UNDECLARED WORK THE LATVIAN VARIANTS

MUTUAL LEARNING PROGRAMME: PEER COUNTRY COMMENTS PAPER - LATVIA UNDECLARED WORK THE LATVIAN VARIANTS Peer Review on Tackling undeclared work: developing an effective system for inspection and prevention Prague (Czech Republic), 4-5 October 2012 A paper submitted by Alf Vanags in consortium with GHK Consulting Ltd and CERGE-EI Date: 10/09/2012

This publication is supported for under the European Community Programme for Employment and Social Solidarity (2007-2013). This programme is managed by the Directorate-General for Employment, Social Affairs and Inclusion of the European Commission. It was established to financially support the implementation of the objectives of the European Union in the employment and social affairs area, as set out in the Social Agenda, and thereby contribute to the achievement of the Lisbon Strategy goals in these fields. The seven-year Programme targets all stakeholders who can help shape the development of appropriate and effective employment and social legislation and policies, across the EU-27, EFTA- EEA and EU candidate and pre-candidate countries. PROGRESS mission is to strengthen the EU contribution in support of Member States' commitments and efforts to create more and better jobs and to build a more cohesive society. To that effect, PROGRESS will be instrumental in: providing analysis and policy advice on PROGRESS policy areas; monitoring and reporting on the implementation of EU legislation and policies in PROGRESS policy areas; promoting policy transfer, learning and support among Member States on EU objectives and priorities; and relaying the views of the stakeholders and society at large For more information see: http://ec.europa.eu/social/main.jsp?langid=en&catid=987 The information contained in this publication does not necessarily reflect the position or opinion of the European Commission.

CONTENTS 1 LABOUR MARKET SITUATION IN THE PEER COUNTRY... 4 2 ASSESSMENT OF THE POLICY MEASURE... 5 3 ASSESSMENT OF THE SUCCESS FACTORS AND TRANSFERABILITY... 7 4 QUESTIONS... 8 ANNEX 1: SUMMARY TABLE... 9

1 LABOUR MARKET SITUATION IN THE PEER COUNTRY This paper has been prepared for a Peer Review within the framework of the Mutual Learning Programme. It provides information on Latvia s comments on the policy example of the Host Country for the Peer Review. For information on the policy example, please refer to the Host Country Discussion Paper. Latvia was the EU country worst hit by the economic crisis of 2008-2009 with real GDP collapsing by a cumulative 25% and unemployment reaching a peak of 21.6% in the first quarter of 2010, the highest in the EU at that time. Since then, unemployment has declined somewhat, but at 16.1% in the second quarter of 2012, remains the third highest in the EU- 27 after Spain and Greece. Table 1: Quarterly unemployment dynamics in Latvia (2007-2012) Source: Eurostat; Latvian CSB Long-term unemployment has persistently formed more than half of the total of unemployed and recently very long-term unemployment 1 has been on the increase also. The crisis also brought wage cuts and bankruptcies. Since 2010, GDP growth has resumed and employment has grown too from its lowest point in 2010, but remains well below the peak achieved in 2007 2. It is widely believed that the crisis led to an expansion of informal activities in Latvia both undeclared work and the shadow economy in general as employers were under pressure to reduce costs in order to survive and workers were faced with the threat of unemployment and wage cuts. However, concern about the size of the informal economy in Latvia predates the crisis and has long been regarded as a major labour market problem 3. Most 1 Long-term unemployed are persons who have been unemployed for more than one year and very long-term unemployed are those who have been unemployed for more than two years. 2 Comparisons of employment and other labour market indicators over time are complicated by the fact that the results of the 2011 Census mean that historical data have to be recomputed. So far adjusted figures are available only for 2011 and after. 3 As in many post-communist economies, shadow activities have been prevalent in Latvia right from the start of the transition to a market economy. This has been mainly a result of the lack of trust in the state and a widespread belief that it is acceptable to avoid paying taxes, as reported in the Host Country paper for the Czech Republic. 4

recently, it has been identified as a priority action area in the Latvian Competitiveness Report 4. 2 ASSESSMENT OF THE POLICY MEASURE From the Host Country discussion paper, the key concerns regarding undeclared work in the Czech Republic are centred on: The so called svarc system in which people work in an enterprise as self-employed or as an individual entrepreneur with a service contract, but in practice are regular workers who should be covered by a normal employment agreement. The illegal employment of foreign workers i.e. third country workers. The illegal employment of jobseekers or registered unemployed. A reason for concern is the loss of revenues to the state from these practices which have been estimated at 5 billion CZK (or approximately 200 million EUR) 5 and also the fact that employees working under the provisions of the svarc system do not enjoy the same benefits as regular workers e.g. they do not have paid holidays or cannot receive free meals at work. As factors behind the observed state of affairs, the Host Country paper notes: The výdajové paušály (spending packages) system a form of presumptive taxation that has been available to the self-employed since 2005. This makes substitution of regular employment relations by service contracts financially attractive for both employers and workers as the example in Table A of Annex 2 illustrates. The majority of business owners consider undeclared work to be a normal thing, almost a necessity for the survival of their firms. A 2012 survey showed that 63% of firms are in favour of the svarc system and would be in favour of legalizing undeclared work. Public opinion in Latvia is rather similar. In Latvia, the prevalence of various forms of undeclared or illegal work is rather different from what is reported for the Czech Republic. For example, the illegal employment of third country workers is not regarded as a major problem according to information from the State Labour Inspectorate (SLI), less than 1% of cases where illegal work has been uncovered involve third country workers. On the other hand, registered unemployed who are actually working illegally emerged as a problem in the economic crisis when according to the SLI about 10% of revealed cases of illegal work involved the registered unemployed as compared with less than 3% before the crisis. Service contracts, author agreements 6 and other forms of agreement that correspond to the svarc system are legal in Latvia provided they represent genuine self-employment and are not used to hide what is in practice a regular employment relationship 7. Although, there are no official estimates of the extent to which svarc type practices prevail in Latvia, Table 1 4 Internet: http://www.mk.gov.lv/files/latvijas_konkuretspejas_izvertejums2011_final.pdf 5 There are no formal estimates of the scale of lost budget revenues resulting from informal activities in Latvia. However, a recent statement from the Finance Ministry regarding incentive payments to state institutions fighting the shadow economy claims that in 2012 the anti-informal economy activities of these institutions are expected to generate revenues of about 50 million LVL (125 million EUR). 6 Author agreements are typically one-off agreements for the provision of services, such as a written report. 7 The burden of proof is on the authorities who have to show that the relationship is really a regular employment relationship. For example, a successful prosecution occurred when in 2006 a bus fleet company concluded service contracts with minibus drivers, taxi drivers, and cashier-attendants. These workers had registered themselves as self-employed, but provided their services using vehicles belonging to the company. The company, appealed but eventually lost the appeal in 2010. 5

shows own-account self-employed 8 as a share total employment for Latvia, the EU-27, and the Czech Republic. Table1: Self-employed persons without employees as % of total employment 2007 2008 2009 2010 2011 EU-27 10.4 10.2 10.4 10.7 10.6 Czech Republic 11.8 11.9 12.4 13.4 13.9 Latvia 5.9 5.5 6.2 6.1 6.6 Source: Eurostat While not being an exact measure of workers involved in a svarc system, this indicator represents the potential pool of such persons, since the self-employed who are also employers are unlikely to be svarc workers. It can be seen the share of own-account selfemployed in the Czech Republic is above the EU-27 average and more than twice as high as in Latvia 9. This data confirms that the svarc phenomenon is very likely to be much less prevalent in Latvia than in the Czech Republic. A particularly important form of undeclared work in Latvia is so-called envelope wages. In this, the employee has a perfectly legal work agreement, but on top of the wage in the agreement (on which all taxes are paid), there is another part that is paid in cash (in the envelope ) on which taxes and other obligatory payments are not paid. Needless to say this form of undeclared work is practically impossible to detect in normal workplace inspections. The prevalence of this practice is accordingly hard to document. In many cases, the legal wage is at the minimum wage (though not universally there is anecdotal evidence that employees with much higher salaries than the minimum wage also receive envelope payments). Nevertheless, the number of minimum wage recipients is an indicator of the potential prevalence of the envelope wage phenomenon. Figure 2 shows the dynamics of minimum wage recipients in recent years. Figure 2: Number of minimum wage recipients in 000s 250 200 150 100 50 0 Source: Labour Force Survey The data shows that the number of minimum wage earners doubled as the crisis developed, and that at the peak in 2010, represented about 22% of total employment and has exceeded 15% in every quarter since the beginning of 2009. 8 Own-account self-employed are those who do not employ other workers. 9 The share of self-employed with employees (i.e. self-employed who also employ other workers) is however very similar: thus in 2011 it was 4.3% for the EU-27 and 3.6% for both Latvia and the Czech Republic. 6

Data on undeclared work in Latvia comes from a number of sources. Firstly, there are the reports of inspections carried out by the SLI which document actual numbers of instances of discovered illegal work. These numbers depend on the intensity of inspections and on the way in which they are carried out e.g. whether or not they are targeted. Thus, the data from inspections cannot be extrapolated to the economy as a whole. Other approaches are based on survey methods and in principle generate global estimates. Thus, using various survey data, M.Hazans 10 claims that the share of employees working completely without a work agreement 11 has been falling in recent years and at the beginning of 2012 stood at approximately 2.3%. On the other hand, using a survey of employers, Putnins and Sauka 12 report that in 2011 the number of unreported employees as a percentage of actual employees in the private sector was 11.6% and unreported salaries were 29.1% of actual salaries. This led the authors to conclude that the shadow economy in Latvia was 30.2% of GDP in 2011 13. In Latvia, the fight against the informal economy is conducted on several fronts: firstly, the Finance Ministry co-ordinates an Action Plan for Reducing the Shadow Economy 2010-13 containing 60+ measures aimed at a combination of changed incentives and an increased intensity of inspection and control; secondly, there is the on-going activity of the State Labour Inspectorate aimed at identifying illegal work as such. Since this represents the direct Latvian counterpart of the measures described in the Czech initiative, this will be the focus of the discussion in section 3. 3 ASSESSMENT OF THE SUCCESS FACTORS AND TRANSFERABILITY The Czech policy instruments introduced in the reforms covered by this Peer Review have a number of features in common with the instruments available to the Latvian SLI. Common features include: more effective sanctions; training of inspectors; awareness raising; coordination of databases and agencies. An interesting issue is the legal definition of illegal work. In the Czech measures, the clarification and strengthening of this definition appears to have been an important starting point for the new initiatives. In Latvia, according to the SLI in Latvian law, there is no concrete definition of illegal work or unregistered employment. Rather, from the regulations, it emerges that the key aspect is the presence of an intention to conceal the real relationship between worker and employer with the aim of optimising taxes and avoiding social protection obligations. This could be an area where the lawyers could see what can be learnt from the 2012 amendments to the Czech legislation. Two specific features of the Czech initiative that are novel in the Latvian context include: Mobile offices The system of CzechPOINT controls However, in commenting on success factors of the Host Country measures, the difficulty is there is little to show so far. As the Host Country paper admits: only 35 000 out of an intended 200 000 controls per year have been conducted up until now and none of the envisaged 180 mobile offices have been purchased due to the complex regulations of 10 Internet: http://www.lu.lv/zinas/t/13298/ (in Latvian) 11 This therefore does not capture the envelope wage phenomenon. 12 Internet: http://www.sseriga.edu/en/research/centre-for-sustainable-business/shadow/ 13 All of these indicators were down as compared with 2009 and 2011. Thus in 2009 and 2010 the share of unreported employees was 14.6%, the shares of unreported wages were 34% (2009) and 35.5% (2010) and the share of the shadow economy in GDP was 36.6 % (2009) and 38.1% (2010). 7

public tenders in the country. There is a high rotation amongst the newly trained inspectors and few of the uncovered employers and employees have been effectively penalized. There is also a lack of clarity: the figure of 35 000 inspections or controls is mentioned on p.14, but on p.12 it is stated that since the end of May 14 304 controls have been launched of which 10 304 have been completed. Here it is interesting to compare success indicators: the 10 304 controls revealed a total of 1 285 people working illegally, or a success rate of about 12%. The latest Latvian figures are from 2011, when 3,248 inspections revealed 2,958 illegal workers (success rate of over 90%). This figure has been achieved by a policy of targeting sectors and enterprises e.g. in sectors such as construction or wholesale trade. However, even earlier before targeting, the worst outcome was in 2009 when 4,996 inspections revealed 1,211 illegal employees (25%). The 2012 plan envisages about 3,000 inspections and an effectiveness rate of 25%. The intensity of inspections in Latvia is perhaps rather higher than in the Czech Republic employment in the Czech Republic is more than 5 times that in Latvia, but the completed inspections (10 000 plus in the year from May 2011) were only 3 times higher than in Latvia. It is interesting that in the Czech Republic sanctions for working illegally are applied to the worker, as well as the employer. This is not the case in Latvia. Only employers are fined. The maximum fine is 10 000 LVL (14 330 EUR) as compared with 250 000 CZK (just over 10 000 EUR). So the Czech sanctions are nominally considerably softer. However, in both countries, the authorities face considerable difficulties in enforcement through the court system. It will be interesting to see how effective the mobile offices are when they finally are in place. Needless to say, Latvia too often has public procurement problems. 4 QUESTIONS The Host Country paper does not mention envelope wages. Is this because envelope wages are not regarded as a problem in the Czech Republic or is it because the practice is not regarded as illegal or unregistered work? On p.11 of the Host Country paper, it is stated that it was estimated that the project would help to reduce the above impacts of undeclared work of at least 10% in the short-run, and up to 30% in the long-run. Another expected outcome of the project was that it would not only reduce tax evasion, but also would help to change the status of currently illegally employed persons to becoming legally employed with the same employees. The estimations showed that the project might result in legalizing 10 000 jobs each year. It would be good to have some information on how these estimates were generated. How do the mobile offices work? Can they be used to make inspections without advance notice? Are there special facilities for people to report illegal work e.g. by telephone, email or on-line? 8

ANNEX 1: SUMMARY TABLE Labour market situation in the Latvia Latvia was the hardest hit EU country in the recession both in terms of GDP and employment Undeclared work and informal activity in general is a long standing problem A major problem in Latvia is the prevalence of envelope wages The prevalence of illegal work and envelope wages increased in the economic crisis Assessment of the policy measure The Host Country policy measure is aimed particularly at the svarc system which is less of a problem in Latvia The fact that illegal work is widely condoned in Czech society as also in Latvia makes action difficult In contrast to the Czech republic the illegal employment of foreign workers is a minor problem in Latvia Assessment of success factors and transferability The Czech measures include a definition of illegal work that could be transferable Key aspects of the initiative are not yet in place e.g. the mobile offices There is much overlap in the approach of the SLI in Latvia and the Czech measures Questions Are envelope wages a problem in the Czech Republic? How have the impact effects of the initiative on undeclared work been estimated? How do the mobile offices work? Can they be used to make inspections without advance notice? Are there special facilities for people to report illegal work e.g. by telephone, email or on-line? 9