The shadow economy

IX. Tackling the shadow economy by enabling formalisation.

9.1. Deterring entry.

To discourage entry into the shadow economy, a number of broad policy measures can be adopted.

Simplifying regulatory compliance
Legal and administrative requirements, such as registration and licensing, can pose an obstacle to small companies declaring work. Compliance costs per worker are often much higher for small companies because of the economies of scale involved in dealing with regulation (see Chittenden et al., 2002, 2003; Hansford et al., 2003; Hart et al., 2005; Michaelis et al., 2001; OECD, 2000). Where the costs of administrative compliance are prohibitive, compliance is often low (see Adams and Webley, 2001; ILO, 2002; Matthews and Lloyd-Williams, 2001). Examples of administrative costs associated with regulatory compliance include the filling out of forms, the payment of tax, inspection (rather than advice), inconsistent application of the rules by different regulators or even different inspectors within the same regulator, and duplication of information requirements from different regulators. Indeed, in an analysis of 45 countries, Richardson (2006) shows that complexity is the most significant determinant of non-compliance, followed by education, income source, fairness and tax morale. Overall, Richardson’s regression results show that the lower the level of complexity – and the higher the level of education, fairness and tax morale – the lower the level of tax non-compliance.


'On the Spot' firm (Empresa na Hora), Portugal.

In 2005, the Ministry of Justice announced the Simplex programme for administrative and legislative simplification.

The 'On the Spot' firm is one initiative under this Simplex programme, which seeks to alleviate the processes and procedures necessary to set up a new firm. This initiative makes it possible to create a company in a single office (one-stop shop) and in a single day. Upon completion, the definitive legal person identification card is handed over, the social security number given and the company immediately receives its memorandum and articles of association and an extract of the entry in the Commercial Register. The security of the incorporation procedure for new enterprises is ensured by having all the details sent to the tax authorities.
Between 2005, when the initiative started, and September 2008, 59,068 new enterprises were created: 574 public limited companies (1 per cent of the total), 34,934 private limited companies (59 per cent) and 23,560 one-person companies (40 per cent). The average time taken is one hour and fourteen minutes and the average cost of setting up a company is €360. Whether such administrative simplification has reduced the shadow economy has not been directly evaluated.
Many countries are investigating the transferability of this initiative. After being recognized as a success by the World Bank, Angola and Cape Verde, for example, have already asked for legal and technical support, and countries such as Slovenia, Hungary, Egypt, Mozambigue, Chile, Brazil, Finland, Sweden and China have visited the 'On the Spot' firm service to understand how Portugal has managed to simplify the procedures required for establishing a new firm.
Thus, a potential way forward is to reduce the costs and complexity of regulatory compliance. One option to deter entry into the shadow economy is to simplify the procedures and lower the costs of establishing and operating a small business – for instance, through easier registration procedures and reasonable and fair taxation, as shown in the box.
Simplifying regulatory compliance, however, need not solely involve relatively minor administrative changes. Measures could also include more fundamental overhauls of the tax system, such as introducing a standard deduction for the expenses of self-employed people on their tax returns (Elffers and Hessing, 1997). In any sector or occupation, a tax authority could simply state that a business in a particular sector and/or with a particular number of employees can claim a specific portion of their total turnover as expenses (perhaps calculated from the median stated on previous tax returns), thus overnight stripping away the need to keep receipts and the massive accountancy industry that adds little to the delivery of goods and services in a nation.