The shadow economy

Targeting customers with indirect tax measures.
One way of encouraging consumers and businesses to use legiti-mate rather than shadow work is to reduce value added tax (VAT) on specific goods and services where the shadow economy is widespread; this could include areas such as the household repair, maintenance and improvement sector (see Capital Economics, 2003). Whether VAT reductions might lead to the increased formalisation of the shadow economy, however, is open to debate. Although early academic research argued that the introduction of VAT had little effect on the extent of the shadow economy (Bhattacharyya, 1990; Feige, 1990; Frey and Week, 1983; Macafee, 1980), few contemporary evaluations have analysed whether this is actually the case.
Despite this, some EU member states have taken up the opportunity offered by Directive 1999/85/EC to reduce VAT on specific labourintensive services. In the sphere of building renovation and maintenance, for example, several member states (such as Finland, Sweden and Italy) have opted for a reduction in VAT. Nevertheless, and as the European Commission (2007: 7) asserts, ‘There is limited evidence of the employment creating effect of a single reduction of VAT.’


Targeting consumers with direct tax measures and wage cost subsidies.
Although general reductions in the rates of income tax might be used to try to cure the prevalence of the shadow economy, this topic, as has been noted, will not be discussed in this chapter because it has much wider implications. More targeted strategies, however, are available. One option is to give straightforward income tax relief, claimed on (self-assessed) tax returns, to customers using declared labour to do specific household tasks (for example, childcare and cleaning). Tax rebates on home maintenance expenses have been available in France since 2000, along with tax reductions for house repairs in Italy and Luxembourg.
An increasingly popular initiative which is being used to tackle the shadow economy is the use of vouchers which can be combined with the tax relief approach. One such initiative which has proved successful is the Cheque Emploi Service Universel (CESU) scheme, which was introduced in France to simplify the process of hiring and paying a domestic worker. The worker’s salary is paid using a system of cheques, which can be purchased at the local bank. The benefit for the customer is that they can claim an income tax reduction that amounts to 50 per cent of the sum spent on purchasing the cheques. For the supplier, meanwhile, the salary cannot be less than the national minimum wage, and a 10 per cent indemnity is also given for paid leave. By 2002, the number of households legally using domestic service workers was some 765,411 while the number of full-time equivalent jobs created was just under 88,000 (Adjerad, 2003). By 2002, 53 per cent of all formal employers of domestic workers used the scheme (ibid.). An estimated 20 per cent of those previously working on an undeclared basis are now officially employed (Le Feuvre, 2000).
Of course, we need to be careful how far we extend such schemes. Some activities such as childcare often attract tax relief in any case and tying such tax relief to the use of non-shadow labour is not an especially significant step. In general, high tax rates distort the economy and reduce the division of labour and use of paid labour with respect to household tasks such as child-care, gardening and cleaning. Although economists generally oppose specific tax relief measures, there can be a case for the creation of limited tax relief measures in certain fields of activity, and it may be possible to tie such measures to assisting the formalisation of the shadow economy.