Underground Economies in Transition

Unrecorded Activity, Tax Evasion, Corruption and Organized Crime

Edgar L. Feige, Katarina Ott, Edgar L. Feige, Katarina Ott

• Publisher: Routledge
• Year: 2019
• ISBN:
  9780429664885
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Published in 1999, this work examines the crucial role played by unofficial and underground activities in the transitional economies of Central and Eastern Europe and new independent states. Countries undergoing radical transformations from socialism to capitalism experience fundamental changes in institutional rules governing property rights, government regulations, taxation and the appropriate conduct of public service. Underground and unofficial activities represents non-compliant economic behaviours involving evasion, avoidance, circumvention, abuse and/or corruption of the institutional rules as well as efforts to conceal these illicit behaviours from the view of public authorities. The book employs the conceptual framework of the new institutional economics to elaborate the theoretical relationship between underground activities and overall performance of transition economies. The social, cultural and economic causes of unofficial activities are examined as well as their consequences for economic policy and performance. Policy issues include the relationship between tax evasion and corruption, the underground economy and organized crime, state and regulation, and methods and consequences of legalization of the underground economy.

PART I
GENERAL ISSUES

1 Underground Economies in Transition: Noncompliance and Institutional Change
EDGAR L. FEIGE^*

Institutions and Economic Performance

The historical laboratory in which transition experiments are taking place has revealed that liberalization, stabilization, and privatization may be necessary but are by no means sufficient conditions for creating 'market economies'. We have belatedly recognized that the successful implementation of each of these programs requires a complex set of supporting institutions, whose absence in transition economies often results in undesirable outcomes. The New Institutional Economics (NIE) is now acknowledged to be an indispensable intellectual framework for understanding economic development and economies in transition. North (1990) has persuasively argued that institutions matter insofar as they affect economic outcomes, but we still lack an explicit formulation of the critical relationship between institutional arrangements and economic performance. We suspect that a stable, credible, transparent and effective set of institutions reduces transaction costs, which in turn improves performance, but again, a precise mechanism is lacking. One hypothesis is that lower transaction costs shift economic activity and resources away from protection and predation toward production.

From the long term NIE perspective of economic history, the institutional change that shapes the evolution of societies is seen as 'overwhelmingly incremental' and highly 'path dependent'. How then, are we to reconcile this 'glacial' view of institutional change with the radical transformations now under way in Central and Eastern Europe and in the New Independent States (NIS)? Are these revolutions less revolutionary and less discontinuous than they appear? What will ultimately determine their outcomes?

North (1990:91) suggests that the outcomes of revolutionary changes will depend on 'the ongoing tension between informal constraints and the new formal rules'. Formal institutions have indeed changed radically in the former communist countries, but informal institutions much less so. What, then, can we learn from a closer examination of the informal conventions, particularly when these include norms of noncompliance with the formal rules?

The NIE has taught us that every market presupposes the existence of property rights to be traded. When these rights are established, supported, and enforced in a transparent, even-handed manner under the rule of law, uncertainty and the transaction costs of exchange are significantly reduced, and economic outcomes are likely to be improved. Many of the transition economies have yet to establish the rule of law, and suffer instead from the legacy of regimes of arbitrary discretion that encouraged noncompliant behavior as the informal norm. Noncompliant behavior breeds underground economies whose persistence and consequences are now coming under increasing scrutiny in transitional economies.

If we are to understand why some transitions have been relatively rapid and successful while others have languished and suffered from huge adjustment costs, we must examine how each society has structured the relative incentives for productive, protective, and predatory behavior. These incentive structures are unlikely to be transparent, particularly when there is a lack of coherence between formal and informal institutions. When formal and informal institutions clash, noncompliant behavior proliferates, forming various underground economies. Tax evasion, corruption, bribery, organized criminality, and theft of government property become commonplace.

Many of the centrally planned economies suffered from fundamental inconsistencies between formal and informal institutions. Formal laws and contracts were often violated while informal norms, reflecting the real world calculus of effective rewards and punishments, sanctioned illegal activities. Consequentially, the transition process had to deal with a legacy of noncompliant behavior involving protective and predatory practices. One of the great challenges for a successful transformation is determining how to restructure institutions and incentives so that resources are redirected toward productive wealth-creating outcomes.

Production, Protection, and Predation

Nations have traditionally allocated scarce resources to acquire, protect, and produce wealth. A nation's growth - its ability to produce new wealth- wili be determined by its technology, the quality and quantity of its total resource endowment, and the amounts of resources employed in the protection and redistribution of existing wealth. Those resources not devoted to protective and acquisitive activities can be allocated to the production of new wealth. Predatory rent-seeking practices are characterized as negative sum games because the winner's gains are overshadowed by the loser's losses as aggregate wealth declines.

As the administrative mechanisms of central planning give way to market allocations, and state ownership is replaced by private property rights, economic behavior is guided by a radically altered system of incentives, sanctions, and opportunities. Given these new institutional rules, individuals and organizations must make strategic decisions about the allocation of their scarce resources among productive, protective, and predatory activities. We might conjecture that the most constructive form of institutional change is that which provides incentives to direct resources away from protective and acquisitive activities and toward productive ones.

Production costs reflect the transformation of inputs into outputs. Transaction costs are associated with the acquisition, protection, and transfer of property rights. The linkage between institutions and economic performance depends critically on the incentive structures that flow from property rights. Efficient institutions provide incentives to minimize the sum of production and transaction costs. When property rights are uncertain and insecure, difficult to measure and monitor, costly to enforce, and inconvenient to trade, transaction costs are high, and considerable resources must be employed for the protection and redistribution of wealth. Conversely, when institutions are successful at reducing these transaction costs, resources are freed to enhance economic performance.

Institutions generate and enforce rules of behavior and rules of procedure. Rules of behavior structure incentives and constraints on permissible activities; rules of procedure specify acceptable means for amending and modifying the existing rules. Institutional change can occur in either a prescribed or a proscribed manner. Prescribed institutional change is in accordance with a society's rules of procedure, whereas proscribed institutional change comes about when behavioral and procedural rules are broadly violated. Prescribed change is typically smooth and gradual, whereas proscribed change, resulting from noncompliance with existing rules, typically appears to be traumatic and radical.

Underground economies are characterized by noncompliant economic behavior involving evasion, avoidance, circumvention, abuse, and/or corruption of the rules, as well as accompanying efforts to conceal these illicit behaviors from the view of public authorities. Noncompliance is responsible for many of the unintended consequences that often result from policy reforms. The effort to conceal underground activity systematically distorts conventional information systems and thereby complicates efforts to observe and monitor the consequences of policy reforms. These consequences and the way they are perceived thus depend in large measure on the extent to which individuals and organizations comply with the new rules. The choice to comply or not depends on the relevant incentives and sanctions and is often conditioned by the institutional structure that prevailed in the pretransition period. Therefore, institutional change is likely to be path- dependent.

When rules are circumvented by widespread noncompliance, economic performance is likely to be powerfully affected. Since institutional change is the defining feature of transition economies, any inquiry into the causes and ultimate consequences of the transition must include an analysis of the incentives and sanctions governing various types of underground economic activities. Indeed, the perception, nature, and consequences of noncompliant behavior depend on the particular rules being violated. Any analysis of institutional change in the context of transitional economies must address the consequences of noncompliant behavior as manifest in different underground economies. These include the widely observed occurrences of bribery, corruption, organized crime, financial scams, tax evasion, property theft, smuggling, money-laundering, and extortion.

Formal and Informal Institutions

Institutions represent the rules that constrain human behavior by affecting the expected payoffs for economic actors. But there are many types of institution, spanning formal legal systems and informal customs and norms. Particularly in times of social transformation, the rules of different institutions may be discordant. Macaulay (1986) observed that 'theories about the state or society tend to overlook the remarkable ability of individuals to cope with attempted regulation by evasion, manipulation, conscious ignorance of the law, and bargaining'. Eggertsson (1997) points out that 'the primary weakness of the economics of institutions is its limited understanding of the amalgam of formal and informal rules and their attendant enforcement mechanisms'.

When the institutional amalgam is hierarchical, consistent, and complementary, we most easily discern effective rules by studying their codification in formal institutions. Coherence between formal and informal norms simplifies the task of defining and enforcing acceptable behavior. Compliance with the existing institutional rules is the dominant behavior.

When formal and informal rules are inconsistent or in conflict, the effective rules germane to economic performance will depend on the extent to which individuals and organizations comply with the formal rules. Observation of widespread noncompliant behavior signals a formal system in distress. The study of noncompliant behavior (underground activities) and the incentive structures that induce this behavior provides a powerful diagnostic tool for identifying which informal institutions effectively motivate relevant economic outcomes.

Noncompliant Behaviors

Changing incentive structures affect the relative costs and benefits of complying with a newly evolving system of rules. Noncompliant behavior- evasion, avoidance, circumvention, abuse, and/or corruption of institutional rules-comprise what can be termed underground economies. A variety of underground economies can be differentiated according to the types of rule violated by the noncompliant behavior.

Noncompliant behavior is often the source of the unintended consequences observed in the aftermath of policy reforms. Moreover, since such behavior i subject to penalties, rule violators will attempt to conceal it from public view. Successful concealment distorts information and hinders our ability to perceive and interpret correctly the outcomes of policy reforms.

Radical institutional reform often creates a climate rife with noncompliant behavior. The extent, nature, and consequences of underground economic activity will affect the impact of institutional change on economic outcomes. The study of noncompliance in transition economies is likely to yield the most revealing view of the effective prevailing incentive structure, of the critical strategic behavior induced by that structure, and thus of the outcomes of policy changes.

Institutional Economics and Underground Economics

The focus of the new institutional economics is on the consequences of institutions - the rules that structure and constrain economic activity - for economic outcomes. Underground economics is concerned with instances in which the rules are evaded, circumvented, and violated. It seeks to determine the conditions likely to foster rule-violations, and to understand the various consequences of noncompliance with institutional rules. The greater the expected net benefit from noncompliance, the higher its expected incidence. Since rules differ, both the nature and consequences of rule violations will depend on the particular rules violated. Institutional economics and underground economics are therefore highly complementary. The former examines the rules of the game, the latter the strategic responses of individuals and organizations to those rules. Economic performance depends on both the nature of the rules and the extent of compliance with them.

There are, of course, as many noncompliant activities as there are rules to be violated. Feige (1990a) has shown that underground economies comprise similar types of noncompliant behavior. For example, when fiscal rules are violated, tax evasion and benefit fraud behavior is said to comprise the unreported economy. As suggested earlier, rule violators, mindful of penalties, will typically seek to conceal their behavior from public authorities. W...

Table of contents

• Cover
• Half Title Page
• Title Page
• Copyright Page
• Contents
• Acknowledgements
• Introduction
• PART I: GENERAL ISSUES
• PART II: POLICY ISSUES
• PART III: MEASUREMENT ISSUES
• Subject Index
• Author Index