The underground economy has stopped shrinking

By Rodrigo Moura and Evandro Guimarães *

The underground economy includes all production of goods and services that is not deliberately reported to the government, in order to evade taxes and evade social security contributions, compliance with laws, labor regulations and the costs arising from complying with applicable regulations the company's activity.

These non-compliances, in addition to harming consumers, end up encouraging non-law-abiding companies to act in the market for longer. As a result, law-abiding companies are at a competitive disadvantage, as they spend time filling out forms, paying taxes and adapting the product to the standards established by regulatory agencies.

In the end, they often close their doors because of excessive bureaucracy, high tax burden and difficulty competing with disloyal companies. Thus, consumers pay a higher price for a lower quality product, due to less competition. As a way of monitoring the size of the underground economy, the Brazilian Institute of Ethics in Competition (ETCO) and the Brazilian Institute of Economics (IBRE) of the Getulio Vargas Foundation (FGV) in Rio de Janeiro publish the Underground Economy Indicator (IES).

In 2003, the first year for which the IES was computed, the size of the shadow economy represented 21% of the country's GDP. In 2014, this percentage was 16,1%, that is, a decrease of almost 5 percentage points (pp) - which represents an average decrease of 0,4 pp each year. But it is important to note that, compared to 2013, the reduction was only 0,2 pp, indicating that, after years of decline, the indicator is heading towards stability or, probably, an increase in 2015.

One of the causes of the probable reversal of the downward trend in the shadow economy would be the stagnation of activity, which, by raising unemployment, induces people who lost their jobs to migrate to the informal labor market.

In other words, many people are more likely to take a job without a formal contract. Allied to this, it increases the chance of illegal and non-compliant companies to proliferate, further fueling the underground economy. Thus, in the midst of fiscal austerity and the need to generate tax revenue, the loss of revenue resulting from these informal activities makes the adjustment of public accounts promoted by the government even more costly for the taxpayer.

In this sense, it is relevant to note that the fiscal adjustment carried out by raising the tax burden further induces an increase in the underground economy, promoting a vicious circle for society.

As informal activities evade taxation - by demanding more paper money and fewer banking instruments, in order to remain hidden from the eyes of the authorities -, the collection is lower than it should be and, with this, the tax base is reduced.

This, in turn, creates the need for further increases in the tax burden, further stimulating underground economy activities, deteriorating public accounts, generating new tax increases and so on.

In other words, more taxes imply higher costs for companies to stay within the law, which, in turn, increases the gain for companies to breach tax legislation, failing to collect due taxes.

The current scenario of stagflation - economic stagnation coupled with high inflation - and fiscal adjustment via increased taxes are ideal for informal activities to proliferate. Thus, the economy as a whole loses efficiency, as workers and managers of informal activities are less productive. The result is the inefficient allocation of resources in the economy. According to World Bank estimates, the size of the shadow economy in the United States in 2006 was 8,3% of GDP, with a downward trend. Even assuming that this percentage has stabilized at around 8%, the size of the Brazilian underground economy is twice that of the United States, and is heading towards an increase in 2015 after many years of decline.

It is important to assess what measures are necessary to reduce the size of the shadow economy. One is the reduction of the tax burden, which would reduce incentives for informal activities. A higher level of punishment and inspection of offenders could also discourage such activities. In this sense, the recent measures of the Ministry of Labor with the objective of increasing the inspection on the labor market have merit - examples are electronic inspection to combat FGTS evasion and the increase of the fine for companies that hire workers outside the regime of the CLT.

In addition, the government should endeavor to legalize certain activities in the shadow economy and make labor relations more flexible, as a way of eliminating the figure of the informal in the labor market, with the aim that all workers become formal.

Another important measure would be to extend the reduction of bureaucracy to comply with tax legislation for all companies, in addition to those that already benefit from the Simples law. Thus, in general, reducing regulation, bureaucracy and changing the laws that impede the production of companies, together with the adoption of a minimum set of clear and stable rules, would be measures that would stimulate the business environment and, consequently, the investment by companies that perform legal activities.

With that, the economy would become more competitive, with an incentive for people and companies to move away from the parallel market of the economy.

* Rodrigo Moura is a professor and researcher at IBRE / FGV and Evandro Guimarães is Executive President of ETCO