Three essential questions
What are the proven means to reduce informality?
In our series of interviews with leading researchers, economists and policymakers, we interviewed Professor Ioana Alexandra Horodnic, Faculty of Economics and Business Administration, "Alexandru Ioan Cuza" University of Iași, Romania on how informality (including “envelope wages”) affects workers and society, and what measures work best in reducing it.
© I. Horodnic
1. Several economists say that informality is a symptom of lower levels of development which will gradually disappear when Eastern European countries catch up with the more advanced European economies. What is your view?
There are four major theories explaining the prevalence of the informal economy. Indeed, the modernization theory has been the dominant perspective towards the informal economy throughout the twentieth century. According to this theory, the informal economy is a result of underdevelopment and it is expected to vanish with economic advancement, modernization of governance and reduced levels of corruption. However, this theory started to be contested in the past few decades as it has been recognized that the informal economy is a large and persistent sphere of the contemporary economy of both developing and developed countries.
The second explanation of informal economy derives from the political economy school of thought (also known as under-intervention theory) which views the informal economy as being generated by inadequate state intervention in regulating work and welfare, pushing therefore the workers to engage in informal economy as a survival strategy. Conversely, the neo-liberal theory (also known as over-intervention theory) argues that informal economy is not necessity driven but it is rather a choice made by the worker in order to avoid burdensome regulations and high taxes as well as to save time and effort required for declaring the work.
Over the past years, however, the institutional theory has become the dominant explanation of informal economy because it synthetizes and incorporates most of the assumptions of the previous three theories. According to this theory, the informal economy is generated by the asymmetry between formal institutions (represented by the rules, laws and regulations of a society) and informal institutions (represented by citizens’ norms, values and beliefs). As such, in order to reduce informality, we need to identify the features of formal and informal institutions that contribute to higher levels of informality. In the end, we need to close the gap between the written rules of the game (usually well developed in Eastern Europe) and the unwritten rules on what is socially acceptable in terms of avoiding formalization.
2. What interventions to reduce informality have worked well in our region and what should governments rather avoid?
The enforcement authorities, especially in Eastern Europe, focus on making participation in the informal economy less appealing by increasing the deterrents or the cost of engaging in such activities (e.g. increasing the risk of being caught and the penalty level) or by providing incentives for declared work/economy (e.g. simplification of compliance, tax incentives). However, this is not sufficient, and these measures need to be complemented with measures that can reduce the asymmetry between the formal and the informal institutions. Applying the institutional theory in practice involves identifying the drivers of informal economy and take tailored remedial measures. This might include initiatives that alter the formal institutions such as modernizing the government and reducing corruption, improving the state intervention in work and welfare, improving law and regulations enforcement capacity, and using incentives for inducing the citizens to declare their work. Improving the formal institutional instability and uncertainty (i.e. reduce the frequency of changing the laws and regulations) is also important. Also, measures aimed at changing the informal institutions could be necessary for making the informal economy less acceptable from the citizens’ point of view. Such initiatives could be education and awareness campaigns about the benefits of declared work and the risk of engaging in informal economy, measures to enhance the citizens` trust that their peers do not engage in informal economy (i.e. horizontal trust) and measures to enhance the citizens` trust in government (i.e. vertical trust). Therefore, for effectively reducing participation in the informal economy, a holistic approach is required by using a full range of direct measures (e.g. deterrents and incentives) and indirect policy measures (e.g. awareness and education campaigns aimed at alerting the informal institutions so the informal economy is found less acceptable by the citizens, and measures aimed at enhancing trust).
3. A considerable number of companies in the region reduced their tax and social contributions by paying staff an official salary and an extra, undeclared “envelope wage”. What are the consequences of this practice and how to overcome it?
Indeed, the practice of envelope wage (also known as underdeclared work) is one of the most common forms of undeclared work in the region. This practice takes various forms. The extra undeclared wage can be paid as a monthly fix amount (e.g. the money exceeding the minimum wage) or variable amounts based on the number of working hours, bonuses and so on. While the employer obtains cheaper labour, the worker and society are negatively influenced. By declaring only a share of the real wage of the employees, the government loses public revenues which could be used to provide better public goods and services. This practice also undermines the government`s ability to have control over the working conditions and puts pressure on the legitimate businesses to engage in similar practices to reduce the unfair competition. By accepting to get paid in this manner, workers reduce their employers’ entitlement to credit, pension and social protection. It also makes them vulnerable to additional conditions imposed by the employer.
This practice is difficult to detect considering that there is a formal working contract and, at first glance, everything looks legal. Therefore, to tackle this form of undeclared work, we need the holistic approach mentioned above, especially for enhancing voluntary compliance. For example, educational and awareness campaigns targeting workers to make them aware of how this practice affects them and what the benefits of having the full work and wage declared can be efficient in achieving reduced informality.