Despite the stable economic growth, the shadow economy in Latvia has increased in 2018 by 2.2% percent compared to 2017

The latest SSE Riga “Shadow Economy Index in the Baltic States” shows a worrying trend; with overall economic growth in Latvia, the shadow economy also continues to grow. According to the results of the study published today, the shadow economy in Latvia reaches 24.2% of GDP in 2018, which is an increase of 2.2% compared to 2017.

In 2018, the extent of the shadow economy in Lithuania is 18.7% and in Estonia - 16.7% of GDP. Over the year, the extent of the shadow economy in Lithuania has increased by 0.5%, but in Estonia it has decreased by 1.5%. According to the results of the study, in all three Baltic states the largest component of the shadow economy in 2018 (similar to 2017) is “envelope” wages, comprising 43.5% of the overall shadow economy in Latvia and 54.5% and 43.2% in Estonia and Lithuania respectively. The average share (%) of wages, that entrepreneurs do not report to the state in 2018 is relatively similar in Lithuania and Estonia (15.5% and 16.7%, respectively) and slightly higher in Latvia (21.5%).

The under-reporting of income, which amounts to approximately 35.2% of the entire shadow economy in Latvia, similarly to “envelope” wages, is the component that causes the biggest differences in the size of the shadow economy between Latvia and other Baltic states. Namely, in Latvia the average share of income (%) not reported by entrepreneurs to the state in 2018 has increased to 17.9% (from 17.1% in 2017), while in Estonia it is 9.9% (a slight increase compared to 9.7% in 2017), but in Lithuania – 13.8% (increase from 12.8% in 2017). As emphasised by one of the authors of the study, Professor Arnis Sauka of SSE Riga: “Both of these factors - “envelope” wages and not reporting income - should receive serious attention when developing policies to fight the shadow economy, especially in Latvia.”

The number of non-reported employees in 2018 has decreased in Lithuania, as well as in Estonia, reaching 5.4%. In Latvia the number of non-reported employees in 2018 has increased significantly: from 7.4% to 9.6%. “According to our estimates, the non-reporting employee component is relatively important in all three Baltic countries, forming 21.3%, 18.7% and 15.6% of the total shadow economy in Latvia, Estonia and Lithuania respectively. As the economy continues to grow and there is a particularly rapid growth in the construction sector, the demand for labour in Latvia will increase. Already now, the availability of employees in Latvia is a big problem and entrepreneurs solve this problem by attracting labour from abroad and often doing it illegally. It is not possible to solve this issue without the help of a smart immigration policy in order to avoid unnecessarily triggering economic growth! ” emphasises A. Sauka.

The proportion of unregistered companies in the Baltic states is also calculated within the study, i.e., unregistered companies in Latvia form 8.6% of all companies, while in Lithuania and Estonia respectively 10.0% and 6.4% of all companies. The results of the shadow economy index also indicate that Lithuania still has the highest level of bribery in the Baltic states, especially regarding government procurement. According to the study, in 2018, Lithuanian companies paid an average of 13.8% of the contract amount in order to be awarded public procurement contracts. In 2017, this figure was “only” 10.1%. In Latvia this figure is 5.3% (a slight increase from 5.1% in 2017) and in Estonia 2.5% (a decrease from 3.9% in 2017) from the contract amount. Unfortunately both in Lithuania and Latvia, the general level of bribery is increasing: from 7.1% in 2017 to 8.3% (of total revenue) in 2018 in Latvia; from 8.4% in 2017 to 9.9% (of total revenue) in 2018 in Lithuania. However, in Estonia, the overall level of bribery in 2018 reaches 5.0%, a decrease of -0.5% compared to 2017.

The highest level of shadow economy in Latvia was in Riga and Zemgale regions. By sector, the highest share of the shadow economy remains in the construction sector. Companies in the Baltic states are still relatively satisfied with the work of the State Revenue Service (SRS). In 2018, the satisfaction level with the tax revenue service increased in Latvia and Estonia, but in Lithuania it slightly decreased. After the fall in 2017, satisfaction with national tax policy in Estonia also slightly increased, where entrepreneurs show almost the same satisfaction as in Latvia. In all three Baltic states, the level of satisfaction with the quality of business legislation has risen slightly.

The results of the study also show, that companies that are not satisfied with tax policy or government tend to be more involved in the shadow economy; satisfied companies do it less often. Also those companies, that believe the probability of being caught or the penalty in the case of being caught is more severe, tend to be less involved in the shadow economy. The results of the shadow economy index also show that newer companies are more involved in activities of the shadow economy than older companies.

Commenting on the results of the latest SSE Riga "Shadow Economy Index in the Baltic states", A.Sauka explains that: “The economic situation of Latvia is undoubtedly improving in recent years and the tax revenue is increasing. For example, the data collected by the State Revenue Service show that the revenue from the mandatory state social insurance contributions in 2018 increased by 14.7% compared to 2017, but the VAT revenue increased by 12.3% compared to the previous year. In turn, in 2018 the excise tax revenue exceeded the one billion threshold for the first time in the history of Latvia, but the increase in labour taxes was positively influenced by both the increase in labour income and the increase in the number of workers. However, despite these impressive figures and also the fact that in some tax positions, such as a reduction in corporate income tax revenue or a higher return on personal income tax, the shadow economy continues to grow and this is by no means a good trend.”

The authors of the study SSE Riga Professor Tālis Putniņš and SSE Riga Professor Arnis Sauka point out that in theory, as the economy grows and tax revenue increases, the shadow economy is expected to decline, but in practice this is not always the case. “For example, as the economy grows, the overall business environment and satisfaction of entrepreneurs with the way the tax money is spent, satisfaction with the support of the state, the quality of legislation and likewise may also show no improvement, so entrepreneurs are less interested in leaving the shadow sector. As the economy grows, the amount and availability of illegal money, which is one of the sources of “envelope” wages, may not decrease, or corruption may not significantly diminish, especially in sectors that are directly dependent on government and local government orders. As we also emphasised last year, these problems undoubtedly exist in Latvia and point to challenges in the field of effective control mechanisms, ” A. Sauka declares.

The authors of the study also point to a number of other factors that may contribute to the shadow economy, despite the fact that the economy is growing or tax revenues are increasing: “The shadow economy may also grow, if the growth in the segments with a high level of shadow economy is faster than growth in sectors with a lower level of the shadow economy. For example, the growth in the construction sector, where the shadow economy is the highest, was very high in Latvia - in 2017 and 2018 it is about 20%. Such growth can be both an engine for significant economic growth and at the same time an increase in the share of the shadow economy. Similar arguments can also be used to explain why the increase in labour tax or other tax position revenue does not automatically mean that the shadow economy has declined or the envelope wages have decreased.”

About the study:

The SSE Riga “Shadow Economy Index in the Baltic states” is determined annually, based on the methodology developed by SSE Riga professor Tālis Putniņš and SSE Riga professor Arnis Sauka and using Business surveys in the Baltic states. Several surveying and data collection techniques are used in surveys, which have been shown to be effective in eliciting relatively truthful responses. In order to calculate the size of the shadow economy as a percentage of GDP, the index includes calculations on the under-reporting of business income, the under-reporting or hiding of workers, as well as unreported “envelope” wages. In this study, the main focus is on estimates of the shadow economy in 2018 and the trends covering the period 2009-2018.