade in Georgia is confusing, given that in this country one gets a receipt even for minor purchases (which is not the case, for example, in Greece). Additionally, Georgia has received much praise for its anti-corruption efforts, and in particular for its tax administration reforms from 2005 (see “Fighting Corruption in Public Services: Chronicling Georgia’s Reforms”, The World Bank 2012). Since 2003 and 2007, Georgia’s underground economy has indeed shrunk, but not as much as one might expect. The shadow rates were 65.9% (2003), 65.5% (2004), 65.1% (2005), 63.1% (2006) and 62.1% (2007). In 1999, at the height of Shevardnadze’s reign, the number stood at 68.3%, just 6 percentage points from the 2007 level. Unfortunately, data is not available for years after 2007, but until then, the size of the underground economy has surprisingly not been affected by the long period of massive government crackdowns on corruption, which began in 2003. Apparently, classical corruption was indeed reduced, but the economy underground was not included in this process.

THE SLIPPING SLOPE OF TAX ESCAPE

Kirchler, Hoelzl and Wahl (“Tax compliance imposed or voluntary: the framework of the ‘slippery slope'”, Journal of Economic Psychology 29, 2008) identify two sources of tax compliance: mandatory and voluntary. The tax compliance imposed results from the fact that tax evaders fear the risk of being detected and sanctioned. Voluntary tax compliance is fostered by citizens’ understanding that government performs important functions that must be funded through tax payments.

As Muehlbacher and Kirchler argue (“Tax Compliance by Trust and Power of Authorities”, International Economic Review 24, 2010), neither power nor trust alone can lead to the best result. What is needed is a balanced mix of trust and power: If the tax authorities are absolutely powerful but the government is unreliable, the economy will slide down the slippery slope into the shadows. Yet the same thing happens if the government is transparent, fair, enjoys a high degree of legitimacy, etc. but has a dysfunctional tax department. The diagram illustrates this idea.

The argument that voluntary compliance is essential at first glance seems to be somewhat “uneconomic”, as it is not based on extrinsic incentives but on intrinsic motivation. It is, however, part of the mainstream thought in the economics of crime and can be applied to almost all kinds of transgressions. The most effective police cannot prevent situations where the probability of being punished for a crime is low, for example if a perpetrator meets a helpless victim in an isolated location. Everyone depends to a large extent on the decency of the people with whom one interacts, and if economic agents were wrong and wrong in every situation where possible, inspection costs would skyrocket and economic activity would increase. would be strongly compromised.

VOLUNTARY COMPLIANCE IS THE KEY

According to Caucasus Barometer of the CRRC, the percentage of Georgians who express complete confidence in the “executive government (prime minister and ministers)” has fluctuated between 30% and 40% in recent years. For comparison: in Austria, the Czech Republic and Great Britain, trust in tax authorities was 89%, 90% and 91% respectively, while the size of parallel economies was on average 16% in these countries. three countries (Muehlbacher, Kirchler and Schwarzenberger: “Voluntary tax compliance vs. imposed tax compliance: empirical evidence of the ‘slippery slope’ framework”, European Journal of Law and Economics 32, 2011). Thus, despite fundamental reforms, the level of trust, destroyed in the post-Soviet turmoil and the Shevardnadze era, had not yet been restored.

The difficulty for Georgia is that, according to conventional economic wisdom, many issues are already dealt with almost ideally. So, there is no obvious way to approach the problem. The 20% Georgian flat tax is extremely simple and transparent. Public spending, as a percentage of GDP, stands at 31.8% – a very moderate figure, compared to 41.6% in the United States, 48.5% in the United Kingdom, 56.1% in France and 57 , 6% in Denmark (data from Index of economic freedom 2014 of Heritage Foundation). In most countries, special interest groups have their hands in the government honeypots, funding all kinds of activities with questionable benefits to the general public. For example, 3.3 percentage points of US government spending, $ 560 billion, is spent on military spending, much of it pocketed by the US arms industry. Compared to other governments, the Georgian public sector can be considered parsimonious and thin.

This does not mean that things cannot be improved. Widespread nepotism is a huge problem. People find it scandalous that their tax dollars, which they have worked hard for, are being used to provide jobs for relatives of government officials. And the posh cars of many government officials, sometimes even escorted by police, give the impression that politicians view their offices at least in part as opportunities to appropriate perks. To gain legitimacy (and improve tax morale), Georgian politicians should follow the example of European politicians: in Amsterdam, the Prime Minister of a country of 17 million citizens and a GDP of nearly 800 billion cycled to his office, and in Berlin you could see ministers riding the metro.

The threat of Islamic terrorism and the need for bodyguards have made it more difficult for prominent politicians, but ordinary MPs still travel like all other citizens, often using public transport. In Georgia, on the other hand, even mediocre civil servants feel entitled to special privileges on the streets of Tbilisi. Such attitudes undermine citizens’ beliefs that their tax payments are being used wisely.

Transparency is achieved to a considerable degree in Georgia. International Transparency, which considers the Georgian e-procurement platform “one of the most transparent in the world”, has managed a database of government tenders since 2010, enabling comprehensive analyzes of the destination of money from taxpayers (www.tendermonitor.ge).

Still, it all works slowly. It is a well-known observation in the debate on the so-called “relay social capital” that trust in institutions, once destroyed, takes time to rebuild. The Shevardnadze kleptocracy has spoiled the attitude of Georgians towards their government, and they cannot be restored in a few years.

There are, however, things that can be done to improve tax morale within a population, related to recent findings in behavioral economics and ingenious ideas about poke by Thaler and Sunstein. This, however, we will discuss in the next issue of Georgia Today.

Graphic – The “Slippery Slope” framework according to Kirchler, Hoelzl and Wahl (2008). Source: Erich Kirchler

Lacha Lanchava

May 28, 2015 11:07 PM


Bonny J. Streater

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