Shadow Economy in the Czech Republic

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The Centre for Economic and Market Analyses published a study about the shadow economy in the Czech Republic. The study deals with the theoretical aspects of shadow economy, methodology and definition, it includes international comparison, determination of driven factors as well as provides a further analysis of chosen industries. The original text is in Czech, however, we provide the executive summary of the study in English below.

EXECUTIVE SUMMARY

Shadow economy is an everyday fact of life for many citizens of the Czech Republic. According to a broader definition, the underground economy, the illegal economy and the informal economy are all part of the shadow economy.
The particular causes of the shadow economy can differ across countries and regions, nevertheless, taxation and regulation are often identified to be the root causes of shadow economic activities.
The higher the tax burden (whether due to tax rate or complicated tax regulation) and the more complex and restrictive is the regulation in a given country or industry, the more expensive it is for firms to hire labor and to operate in the official economy in general.
Especially in countries of the Central and the Eastern Europe, the (low) quality of institutions, the quality of goods provided by the public sector, is a strong factor influencing people’s decision to move into the shadows.
Given the hidden nature of the shadow economy, its precise measurement is very difficult. According to the available estimates, shadow economy formed approximately 14.3 % of EU economy in 2014, i.e. almost 2 trillion EUR.
The estimated size of the Czech shadow economy differs depending on the used method. According to the most recent estimate of the Czech Statistical Office, the size of the underground economy in 2013 was approximately 8.9 % GVA (the whole non-observed economy 11.6 % GVA). According to the MIMIC method, the shadow economy will be approximately 15.1 % GDP in 2015.
In the Czech Republic, the shadow economy is mostly spread in the sectors of non-financial institutions and households. With respect to the industrial sectors, the shadow economy is spread especially in the sectors where it is possible to effectively underreport profits, these can be often characterized by a large amount of small cash transactions and undeclared labor.
In relative terms, underground economy in the Czech Republic is dominant in activities of households as employers, in accommodation and food service activities and in construction. In absolute terms, it is spread dominantly in construction, wholesale and retail trade (including repair of motor vehicles and motorcycles) and manufacturing.
Existing studies document negative correlation between the extent of the shadow economy and the amount of cashless transactions. Cash transaction allow systematic tax avoidance and are a common characteristic of industries with widespread shadow economy. Therefore, cash is often considered to be the “grease in the wheels” of the shadow economy.
Most of the shadow economic activities include undeclared labor, i.e. activities that are lawful in their nature and remunerated by wage and that should be but are not declared to the public authorities. One of the most significant factors influencing undeclared labor is the strictness of labor regulations. Undeclared labor is motivated by low wages in the official economy, insufficient oversight of public authorities and insufficient amount of job opportunities in the official economy. According to the employees of the Labour Office of the Czech Republic, as much as third of the unemployed works in the shadows.
In the Czech Republic, similarly to Hungary, Lithuania, Poland, Slovakia and the countries of Southern Europe, the dominant part of undeclared labor is performed by the self-employed own-account workers. Specifically, one of the most commonly identified forms of undeclared work in the Czech legislative system is the false self-employment (in the Czech language the so-called “švarc system”), which exploits the difference in the tax treatment of own-account self-employed workers and regular employees. “Švarc system” is common in construction, among retail staff, hairdressers, waiters, pharmaceuticals sales representatives and real estate agents. According to the State Labor Inspection Office the share of “švarc system” in the overall number of cases of uncovered illegal employment was 10 % in 2012, 6.2 % in 2013 and 4.7% in 2014.
In 2013, 19 % of Czech respondents answered that in the past 12 months they bought goods and services they suspected to be produced with undeclared labor. 33 % of respondents knows someone who works undeclared. The most demanded goods and services are household repairs and renovations and car repairs and mostly in the circle of friends, colleagues and acquaintances. The most commonly stated reason for such purchase is lower price.
4 % of respondents in 2013 in the Czech Republic admitted that they worked undeclared in the past 12 months. According to the estimates of the Czech Statistical Office, 162 324 (approximately 3% of labor force) residents and 36 961 non-residents worked undeclared in 2013. Most of these people worked in the wholesale and retail trade and repair of motor vehicles and motorcycles, construction, accommodation and food service activities and manufacturing.
In 2014 there were 15 911 inspections conducted by the State Labor Inspection Office. Some form of illegal employment was discovered in 7 % of these inspections. Majority of the illegal employees were residents of the Czech Republic (60%). Among the nonresidents, majority came from countries outside of European Union (31%), particularly from Ukraine and Vietnam.
36 % of Czech firms face competition in the form of informal or unregistered firms and 23 % identifies shadow activities of their competitors as a major hindrance to their business. VAT tax evasions have been especially significant problem in EU in the past few years. These are mostly conducted in the form of carousel trade schemes and using the so-called straw men. The VAT gap in the Czech Republic was estimated to be approximately 22 % of the theoretical VAT in 2012.
Shadow economy on the market (both underground and illegal) with alcohol is mostly spread in countries with high alcohol prices (often due to high excise taxes) and also in countries with the overall large share shadow economy and widespread corruption.
In 2010, 25 % of the world’s consumption was satisfied by the alcohol delivered from the shadows. In the Czech Republic, shadow economy generates 9 % of the overall consumption. Even though the shadow market with spirits subsided after the so-called “methanol affair” in 2012, the shadow economy with wine increased in importance in the past few years. Between 2013 and 2014, Customs Administration of the Czech Republic registered increase of confiscated still wine by 3 343 %. Czech Agriculture and Food Inspection Authority identified 32.1 % of falsified wine in the 471 tested samples of barrel wine in 2014.
The dominant shadow activities on the market with tobacco are smuggling, production and sales of counterfeit or unmarked cigarettes and tobacco and non-payment of administrative fees and taxes. According to the estimate by the so-called empty package survey method, the shadow economy share in the Czech tobacco market is approximately 3.1 %. Customs Administration of the Czech Republic estimated the tax evasions in the 2014 to be 78 million CZK (approximately 2 % of the raised excise taxes from tobacco).
Considering the Czech energy market, shadow economy is present mostly on the market with mineral oils (including fuel). According to the 2011 estimates of the Gas Stations Association, as most as 40 % of fuel sold at private gas stations is connected with tax evasion schemes. The General Financial Directorate estimates the amount to be between 50 and 100 million liters per month (depending on the season).
After the Czech Republic joined the European Union, VAT tax frauds have become widespread. With each such scheme the state losses approximately 190 000 CZK on every cistern. The General Financial Directorate estimates the overall loss to be approximately 6-8 billion CZK yearly.