CC BY
8DOI: 10.29141/2658-5081-2022-23-3-1 EDN: ZMKKOM JEL classification: D23, O17
Daniil A. Sitkevich The Russian Presidential Academy of National Economy
and Public Administration, Moscow, Russia
Shadow economy: To legalise or to tolerate?
Abstract. In many countries, and especially developing ones, illegal enterprises create a significant share of the gross product. The article studies possible directions of the state policy on the shadow economy, as well as the justification of such measures. The research methodology rests on a comparative analysis of approaches to the understanding of shadow economy within the framework of the modernisation theory and the new institutional theory. The paper applies the case study method to analyse various measures to combat the informal sector and contrast their efficiency. The study demonstrates that the approach that considers the shadow economy as an obstacle to economic development originates from the modernisation theory and does not reflect the recently discovered reasons why firms operate outside the legal system. Moreover, in some cases, a specialised policy aimed at stimulating legalisation may lead to the withdrawal of shadow business from the economy and an increase in the unemployment rate. Based on foreign experience, the article highlights two main public strategies to push business towards legalisation: the 'cleansing strategy', which implies driving up the costs of being in the shadows, and the 'reconciliation strategy', which entails reducing the costs of functioning in the legal field. The practice evidences that it is the 'cleansing strategy' that leads to negative consequences for the economy, which do not arise in the case of the 'reconciliation strategy'. At the same time, the simplification of doing business in the country impacts only moderately on the size of the shadow sector, which is due to the limited possibilities of the policies of this kind and specific incentives for shadow entrepreneurs. The paper concludes that the 'reconciliation strategy' would be a more optimal strategy for reducing the shadow sector in the least developed regions of Russia.
Keywords: shadow economy; legalisation; modernisation theory; economic policy; 'reconciliation' strategy; 'cleansing' strategy.
Acknowledgements: The paper was prepared in 2022 as part of the state assignment to the Russian Presidential Academy of National Economy and Public Administration.
For citation: Sitkevich D. A. (2022). Shadow economy: To legalise or to tolerate? Journal of New Economy, vol. 23, no. 3, pp. 6-22. DOI: 10.29141/2658-5081-2022-233-1. EDN: ZMKKOM.
Article info: received January 31, 2022; received in revised form February 15, 2022; accepted March 16, 2022
Introduction
Discussions about what to do with the informal sector of the economy are ongoing in many developing countries and regions. It is not surprising, given the significant role that shadow business plays in their economies. According to the IMF1, more than a third of all GDP in low- and middle-income countries is accounted for by firms outside the legal framework2 (in rich countries, the share of the shadow sector is less, it is about 15 %). Moreover, according to the same data, over 60 % of the world's workforce is at least partially involved in economic activities that are outside government control and regulation.
The informal economy is also widespread in Russia, though according to Federal Service for State Statistics (Rosstat), the share of the shadow sector in the national economy was about 20 % in 2018, and international organisations estimate that it reached 30-40 % at some points [Kapitonova, Kapitonova, 2021]. The prevalence of informal entrepreneurship in the subjects of the federation varies greatly. For example, traditionally, the region in which entrepreneurs are most often in the shadows is the North Caucasus. However, there are no exact estimates of the size of the shadow sector in the North Caucasian economy due to the extremely unsatisfactory quality of regional statistics and fictitious data on gross output [Zubarevich, 2012]. Expert estimates suggest that "the population of the republics of the North Caucasus is accustomed to relying on the alternative shadow economy and clan mechanisms as sources of income" [Gimbatov, 2012, p. 115]. This fact is also confirmed by the statements of the regional authorities. For instance, according to Yury Chaika3, the Plenipotentiary of the President of the Russian Federation in the North Caucasusian Federal District, up to half of the working population of the region is employed in the informal sector of economy.
1 IMF. https://www.imf.org/en/News/Articles/2021/07/28/na-072821-five-things-to-know-about-the-infor-mal-economy#:~:text=The%20informal%20economy%20is%20a%20global%20phenomenon%2C%20 but%20there%20is,15%20percent%20in%20advanced%20economies.
2 This indicator does not take into account enterprises engaged in illegal activities (for example, human or drug trafficking). Further in the article, speaking about the shadow sector of economy, we will consider only those firms which activities in the production of legal goods or services are outside the legal framework.
3 Yury Chaika: About half of the population of the NCFD works in the informal economy. RBC, 2021, June 15. https://kavkaz.rbc.ru/kavkaz/freenews/60c8bb399a79471f30ef8e29. (In Russ.)
It is quite natural that the informal economy in the North Caucasus is being actively discussed both by the federal authorities (which consider shadow employment as one of the main obstacles to economic development as per the official development strategy of the region1) and the regional authorities of the North Caucasian republics. However, regional and federal strategies to achieve the legalisation of the shadow sector differ. If representatives of the RF subjects speak mainly of forceful methods of resolving the issue (for example, the creation of groups of volunteers who will hunt for shadow enterprises2), the federal authorities propose creating special production sites and providing financial support to legalised enterprises. Despite the difference in the approaches, they share the perception of the shadow sector legalisation as a potential trigger for economic growth in the North Caucasus.
The purpose of the study is to identify the optimal economic policy of the state in relation to the informal (shadow) sector of the economy. In accordance with the purpose, the following objectives were set:
• describing the evolution of theoretical approaches to the informal economy;
• identifying major factors behind the emergence of the informal sector of the economy;
• conceptualising the main strategies to tackle the shadow economy;
• analysing best practices in relation to the informal sector of the economy and the degree of their applicability in the Russian context.
In the work, we used methods of analysis and synthesis, with the help of which the vital prerequisites, provisions and conclusions of two different economic theories (the theory of modernisation and the new institutional theory) were analysed and compared, and a single explanation for the formation and sustainability of the shadow economy was synthesised. In line with the case-study method, we considered cases of implementing specific policies on the shadow sector described in the scientific literature and examined best practices of public administration. In addition, other general theoretical methods were used. This way, by means of the conceptualisation method, the state policies discussed in the scientific community were categorised.
The first part of the article explores the views on the shadow economy existing in economic science, which relate to the theory of modernisation and the new institutional theory respectively. By comparing two different research traditions, we reveal both causes of emergence of the informal sector and prospects of implementing a
1 On amendments to the state program of the Russian Federation "Development of the North Caucasusian Federal District": Decree of the Government of the Russian Federation of December 16, 2021 no. 2335. https:// www.economy.gov.ru/material/file/163468e0c7bfaa37ff4b15b667e8d500/2335_16122021.pdf. (In Russ.)
2 Vladimir Vasiliev met with the representatives of the business community of Dagestan.https://rgvktv.ru/ obshchestvo/58796. (In Russ.)
special economic policy in relation to it. The second part proposes a classification of possible strategies for this policy, as well as considers case studies of various measures to identify best practices. Based on the data on the best and worst practices for stimulating the legalisation of the shadow business the conclusion presents an opinion on what the optimal policy regarding the shadow economy in the North Caucasus might be.
Key theoretical approaches to the shadow economy
The topic of the informal economy, apart from the issues of tax policy, remained un-considered by specialists for a long time. For the first time, the informal sector of the economy as a phenomenon that has a specific impact on its development was discussed by representatives of the theory of modernisation, which was created in the United States in the mid-1950s. They could notice that in low-income countries, informal entrepreneurs play a decisive role in the economy, so the topic of the shadow sector and its legalisation has received special significance for them. Although already in the 1970s the theory itself was perceived as poorly describing reality [Gilman, 2004], a part of its intellectual heritage has been kept in economic and sociological science and it influences how scientists and experts look at the problem of activities that are outside state control and regulation.
The second theory, through the prism of which the shadow sector of the economy is considered in this paper, is the new institutionalism. If modernisation theory initially looks at the informal sector as a phenomenon that appeared on its own, being primarily interested in its impact on economic growth, for institutionalists it is important why the shadow economy is widespread in some countries, while not in the others. In other words, if for the theory of modernisation the informal sector is the cause of economic processes, for institutionalism it is a consequence of the peculiarities of the institutional environment.
Such differences in research ways could not but resulted in different approaches to both explaining the reasons for the emergence of the informal sector and choosing the optimal strategy in relation to it. As noted in the introduction, the debate about the shadow economy is mainly in terms of how to tackle it and how to push businesses to return to the legal framework. However, the need itself to bring business structures into the legal framework is usually not questioned, and this perception of the shadow and informal economy as a backward and inefficient form of organisation of production, which must certainly disappear in the course of economic transformation, is a consequence of the intellectual tradition of modernisation theory.
Representatives of this theory believed that existing economic models in developing countries in the 1950s-1960s were not capable of launching the process of
economic growth, since only large modern industry, and not small and medium-sized businesses, can be its source [Brusco, 1990]. According to researchers, since the entrepreneurs in a country are not able to make expensive investments themselves to foster new high-tech enterprises, they should be replaced by the state and international organisations [Rostow, 1960].
One of the main ideas for representatives of the theory of modernisation is the 'development traps' which are considered as stable equilibria in society that hinder economic growth. The dominance of the shadow sector of the economy is one of these 'traps' [Geertz, 1963]. This is due to the following reasons:
• illegal enterprises, as well as those who work for them, do not pay taxes to the budget, which reduces the tax base. This, in its turn, leads to the fact that the state does not have the resources to pursue a policy of catch-up development. In addition, due to a lack of funds, public goods (for example, the transport infrastructure needed to transport goods) can be chronically underproduced, which can also reduce the competitiveness of local businesses;
• without formal registration, it is more difficult for firms to protect their property and concluded contracts. For this reason, they will not invest in their property for the fear of expropriation, and they will choose only close and reliable contractors. This, in its turn, severely limits the growth of firms and forces them to operate only at the local level, where the institution of reputation protects transactions;
• it is much more difficult for informal enterprises to obtain additional financing. Since they do not have effective access to bank loans to businesses, it is more complicated for them to find sources for their growth.
According to representatives of the modernisation theory, this situation is a 'trap' because the shadow entrepreneurs themselves do not want to legalise their business activities despite all possible benefits. According to Geertz, who conducted a field research among informal entrepreneurs in Indonesia, it is due to the traditional norms of residents in developing countries, because of which entrepreneurs are not ready to use formal institutions [Geertz, 1963]. Therefore, to get out of the 'trap', poor countries need external investment that will create new large industrial enterprises; former entrepreneurs, doing their business in the shadow economy, are considered only as a source of labour.
However, as the theory of modernisation proved to be incapable of boosting economic growth in developing countries [Gilman, 2004], the views on the shadow sector began to change in economics as well. Just at that time, a new institutional theory began to develop, and the Peruvian economist de Soto , who worked within the framework of its main postulates, offered a different view on this issue. According to his data, extralegal business (the scientist used this exact term in his work) is founded
mainly in cities but not in traditional rural communities. Moreover, it is the process of urbanisation that is one of the reasons behind the formation of the shadow sector, since outside the legal framework there are mainly 'forced entrepreneurs' who moved to the city for a better life and they could not find work there [de Soto, 1989].
However, unemployment is not the only reason for the emergence of extralegal business as consistent with the scientist. Institutional reasons such as excessive regulation, opportunistic behaviour of the bureaucracy, as well as high levels of taxation play a vital role. In a situation of high administrative barriers, legalisation costs can become so significant that they outweigh the benefits associated with property rights and access to bank loans [de Soto, 1989]. The reasons proposed by de Soto for the emergence of the shadow sector of the economy are empirically confirmed. Thus, this sector is more widespread in countries with a high level of taxation [Johnson, Kaufmann, Shleifer, 1997], poor quality of institutions, and high levels of corruption [Buehn, Schneider, 2011]. Cyclical contractions in the formal labour market also lead to an increase in 'forced entrepreneurship' among informal entrepreneurs [Loayza, Rigolini, 2011].
As for the internal structure of the shadow sector, recognising the disadvantages that extralegal status brings, it is not worth exaggerating the deplorable situation of firms that are in the shadow. Informal enterprises do not operate in an institutional vacuum; they do their business among stable informal regulators [Coetzee, 2001], who may be officials themselves (in exchange for the corruption rent) or organised crime, as well as community regulators. The latter have long been considered a less efficient way of creating public goods. However, studies show that in stable communities of this kind, informal regulators can cope with their task (for example, regulating fishing or creating an irrigation system) even better than formal institutions [Ostrom, 1990]. This is due to the fact that local communities are less likely to be corrupted (which is not possible to say about officials in developing countries) and they are better able to collect information about the desired level of production of public good.
At the same time, informal regulation also has its disadvantages. Although local rules can be more stable and workable, they can also create extremely high transaction costs for counterparties from the external environment. This, in its turn, may hinder the development of local businesses outside of their native communities [Jes-sop, 2001]. Moreover, the predominance of informal institutions often promotes corruption: the guarantors of formal rules have incentives not to enforce them, but to collect rent from 'violators' (i.e., from a significant part of entrepreneurs) [Baker, 2000]. In fact, we can talk about the 'shadow sector trap', which was described by the supporters of the modernisation theory, but which in reality is connected with the opportunistic behaviour of officials but not with the traditionalism of entrepreneurs.
Does this mean that the state should pursue a special policy to get out of this trap? Even if we do not take into account the fact that it is extremely difficult to implement institutional changes (namely, they are needed to reduce the costs of running a business in the legal framework) [North, 1990], it is impossible to say that such a policy will always be justified. Although de Soto himself noted the importance of the process of deregulation and the reduction of administrative barriers, this kind of approach, in his opinion, is aimed at economic development in general, but not just at resolving the issue of legalising the extralegal sector. In de Soto 's opinion, the shadow economy is not a problem by itself, but a symptom of poverty, inequality, low economic growth, uncontrolled urbanisation, and the poor quality of institutions. Therefore, stimulating legalisation without correcting the significant disadvantages of the institutional environment can even harm an entrepreneur. For example, if the state fails to settle the problem of corruption, pushing business into the legal framework will lead to the fact that the costs of formal regulation (taxes) will be added to the costs of informal regulation (the corruption tax, which will still have to be paid to officials).
Another argument against a specialised policy to counter shadow sector is that extralegal firms themselves are not very keen on legalisation due to the fact that they are forced entrepreneurs. Those firms that want to grow can get out of the shadow sector trap on their own, as evidenced by the fact that in developing countries there are not only small informal enterprises, but also large firms that stay in the legal framework. Moreover, although registered firms are on average more productive than unregistered firms, this is not due to the effect of legal status, but to the problem of self-selection: those firms that operate in unproductive sectors of the economy or do not plan to expand, usually have less incentive to bear the regulatory burden in order to get access to financial markets [Bruhn, McKenzie, 2014]. In other words, the informal sector is dominated by companies that do not want to develop, so their coming out of the shadow sector by itself will not be able to stimulate economic growth.
However, there is not any consensus among modern researchers on the impossibility of any policy that can achieve the legalisation of the shadow sector. Thus, experts note that there are not only forced entrepreneurs among informal businesspeople, but also those who are engaged in business consciously and stay in the shadow sector for a reason that it seems profitable to them. Unlike 'forced informal entrepreneurs', 'voluntary informal entrepreneurs' often make a decision to stay outside the legal framework being affected by a situation or because of well-established informal business connections. Therefore, it is realistic to create a system of incentives for them to be legalised [Oviedo, Thomas, Karakurum-Ozdemir, 2009]. The author of a field study
in India comes to a similar idea: among informal entrepreneurs, there are both those who do not want to expand production, and those who do not have the resources for the expensive legalisation process. Therefore, in order to get out of the shadow sector trap, the state should support the process of formal registration of these potentially productive firms [Kanbur, 2017].
In addition, in recent years, researchers have moved away from the rigid dichotomy between legal and illegal business. Most of the shadow entrepreneurs do not work completely illegally - rather, they are in the 'gray zone', when some of the activities are carried out within the legal framework, and some are outside the state regulation. Therefore, the legitimate goal for the state in relation to informal enterprises may not be their complete formalisation (which seems impossible in countries with a low quality of institutions), but partial legalisation, which can reduce the costs of being in the shadow sector [Diaz et al., 2018].
Thus, although the ideas of modernisation theory about the causes of emergence of the shadow economy turned out to be incorrect, the opinion that the prevalence of informal enterprises is a trap that can be overcome with the help of public policy is extremely popular among modern researchers. However, not every institutional change aimed at legalising the shadow sector can lead to an increase in public welfare. Therefore, when deciding whether to pursue such a policy, each entrepreneur needs to weigh the benefits that shadow firms can receive (access to public goods produced by the state) against the possible costs (increased regulatory and tax pressure) associated with the transition to the formal sector. Only when the benefits outweigh the costs, legalisation incentives can be justified [Loayza, 2016].
The way such a policy might be implemented in practice will be discussed below.
'Cleansing' and 'reconciliation': Possible strategies for legalising shadow business
Speaking about how the policy of pushing informal business towards legalisation can be carried out, it is worth noting that it must somehow affect the revenues and costs of entrepreneurs. This can be achieved in two ways.
First, it is possible to make the costs of using informal regulators so high that extralegal businesses will either be forced to legalise themselves or leave the market. First of all, the tools of this strategy are forceful actions: tougher penalties for illegal entrepreneurship, an increase in the number of checks on informal business, etc. We will further call such a set of measures the 'cleansing strategy', since these measures provide for the forceful destruction of the shadow economy.
Second, on the contrary, the state can reduce the costs of using formal regulators by winning competition against informal institutions. To do this, it is necessary
either to improve the quality of public administration and market regulation, or to give former informal firms material incentives for legalisation (for example, soft loans or a simplified tax regime). Due to these measures, it becomes more profitable for firms to move their activities into the legal framework, which is why the size of the shadow sector of the economy is reduced. At the same time, the state does not exert special pressure on those who do not follow the path of legalisation, and it allows companies to legalise partially, and leave part of their activities outside the legal framework, considering possible losses from the complete withdrawal of firms from the market unacceptable. This kind of strategy can be called a 'reconciliation strategy': although the state is making efforts to ensure that legalisation was more profitable for firms than staying in the shadow sector, it admits the existence of the informal economy.
How optimal can these strategies be? As for the 'cleansing strategy', its effectiveness is questionable. On the one hand, existing empirical research in Central and Eastern Europe shows that this approach works: both the severity of the penalties and the perceived likelihood that the violator will be caught negatively affect the willingness of citizens to participate in informal economic activities, with the factor of inevitability of penalties being more significant [Williams, Horodnic, 2017].
On the other hand, strengthening penalties and control over compliance with existing rules has the following significant disadvantages:
• withdrawal of firms from the market. A study of Ukrainian shadow entrepreneurs has shown that some of them want to have a legal status, but are not ready to bear the very high regulatory and corruption costs [Williams, Round, 2007]. If the pressure to do business in the shadow sector escalates, these firms will have to leave the market completely. Considering that extralegal business is often 'forced entrepre-neurship' associated with the impossibility of finding a job, such measures can lead to the situation when citizens who are already in unfavorable social circumstances might lose all their money;
• inefficiency in developing countries. While in European countries the tightening of forceful pressure can lead to a reduction in the shadow sector, in countries with low quality institutions (which are almost all developing countries), an increase in penalties or frequency of inspections leads to a rise in the negotiating power of officials. Because of this, as researchers note, greater pressure on business does not lead to its coming out of the shadow sector (since in this case the corruption tax will not be eliminated), but it will make production costs higher [Dibben, Wood, Williams, 2015];
• presence of an 'iron fist' that strictly enforces the rules can lead to a loss of trust to the state [Williams, Oz-Yalaman, 2020]. The tightening of rules can destroy the social
contract between the state and society, as a result of which the willingness of citizens to be outside the legal economic field will grow;
• excess of regulatory costs over benefits. The researchers, who consider the process of legalisation from the viewpoint of the state, argue that the formalisation of the informal economy is rather beneficial for the authorities, since it leads to an increase in the tax base. However, in some cases, when microenterprises become the object of state policy, the rise in tax collection may be insignificant compared to the costs of implementation of this policy [Bruhn, McKenzie, 2014].
All of these disadvantages lead us to recognise that while the 'cleansing strategy' can be truly effective in some circumstances, the risks of corruption, business failure, and overregulation problems make it impossible to use it in low-income countries with weak institutions.
As for the 'reconciliation strategy', the most optimal measure that can make formal regulation more attractive to business is the general improvement of the institutional environment. However, historical experience shows that such reforms are difficult to implement due to the 'blocking effect' [David, 1994], which holds back important institutional changes. Nevertheless, there are a significant number of different economic policy instruments that can influence the incentives for extralegal entrepreneurs through targeted changes.
Let us consider the main measures of this kind.
Tax and property amnesties. The idea behind special amnesties is that many shadow entrepreneurs are not ready to legalise due to possible penalties for tax evasion or illegal use of property. Therefore, the state should break this vicious circle and, during the amnesty, allow entrepreneurs to pay their taxes without additional fines and penalties, as well as register their property.
The corresponding programs show some moderate success. Thus, carried out in 1996-2004 Peru's property amnesty policy, in which the state was willing to recognise ownership of any property occupied by a citizen prior to 1995, led program participants to invest more in their property [Field, 2005]. Tax amnesties can also be successful, especially if the state has previously taken steps to simplify doing business, which can create an incentive to come out of the shadow sector [Bose, Jetter, 2012]. The amnesty itself cannot become such an incentive, but it removes barriers to legalisation associated with the past of the company.
However, it cannot be said that this practice always plays a positive role. As the experience of tax amnesties in Asia [Ibrahim et al., 2017] and property amnesties in Latin America [Sjaastad, Cousins, 2009] shows, they often provide incentives not to formalise, but, on the contrary, to go into the shadow sector, counting on what is hidden from states can be legalised during the next amnesty. According to the study in
Asia, this behaviour is especially common in those countries where tax amnesties are carried out regularly. Moreover, participation in the amnesty is associated with the fact that entrepreneurs have confidence in the state [Inasius et al., 2020]. Therefore, in the absence of trust, this measure will not affect the actions of representatives of the shadow sector.
Financial support for legalising enterprises. The essence of this measure lies in the fact that the state actually 'buys out' the existing administrative barriers, paying business for the fact that it receives a formal status.
The consequences and limits of the effectiveness of such a policy were analysed in detail in an experiment conducted in Sri Lanka [de Mel, McKenzie, Woodruff, 2013]. Its participants were representatives of illegal business were randomly divided into three groups. The first one became the control group; the second one was given a course on the benefits of legal status; representatives of the third group were provided with a payment in the amount of a two-month turnover in exchange for obtaining such a status. The results showed that informing entrepreneurs about the benefits of legalisation has no effect, while paying money for company registration often leads them out of the shadow sector - 48 % of companies that were offered money were formally registered. Subsequently, the firms that legalised performed better on average than the control group, and although this effect is associated mainly with a few highly successful firms, it indicates the effectiveness of this programme.
However, it should be noted, that slightly more than half of the informal entrepreneurs remained insensitive even to significant monetary incentives. According to the interviews conducted by the authors, this situation is due to the fact that the main contracts (for example, for land ownership) were concluded by entrepreneurs on the informal market, and in many cases they cannot be legalised. Because of this, even a large amount of money does not compensate for the losses associated with deprivation of property.
Reduced regulatory costs for business. Many states, as part of the fight against the shadow sector of the economy, are going to simplify the procedures for registering new firms and reduce the volume of regulation. A typical policy of this kind is the creation of 'one-stop-shop' systems, which provide for the concentration of all bureaucratic procedures for starting a business in one place. For example, in Mexico, the implementation of this policy reduced the period for registering enterprises from 30 to 2 days, which led to an increase in the number of companies. The fact that this effect fades after a few months proves, in the opinion of the authors, that the increase is associated with the legalisation of shadow entrepreneurs [Kaplan, Piedra, Seira, 2011]. At the same time, the effectiveness of this measure is due to the overall quality of the institutional environment. Thus, the creation of one-stop shops helped
companies to come out of the shadow sector in Vietnam as well, but the effectiveness of the reform was stronger in provinces with a higher quality of public administration [Malesky, Taussig, 2009].
A similar program was implemented in Brazil, and it included not only debureauc-ratisation, but also tax cuts for small businesses. Its results were more moderate - a 13 % rise in the number of retailer registrations was recorded, but no impact was found on the rest of the Brazilian economy [Monteiro, Assun^ao, 2012]. This is due to the differences between trading companies, industry and the construction sector: for the first group the key reason for staying in the shadow sector is high taxes and registration costs, for the rest it is the protection of property rights and regulatory pressure.
The field of business activities of firms is not the only factor influencing the success of debureaucratisation. Thus, practices similar to the creation of one-stop shops concern only a small part of informal entrepreneurs who have gone into the shadow sector due to regulatory or tax pressure [Bruhn, McKenzie, 2014]. However, such measures will not affect 'forced businesspeople, since they do not associate their future with entrepreneurship. Evidence of this is the Mexican reform described above - it led to a moderate reduction in the informal sector, not only because some companies legalised their activities, but also because some of them found work in new enterprises. Another research also shows that Mexico's deregulation policies quickly were faced with the disillusionment of emerging businesses with doing business legally. Although in the first year of implementation of this policy, there was an increase in the number of business licenses received, after a year many of them were not renewed [Mullainathan, Schnabl, 2010]. Whether it is due to the fact that entrepreneurs either found work or returned to the shadow sector is not completely clear. However, the fact that the considered approach is only partially capable of legalising the shadow business is obvious.
Comprehensive legalisation incentive programs. Many states are pursuing a comprehensive policy to stimulate the legalisation of the shadow sector. This is due to the problems of individual measures described above - being effective for some entrepreneurs, they are meaningless for others. The implementation of a wider set of measures will create incentives for the majority of existing informal entrepreneurs at once.
According to a field study [Dibben, Wood, Williams, 2015], an example of this is Mozambique, a country where the shadow sector of the economy accounted for a large part of GDP. For a long time, the government fought against informal entrepreneurs by force, but in the 2000s it decided to increase tolerance towards the shadow sphere - for example, the police no longer arrange raids on illegal street vendors. Moreover, within the state-linked trade union an association has emerged that
includes representatives of the informal sector and is a body, the opinion of which is taken into account in the implementation of legalisation policy.
At the same time, recognising the importance of the shadow business, the state has taken the following measures to facilitate the transition of entrepreneurs to the formal sector:
1) created official markets with all the necessary infrastructure, where traders can legally sell their products in exchange for a single market fee (and at the same time use the territory of informal markets for other needs);
2) created a system of loans for legal entrepreneurs and co-financing of local initiatives, promotion of the development of microfinance organisations;
3) introduced a single tax on small businesses (if possible, choose either a percentage of revenue or a certain capitation tax as the tax rate);
4) reduced regulatory pressure on cooperatives.
The authors note that the results of the policy are quite moderate: the majority of Mozambican entrepreneurs still work in the informal sector; many of them do not move to new legal markets, not wanting to pay any taxes; grants to finance local projects are often stolen, and the transition of small businesses to a simplified taxation system has been slowed down due to the fact that the law required an entrepreneur to have a bank account and an ID (a rarity in Mozambique). Nevertheless, the described measures pushed some entrepreneurs to legalise without destroying the entire informal economy, which is the only source of income for a significant proportion of the country's residents.
Another example of a comprehensive legalisation promotion policy is Georgia. By the beginning of the 2000s, the shadow sector dominated the Georgian economy, but after a series of reforms, which included a tax amnesty for legalising businesses, and debureaucratisation, and a reform of the law enforcement system, many Georgian entrepreneurs began to come out of the shadow sector. At the same time, each measure implemented alone might not have worked. For instance, a tax amnesty itself with a remaining corrupt bureaucratic system would not create incentives to move into the legal sector of the economy, whereas without an amnesty, the potential costs of legalisation could be too high [Burakova, 2017].
Analysing the whole range of measures within the framework of the 'reconciliation strategy', we can conclude that most of them, unlike the 'cleansing strategy', are not capable of harming public welfare. However, the success of such measures is far from guaranteed. The effectiveness of stimulating legalisation depends on which particular business is predominantly in the shadow sector, for what reasons formal institutions lose competition to informal ones, and how much extralegal entrepreneurs are ready to trust the state.
Conclusion
Let us summarise the main points. For a long time, informal entrepreneurs were seen as an obstacle to economic development. However, modern theoretical approaches to the problem of the shadow economy suggest that people doing business outside the legal framework are more likely a victim of the economic and institutional system in which they find themselves. The reasons for the emergence of the shadow sector are not the desire not to pay taxes or following some certain 'traditional norms', but rather unemployment, on the one hand, and the lack of competitiveness of formal institutions compared to informal ones, on the other hand. In many cases, policies aimed at tackling shadow economy will harm public welfare, because many firms will choose to close down rather than legalise, and high unemployment will make it difficult for shadow workers to find work. Nevertheless, the 'shadow sector trap', due to which informal entrepreneurs are in a non-optimal balance both for themselves and for society, is real, and certain measures aimed at reducing the costs of being in the legal framework (from debureaucratisation to 'buying out' administrative barriers) can be useful for economic development.
As for the optimal policy towards the informal economy in the North Caucasus (and in general throughout Russia), most of the measures aimed at this in Russia, according to researchers, turn out to be rather a stick but not a carrot for informal entrepreneurs [Suslina, Leukhin, 2016]. This can be explained by the fact that the Russian authorities are guided by the desire to increase budget revenues in the short term, for which tax control tools are better suited. However, in the long run, such measures do not work - regulatory pressure only creates incentives to go into the shadow sector or other legal jurisdictions.
Although the share of the legal sector is growing in the North Caucasus, a study of the activities of local shadow entrepreneurs [Starodubrovskaya, Kazenin, Sitkevich, 2021] shows that this is due to the need to conclude contracts with large suppliers and retailers. Moreover, one of the main reasons for firms' only a partial coming out of the shadow sector is distrust to the state. Building credibility through imposing tougher penalties and scrutiny seems impossible, so a 'reconciliation strategy' appears to be more promising as it gives firms positive incentives to legalise. At the same time, among the available tools of the 'reconciliation strategy', given the low quality of the institutional environment and the predominance of taxes imposed by the federal center, a comprehensive approach seems to be preferable, including both public administration reforms in the region and material incentives for legalisation (which can be programs of soft loans, rent and leasing but not only direct transfers).
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Information about the author
Daniil A. Sitkevich, Cand. Sc. (Econ.), Researcher at the Institute of Applied Economic Research. The Russian Presidential Academy of National Economy and Public Administration, Moscow, Russia. E-mail: Sitkevich@iep.ru
© Sitkevich D. A., 2022
