Informality: Regulations, Institutions and Enforcement. Background Paper prepared by Necdet Kenar

Transcription

1 Informality: Regulations, Institutions and Enforcement Background Paper prepared by Necdet Kenar for Country Economic Memorandum (CEM) Informality: Causes, Consequences, Policies June

2 1. Introduction The focus of this paper is on regulations, institutions and enforcement which impact the degree of informality. There are several definitions and dimensions of informality. As is seen from the aspect of labor informality definition; TUİK formulates a categorization of registered/unregistered employment. According to TUİK, unregistered employment includes, all employed persons who were not registered to any social security institutions corresponding to their main job during the period. EU has developed an undeclared work definition. According to this definition the undeclared work can be identified as, "any paid activity which is legal per se but not declared to public authorities, taking into account differences in legal systems across MSs". In this paper it is attempted to focus on legal economic activity and employment which are not declared or not taxed. The paper is composed of six sections. In the second section, informality in terms of the firms and the employees is examined. In the third section, the costs of formality and the labor market regulations are investigated. The fourth section comprises the quality of regulation and the role of the regulatory framework. The fifth section involves the enforcement capacity (enforcement of laws and institutional capacity). And lastly, the paper ends with a suggestions part. 2. Various forms of non-compliance, degree of informality The Turkish business sector and labor market comprise a multilayered and heterogeneous structure. Some enterprises comply with all rules regarding the tax and employment legislation (laws and regulations). All of their transactions are registered; they do not engage in tax evasion; they do not commit in uninsured employment; they declare their employees wages as they actually are. Additionally these enterprises fulfill the employment legislation requirements fully; they disburse the severance benefit, meet the mandatory employment obligations such as the obligation for handicapped employment, and abide by the regulations on environment and work safety. The majority of the large-size firms, especially the unionized establishments, fall within this category. On the other hand, some enterprises are entirely informal. They do not register any of their activity to the relevant state institutions such as tax offices, municipality, trade chambers tradesmen and craftsmen chambers. Hence, as a matter of fact, they do not exist officially. They do not declare their economic activity to related public authorities nor pay any income taxes or social security premiums. Therefore, their commercial transactions and employment volume are all beyond the public authorities cognizance. Some enterprises are registered formally; yet they neither do meet their tax obligations nor comply with the employment legislations fully. This is the most common type of informality in Turkey. The majority of the informal activity is carried out by registered firms. The great majority of firms in Turkey are registered in public offices, such as tax office, social security institutions, municipality and relevant business associations. Registration is the most important indicator of the existence of the firm; in fact it is very difficult for any firm to accomplish recognition without being registered. Firms have to be registered to provide service particularly for state institutions and private firms (especially large and medium size companies) and they also have to be registered for making out invoices. An enterprise faces invoice requests in some of its deliveries, if not all of its goods and services deliveries. If the firm is not registered with the tax office and cannot issue receipts, it cannot do business with the firms and people requesting receipts. In a market where competition is intense, not being able to do business with some customers would reduce the company s chance of survival. 2

3 Moreover, being registered is crucial for the sustaining of business activities and brings along advantages for the firm. The tax registration is requested in the process of applying for the basic public utility services including water, electricity and natural gas in the business place. Some commercial and industrial activities require license and the application to relevant authorities to get the license requires tax registration. Similarly, using credit or transferring money in the banks requires tax identification number of the firms. Other reasons for the commonality of firm registration can be listed as; the convenience of registration procedure and the possible risks of operating unregistered. It is very hard for a firm that is operating without being registered to hide itself from official bodies. An unregistered company is detected very easily in the tax office, municipality and other state institutions inspections and in this case all of its transactions are examined. It is very hard for an unregistered firm to operate and run its transactions without any problem. However, it is not so hard for a registered firm to run some of its transactions in an unregistered manner, without being detected. Therefore, it is a common practice of the firms in Turkey to register with public offices. It is also a common and familiar practice of the firms in Turkey to carry on informal activity to avoid tax and other burdens. In fact, there is a widespread perception prevalent among the firms in Turkey that taxes and other burdens on enterprises are very high and it is not possible for a firm to operate by fulfilling all of these legal requirements (World Bank, 2008; Revenue Administration, 2007; Çiçek, 2006). The registered firms, in order to avoid the burdens of operating formally, either hide a portion of their activity or carry out under-invoicing. Similarly numerous firms involve in informal employment in Turkey; they either hide their employment totally or, more generally, at least hide some of it. The extent of the firms informal activity depends on their sector or size. In sectors like construction, textile, clothing, retail, restaurant, informality is more common than other sectors. Additionally, informality is more frequent among small and medium sized firms (SMEs). As it has been stated; because of the higher volume of business as well as higher frequency of working with government agencies or participating in government bids, large enterprises seem to be more diligent in doing business with receipts (World Bank, 2008). For employees, there is also a segmented labor market. A portion of employees have insurance, the premiums are paid on their actual wages and they benefit from all protective decrees of the Labor Code. Some employees work informally, they are not in the scope of social security or the Labor Code. The rest is registered and they are in the scope of social security yet either their wages are not declared fully or they can not benefit from some facilities the Labor Code offers like work safety or severance pay. In the following sections of this paper, business sector, which manifests a multilayered and heterogonous structure, and labor market institutions will be examined in detail regarding informality. 3

4 Table 1: Employment status of persons who are not registered to any social security institution for their main job (non-agriculture,%, 15+ Age) Own account worker Unpaid family worker Regular Casual Years Total employee employee Employer Source: TUİK Firm informality Self employed Unregistered labor or overall economic activity is common among self-employed part of employment despite being registered. According to 2007 TUİK Household Labor Force Survey (LFS), the rate of self-employed unregistered with the social security institutions in non-agricultural sectors is 52.4% in 2007 (Table 1). It should be noted that the self-employed are voluntarily unregistered. While the poverty rate was 3.74 % among regular workers in 2007, this rate was % for casual workers, 0.9 % for employers, % for selfemployed and 20.5 % for unpaid family workers in urban areas. The group of self-employed, casual workers or unpaid family workers, which have relatively high poverty rate, involve more often in informal activity. Therefore, we can speak of exclusion for some of those people who are not able to afford the formality costs due to poverty rather than voluntarily exiting from the system. At least 10% of self employed in urban are too poor to pay their secial security premium. 4

5 The Code 5510 exempted those among the self employed who are exempt from income tax and who have a very low income from mandatory insurance coverage. These people may have voluntary insurance. Code 5763 dated 2008 made a decision on the payment of half of the voluntary insurance premiums of self employed women by the government (in the following years it will be increased by one grade for each year) and encouraged this group to be included in voluntary insurance coverage. Street vendors can be regarded as fully unregistered. The majority of street vendors does not have a certain work place and are not registered with the tax office and other public authorities. A limited number of street vendors are excluded from taxation by the law. 1 Another group that can be considered under this category is trained independent workers that have expertise in an area. Tutors are examples to this group. However, an important detail should be noted here. Some self-employed persons may be registered with the social security institutions. The largest segment within this group is made up of pensioners. Some of the self-employed are covered by the social security system since they get pension as retires or due to the death of their spouse or father (only for women). Likewise, the self-employed that are covered by the optional social insurance but continue to work unregistered can also be included in the same category though they have to be registered. Another example for people included in this category is the moonlighters who are covered by the social security system. These people (e.g. street vendors or tutors) have registered and paid jobs in the public or private sector and thus are covered by the social security system. However, they continue their second unregistered jobs. The registered self-employed also run a substantial amount of unregistered activity. 1 Under Article 9 of Income Tax Law, self-employed exempt from tax are defined as: Those that are engaged in retail trade either temporarily or without opening a place of business, provided that motor vehicles are not used (excluding those that sell clothing, personal goods and accessories, house appliances with high values, food, grocery and cleaning products through market monitoring and selling the products that are sold in permanent business places through opening a stall in front of those permanent business places), -Small artisans such as carders, tiners, solderers, plumbers, shoemakers, shoe polishers, barbers, blacksmiths, photographers, wood or coal breakers, launderers, and carriers, who work temporarily without opening a workplace and who do business directly with the consumer. 5

6 Table 2. Poverty rates according to employment status of household members, urban. Rate of poor individuals (%) Employment status Total years old and more Employed Regular employee Casual employee Employer Self employed Unpaid family workers Unemployed Economically inactives Younger than 15 years old Source: TUİK, Results of 2007 Poverty Study Small-sized enterprises (micro-enterprises) Small-sized enterprises (SSEs) are enterprises employing 1 to 9 employees and are assumed to be working mainly in the informal sector. They have small capital and technological infrastructure, as well as low efficiency. In order to ensure competitiveness with such inefficient structures, they run a significant amount of their activities unregistered. There are in fact unregistered enterprises among SSEs. According to 2007 LFS, the rate of employers unregistered with any social security institution among non-agricultural employers is 24.7% (Table 1). However, the majority of SSEs are registered with some kind of public authority - tax office, social security, municipality or relevant business associations. According to the World Bank Qualitative Interviews Study, forty-seven enterprises out of fifty in the survey are registered with the tax office and many of those registered are also members of the relevant business associations (World Bank, 2008). SSEs and the self employed have a significant place in the Turkish business sector. According to the Social Security Institution (SGK) records, 85.5% of the registered enterprises as of December 2007 are SSEs. The number of registered workers in these enterprises is nearly 2.5 millions, which corresponds to 28.85% of all people covered by the social security system. Almost all of the SSEs are family enterprises and the majority of the employees are family workers. The use of bank credits by these institutions is limited especially for the start-up capital. SSEs are highly flexible since they work with very low operating costs and do not follow the majority of the regulatory rules. Their entry into and exit from the market and employment adjustments are rapid and cost efficient. The fully unregistered SSEs do not meet any of the requirements of being registered. The ones that are registered run some of their activities unregistered and do not pay their due taxes fully. One way of doing this is not to issue receipts for some of the goods and service sales, and another one is to give less-valued receipts. As indicated by the World Bank Qualitative Report, A majority of the interviewees said that doing business without receipts or less-valued receipts was quite frequent in their business 6

7 sector. 2 Among those who said it is not very frequent are those which are the few bigger enterprises included in our sample (employing labor more than 20). Employing unregistered workers in SSEs is quite frequent. According to TUİK, the rate of unregistered employees in enterprises employing 1 to 9 workers is 54.2%. If the SSEs are unregistered enterprises, the workers are also unregistered consequently. A certain number of registered SSEs insure all of their workers. All or some of the employees in some registered SSEs may be unregistered. Half of the enterprises in the sample included in the World Bank Qualitative Survey stated that they insured all of their workers. The basic advantage of employing uninsured workers for the enterprises is the elimination of nonwage labor costs. Through employing unregistered workers, enterprises avoid social security obligations, minimum wage regulations, health and safety regulations and other regulatory costs. Another reason for the frequency of employing unregistered workers in SSEs is the high labor turnover rate in such enterprises. Despite their advantages of higher flexibility, low tax burden and other regulatory costs, these enterprises work under intense competition pressure. Since such companies have limited capital, low technology and less skilled workers, their productivity level is well below the industry average. The intense competition pressures created by the large domestic companies with high efficiency and the competition created by the imports from low-wage-countries as well as volatile economy put significant pressure on such companies. There is a common belief that a certain number of such companies will not survive if the costs of being registered are added. Figure 1: Unregistered employment according to size of firms in non-agricultural sector (%) 60,0 54,2 50,0 40,0 33,9 30,0 27,4 20,0 16,7 10,0 8,8 4,5 2,4 0,0 Total Source: TUİK Medium-sized enterprises (MSEs) 2 The sectors are trade, service, construction, transportation, communication and manufacturing. 7

8 Medium-sized firms (employing between 10 and 249 employees) are firms that are registered and they operate in the formal sector. With the high rates of growth in the last few years, MSEs have had a significant place in the Turkish economy. As of the end of 2007, the number of MSEs registered with the SGK is 158,621; this corresponds to 14.2% of all registered enterprises. The number of employees with social security in MSEs is 4.6 millions as of the end of 2007, which corresponds to 54.4% of all workers with social security. MSEs are also usually family enterprises, which have dynamic, flexible structures. MSEs operate in manufacturing sector and in all service sectors. Compared with the SSEs, they have stronger capital and technological structures. However, with regard to financial and human capital they are disadvantaged compared to larger companies. MSEs are registered but they do not fulfill some of the official regulations, and thus avoiding some costs of the tax system and strict rules of other regulatory systems. Therefore, labor markets display a flexible structure for such companies. Some of these firms do not fulfill tax and social security obligations through hiding some of their commercial activities and their employment in line with their size and the structure of the sector in which they operate. Formality increases with the increase in firm size. Figure 2 shows the relation between firm size and unregistered employment. As the number of workers in the enterprises increases, unregistered employment decreases. While the share of workers without social security in enterprises employing employees is 27.4%, this share falls down to 16.7% for enterprises employing employees and to 8.8% for enterprises employing employees. In some MSEs, all transactions and employment are registered. However, MSEs generally use certain special methods to avoid burdens of formality. For instance, the enterprises employing 30 or more employees are subject to job security legislation; the enterprises employing 50 or more employees must employ handicapped workers and are subject to such regulations as work safety and health. Many firms try to remain below these figures and when they need to grow, they either hire workers informally or take some of the employees out of the company s payroll and use these workers through outsourcing or subcontracting Large-sized enterprises Large-sized enterprises represent the formal and registered sector. All transactions of most of these firms are registered and the rate of workers without social security is very low (4.5% for enterprises employing workers; 2.4% for enterprises employing 500 and more workers). Moreover, such enterprises also follow the rules of labor legislation; disburse severance payments, fulfill their compulsory employment obligations (e.g. handicapped employment requirement) and abide by the environmental and work health and safety regulations. Such enterprises employ 250 and more workers. As of the end of 2007, 0.25 % of the enterprises registered with the Social Security Institution are large sized firms, employing 17.05% of all registered workers. These firms have high technology, highly educated professional administrators and employees. Therefore, their efficiency level is high. Since these enterprises follow all regulatory rules in general, they have to operate with higher employment taxes and higher costs than the SSEs and MSEs, due to strict regulations. 8

9 Table 3- The distribution of the workplaces and compulsory insured persons by group of insured person in December 2007 Number of compulsory insured persons % of total insured persons Group of insured person Number of workplaces % of total workplaces , , , , , , , , , ,55 Total , ,00 Source: SGK, Annual Statistics, Labor informality Unregistered unpaid workers Unpaid family employment is especially more common in the agricultural sector in Turkey. According to LFS, 45.4% of the total employees in the agricultural sector were unpaid family workers in 2007, and 98% of these family workers were not registered with the social security institution. The rate of unpaid family employment in non-agricultural sectors is 7.4% and the rate of the unregistered with the social security institution among the unpaid family workers in the non-agricultural sector is 84%. Informality can be considered as voluntary employment in this case since these are family enterprises. This group has the highest rate of poverty and as poor family members cannot be expected to meet insurance costs, due to poverty it would be more accurate to speak about exclusion for many unpaid family workers Casual workers Casual workers work on a daily payment basis for one day or a few days and include daily cleaners, porters and casual or short-term workers in the construction sector. This group constitutes the category which has the highest rate of informality in non-agricultural sector. Due to the traits of their job, casual workers constitute the group that is technically the most difficult to register. According to LFS, in 2007, 86.8% of all casual workers in nonagricultural sector are unregistered, which, in this case, may not be unlawful. In fact, the social security system does not require these casual workers to be registered with the work they do, since they are directly hired by the client on a daily basis. In this regard, it would not be inaccurate to argue that the social security system excludes casual workers. The basic form of being insured for casual workers is voluntary insurance. Thus, some of the casual workers are insured on a voluntary basis but such voluntarily insured casual workers may be categorized as both registered and unregistered in the statistical records. Since voluntary insurance is not related to the main job, the workers that are voluntarily insured are normally categorized as unregistered in the TUİK statistics. However, some voluntarily insured workers consider themselves insured and answer the question posed by the interviewer of TUİK as registered. The number of people categorized as registered by the TUİK is less than the figures announced by the Social Security Institution. According to TUİK 2007 LFS, out of the 21,2 million people employed, 11,3 millions are registered with the social security institutions related to their main jobs. However, the number of insured people registered with the Social Security Institution in 2007 was 15,1 millions. It would be difficult to explain all of nearly 3,9 people that seem to be unregistered according to TUİK but 9

10 are registered with the SGK, but 269 thousand voluntarily insured people may partially explain this difference. The new Social Security Code 5510, which came into force in 2008, facilitated access to voluntary insurance. Through abolishing some of the conditions in the former regulation such as the requirement of being regularly insured for at least five years in the Social Insurance Institution (SSK) and at least 10 years of service in the Pensioners Fund (ES) to be voluntarily insured, the new regulation stipulates that everyone over 18 years old who request to be insured can become voluntarily insured. While the former regulation required that the people who wanted to be voluntarily insured could not work in a business place, the new regulation allows workers (particularly part-time employees) to complete the missing days of insurance in a month through the voluntary insurance system. Moreover, while the former regulation did not stipulate the health insurance option, the new regulation foresees that people can benefit from health services through paying the general health insurance premium. The terms and conditions of the new regulation are particularly significant for its including casual workers in the insurance system and thus for its role in preventing exclusion and reducing informality. However, TUİK statistical records continue to categorize casual workers that are voluntarily insured as unregistered as they are not insured related to their main jobs Regular workers The rate of unregistered workers among regular workers is 20.8% for the non-agricultural sector. For regular workers, we can talk about both exclusion and exit. Regarding exclusion, the employer employs all or some of the workers without being registered with the social security system in order to avoid tax and other obligations. This is a common practice in Turkey. Normally, it is logical for workers to demand to work as insured under the protection of the social security system. Therefore, for the majority of unregistered regular workers, exclusion takes place out of the will of the workers concerned. Although not preferred, some workers have to work without being insured because they cannot find a job with insurance. And they know others are available out there to accept the uninsured job. The job seekers who cannot find a job with insurance as they are mostly low educated and unskilled may have to accept the uninsured job offer of the employer. Moreover, unregistered employment is also common among young people, students and pensioners. As there are less health problems during youth and retirement is considered by them to be very far a way, young people are not much concerned about uninsured employment. 57.1% of workers between the age of 15 and 19 are unregistered, while this rate falls down to 42.3% for workers between the age of 20 and 24 and to less than 30% for workers between the ages of 25 and 29 (Figure 2). There are also many people working unregistered by their own will. The majority of such workers are already benefiting from such rights as they are covered by the social security system, such as pensioners and orphan girls or single daughters who are paid their parents pension. Figure 2 indicates that unregistered employment rapidly increases for the age group above the age of retirement in Turkey. While unregistered employment rate is 26.9% for age group, this rate increases to 33.7% for age group, to 47.2% for age group, to 57.7% for age group and to 65.8% for age group. The people that continue to work after retirement as well as those who cannot get retirement since they are not at the retirement age despite having completed the minimum contribution period for retirement agree to work unregistered. 10

11 Figure 2: Age cohorts of unregistered, urban, 2006 (%) 80,0 70,0 60,0 50,0 40,0 30,0 20,0 10,0 0, Source: TUİK Pensioners A significant portion of unregistered employment is accounted for the pensioners. With the social security reform launched in 1999 in Turkey, the minimum retirement age was set as 58 for women and 60 for men. Before 1999, there was no minimum retirement age and women could get retired after they worked for 20 years and men after 25 years of service. With this rule, it becomes possible to provide retirement at age of 38 for woman and at the age of 43 for a man. The 1999 reform that brought the minimum retirement age condition, however, stipulated a long transition period for the regulated minimum retirement age, which means that in 2008, which is 8 years after the reform, women can retire at the age of 45 and men at the age of 49. Significant portion of the people retired at an early age enter the labor force again. If the people who are retired and continue to be in labor market are employed registered, the employers pay 31 to 36.5% social security support premium over the wage. This rate is the same as the social security premium paid for other employees. However, since the retired employees get pension and benefit from the health insurance, registered employment does not bring along any additional benefits for these people. Therefore, some pensioners are willing to work unregistered and thus a significant portion of the pensioners work unregistered. The people that are retired and work as self-employed are subject to a 12% social security premium cut from their pensions for This cut will be increased to 15% in the coming years, with a one percentage point increase every year. The number of pensioners working unregistered can be estimated. According to SGK Monthly Statistics and LFS, the number of people getting pension is 5.7 millions in July 2008 and the number of people that are not considered in the labor force because of being retired is almost 3 millions. Therefore, 2.75 millon pensioners are in the labor force and approximately 87.7% of these people work (approximately 2.4 millions). However, the number of pensioners that work registered and pay social security support premium is 487 thousands. Thus, we can estimate that over 1.9 million pensioners work unregistered. Some of the unregistered workers are regular while some are casual workers, some are self-employed and some work as employers (micro enterprise owners). These figures will be elaborated on the part about self-employed. 11

12 Table 4: Estimation of number of pensioners that work unregistered, in July The number of pensioners (SGK actual number ) The number of persons who are out of labor force, because of retirement (TUİK, survey) (-) The number of pensioners in the labor force % of non-agriculturel unemployment rate (-) Estimated number of pensioners who work The number of pensioners who work registered (SGK, actual number) (-) Estimated numbers of pensioners who work unregistered Source: SGK Monthly Statistics and TUİK HLFS The individuals whose insured parents or spouse have passed away receive pension payment as beneficiaries. Among these individuals, orphans do not get paid pension if they start to work insured. In July 2008, 2.5 million people are paid widows or orphans pension. In practice the orphans may opt to work unregistered to continue to get orphans pension. Likewise, the widows may also opt to work unregistered since they already have social security benefits Child labor A group under the unregistered employment category is composed of child workers. For employers, child labor means low wages and low labor costs because of unregistered employment. According to 1999 TUİK Child Labor Survey, there are 1.6 million working children aged between 6 and % of these children work in non-agricultural sectors (22.4% industry, 10.2% commerce). Out of the working children, 961 thousands are unpaid family workers, 387 thousands are regular paid workers, 257 thousands are casual workers and 31 thousands are self-employed. 87% of working children work in small enterprises (1 to 9 employees) Foreign illegal workers Another group that work unregistered voluntarily is foreign illegal workers. Foreign illegal workers are people who have entered the country either illegally or legally but work without a work permit. It is difficult to find data and make healthy estimates about the number of foreign illegal workers in Turkey. Particularly following 1980s, the war in the Middle East, the Gulf crises in 1991 and 2003, the dissolution of Soviet Union and the Eastern Bloc, the civil wars in African and Asian countries and other conflicts forced the people living in these countries to migrate and Turkey had its share from such migration movements (MOLSS, 2004). Some of the foreign illegal workers are foreigners who intended to use Turkey as a transit route to migrate to another country in Europe. Other than such people, there are also foreigners who came to Turkey to work. Foreign illegal workers in Turkey are usually employed in small and medium sized enterprises. The sectors in which foreign illegal workers work are those where informality is common, such as construction, founding, leather, textile, plastics, agriculture, shipping, loading-unloading, cleaning, tourism and food in which foreign illegal workers can find jobs. Working for low wages, unregistered, and under bad conditions, these workers are cost effective for employers. Furthermore, foreign illegal workers also work as independent workers (e.g. street vendors). Another area that provides employment opportunities for foreign illegal workers is elderly and child care and domestic work. Female 12

13 from Turkic republics (Azerbaijan, Kyrgyzstan) and former Eastern Bloc countries (Moldavia, Ukraine) work illegally as domestic workers or as elderly and child caretakers by staying in the houses of their employers. Since they work illegally, such workers are also unregistered on their own will. As such workers are not considered workers under the law; it is not possible for them to be registered, to be covered by the social security system and to benefit from the legal clauses protecting the rights of workers. There is no satisfactory data about the number of foreign illegal workers in Turkey. The only data available is the number of 462 thousand people who were caught by the Turkish National Police for having entered Turkey illegally between 1995 and According to Act No: 4817 on "Work Permits for Foreigners" which entered into force in 2003, foreigners who are to work in Turkey have to receive permission beforehand from the Ministry of Labor and Social Security. Under the law, a total of 47,124 foreign work permits were issued until November 30, In the same period, a total of TL15.4 million fine was imposed on 3,273 illegal foreign workers and 1,520 employers who employed illegal foreign workers Under-declaration of wages Another aspect of informality is the underreporting of the wages which is common in practice. A large number of private firms report and pay social security contributions on the basis of minimum wage even though they pay actually higher than the minimum wage. In 2007, 46.6% of the private sector wages is on the minimum insurable wage level. This ratio is 1.1% in the public sector (SGK Annual Statistics, 2007). Through an amendment to the Labor Law in 2008 to prevent under-declaration, Ministry of Labour and Socieal Security (MOLSS) introduced the obligation of payment of the employees wages through banks as of January 1, 2009 for enterprises employing at least 10 employees. The employers that do not fulfill this requirement are imposed 112 TL fine for each employee and each month. Whether this amendment will decrease the underreporting behaviors of the firms remains to be seen. However, it is highly probable that the firms making underreporting will continue their former behaviors through paying a certain portion of the wage through the bank and paying the rest through channels other than banks Under-declaration of working days Under-declaration of working days is also quite common in Turkey. Some employers declare their full-time employees as part-time to pay lower tax and premium. The amendment made in 1999 to prevent this also brought the condition of paying 30 days of premium a month for regular workers; and although it also stipulated that in case of employment for less than one month or on a part-time basis, the employer must produce proof through a contract of employment, under-declaration of working days is still common. 3. The costs of operating formally The economic theory assumes that profit-maximizing firms make a cost-benefit analysis to make decisions. Undoubtedly, firms also make cost-benefit analysis for their unregistered operation decisions. The costs for registered operations are elaborated below. However, the costs and benefits of being formal may be calculated and perceived differently by different firms. Costs and benefits may vary in line with the size of the firm, the sector it operates in, its 13

14 efficiency, the quality of state institutions, the state s enforcement capacity, fines and some other factors. These factors may also determine the firm s degree of formality. In the majority of developing countries, informality is very common among small-sized enterprises. Business environment and regulations, such as access to credit opportunities, may not be favorable for small firms to benefit from the possible benefits of formality. Likewise, since small firms work with low efficiency, heavy taxation on commerce and employment may precluded such firms from competing with large firms. Inefficient firms are more likely to be informal since they are unable to cope with the costs of being registered. Since young firms are usually small and have higher risks of failure, they tend to be more informal (World Bank, 2007). The sector the firm operates in also influences the cost-benefit analysis. In the labor intensive sectors such as textiles and construction where competition is intense, costs of formality are felt more heavily. Legal environment is also important, as capacity of detection possibility and severity of penalty increase the cost of informality. The presence of all these variables lead to differences in the firms perceptions of costs of formality and thus to differences in informality practices. The most important costs of operating formally are the tax and social security obligations as well as the labor market regulations Taxes and Social Security Contributions The common perception in Turkey about taxes (VAT, income taxes and social security contributions) is that they are very high compared particularly with other developed and developing countries. Regardless of firm size, enterprises of all scales believe that they are under a very heavy and unjust burden of taxation. Small-sized enterprises feel that based on their revenue they are under a heavier burden of taxation compared to large-sized enterprises. The common perception among small-sized enterprise owners is that large-sized enterprises find legal ways (through declaring more costs than their actual costs, through deducting their sponsorship and charity costs from their revenue) to pay less tax based on their revenues. Moreover, the common perception among small-sized enterprises is that large-sized enterprises are not properly inspected (World Bank, 2008). Therefore, small-sized enterprises believe that they are disadvantaged in the market and have no choice other than evading taxes to survive. The perception among large-sized enterprise is just the reverse. Large-sized enterprises feel that they are under heavy taxes and other legal burdens that they cannot evade taxes as all their transactions are registered and that small-sized enterprises hide their transactions and production (also expressed as below the stairs ) from state institutions and evade taxes and are not inspected properly by state institutions, thus resulting in unjust competition. The perception that taxes are very heavy leads to the justification of tax evasion in the eyes of enterprises. Small-sized enterprises believe that they cannot continue their operations if they pay all due taxes and not evade any tax at all. In a survey conducted in Istanbul, 57% of employers believe that a taxpayer who pays all the due taxes under the current circumstances will go bankrupt in a few years (Çiçek, 2006). Therefore, the majority of them consider tax evasion as their most natural right in order to keep their enterprise operating. These enterprises also believe that they pay ample tax compared to their revenues although they do not declare some of their activity and thus evade tax (World Bank 2008). Furthermore, the common perception among small-sized enterprises is that both large-sized and small-sized 14

15 Norway Sweden Denmark Iceland Finland Poland Belgium Portugal Ireland Italy Austria Hungary France Germany Netherlands Greece Czech Republic Slovak Republic Turkey United Kingdom Spain Luxembourg Mexico New Zealand Australia Korea Switzerland Canada Japan United States 5 6,0 7,6 10, , , , , , , , ,0 24,5 enterprises evade tax. 96.3% of the participants in the study by Çelikkaya and Gürbüz believe that nobody in Turkey pays all of their due taxes and that if they do not evade tax while everybody else does, this would hinder their competitiveness. The common perception among enterprises is that VAT, corporate, income and payroll taxes are very heavy in Turkey. Value added tax rate is 18% and close to the OECD average rate of 17,71%. For some essential goods, the rates of 1% and 8% are applicable. The rate was reduced to 8% for textile goods in Among the OECD countries, the lowest rate is in Japan with 5% and the highest in Sweden, Denmark and Norway, with 25%. Figure 3: VAT rates in OECD countries, Source: OECD In Turkey, the corporate income tax rate is 20%. This rate was 46% from 1986 to 1993, 25% from 1994 to 1999, 33% from 1999 to 2003, and 30% from 2003 to Compared to OECD countries and other developing countries, this rate of taxation can not be deemed high. Among the twenty nine OECD countries only four apply lower income tax rates than Turkey. These countries can be listed as; Ireland with 12.5%, Iceland with 15%, Poland and Slovak Republic with 19%. The highest corporate income tax rates among the OECD countries are 39.54% in Japan and 39.25% in the U.S. In Turkey, the progressive income tax system is applied. Currently, there are four tax brackets and tax rates are between 15% and 35%. Income tax rates were between 25% and 55% from 1985 to Thus, while the tax rates were higher than the rates in the OECD countries before 1999, the current rates are lower from the OECD average. 15

16 Japan United States France Belgium Canada Luxembourg Germany Australia New Zealand Spain Norway Sweden United Kingdom Mexico Italy Korea Portugal Finland Netherlands Denmark Austria Greece Switzerland Czech Republic Hungary Turkey Poland Slovak Republic Iceland Ireland 12,50 15,00 21,17 21,00 20,00 20,00 19,00 19,00 28,00 28,00 28,00 28,00 27,50 27,50 26,50 26,00 25,50 25,00 25,00 25,00 30,38 30,18 30,00 30,00 30,00 34,43 33,99 33,50 39,54 39,25 Figure 4: Corparate income tax rates in OECD countries, ,00 40,00 35,00 30,00 25,00 20,00 15,00 10,00 5,00 0,00 Source: OECD The social security contributions rate (including unemployment premium) paid by the employers and the employees varies between 36.5% and 42.5% (depending on the sectors) of an employee s wage. 3 15% of this is the share of employee and the rest is the share of employer. 4 The high rate of social security contributions increases the size of the tax wedge. The tax wedge (income taxes and combined employer and employee social security contributions as a percentage of total labor cost) for a minimum wage earner, single, without dependent, is 35%. The tax wedge of a minimum wage earner married and with two children is 32.5%. Higher social security contributions (SSC) which increase the tax wedge discourage firms from employing low-skilled workers in the formal sector. The reason for high SSC lies beneath the generous pension rights. In order to finance higher replacement rates, shorter contribution period and longer retirement period, higher SSC is required. Despite this high SSC amount, the deficit of the social security system accounted for 3.87% of GNP in % for old-age pensions including disability and surviver pension (employer 9%, employee 11%), 12.5 % for general health insurance (employer 7.5%, employee %5), range between 1% and 6.5% for work accidents and occupational diseases (employer), and 3% for unemployment insurance (employer 2%, employee 1%). 4 The wage bargain is based on net wage, and so all payroll taxes are paid by employers. 5 The government brought minimum living allowance through the amendment it made in revenue law in With this practice, the net wage of a single person paid minimum wage increased at a proportion of 9.7% and the net wage of a married person with two children increased at a rate of 14.8%. 16

17 Table 5: The monthly labor tax wedge for a minimum wage earner (TL) Labor cost Social insurance premium 19.5% (employer s share) (if no debts minus treasury support 31,94*) 3.Unemployment premium 2% (employer s share) Gross minimum wage Social insurance premiums 14% (employee s share) Unemployment premium 1% (employee s share) Employee s income tax and stamp tax (15% and 0.6%)** Minus minimum living allowance of Total labor tax ( ) Net minimum wage Net minimum wage as a percentage of labor cost (%) Tax wedge (%) (income tax 5.10%; social insurance 30.04%) Non wage cost as a percentage of net minimum wage (%) Under the Code 5763, known as the employment package, 5 points of the social security premium of the employers share in the private sector is paid by the Treasury as of October In the private sector to benefit from this incentive, employers should not have any premium debt, not employ unregistered workers and pay their current premiums in due time. When this incentive is added, the tax wedge on the minimum wage falls down to 32.3% for the single worker and to 29.7% for a worker who has two children and whose spouse does not work. This rate is considered still high by employers and employees, and yet, but, compared with the 41% tax wedge two years ago, one can argue that the government has achieved progress towards decreasing the non-wage labor cost. Furthermore with the Code 5763, it is anticipated that premiums for the youngsters between the ages of and for women older than 18, those recruited within 1 year as of July 1 st, 2008 (i.e. from July 1 st,.2008 to June 30 th,.2009) are to be paid by the employers social security contribution fund. The employers social security contribution for those individuals calculated via minimum wage shall be paid from the unemployment fund for five years, at a rate of a hundred percent for the first year and in the following years decreasingly at the rates of 80%, 60%, 40% and 20% respectively. The enterprises have to meet two conditions in order to benefit from this incentive. The first condition is that those individuals should be other than registered insured in the period of 6 months prior to the enforcement date of the Law, i.e. in the period from January 1 st, 2008 to June 30 th, The second condition required to benefit from the incentive is that they should hire women or youth in the period from January 1 st,.2008 to June 30 th, The gap between employment cost of workers and their net income creates strong incentives for employers to employ informally. 17

18 Germany Belgium Denmark Hungary Netherlands Austria Poland Turkey Finland Norway Luxembourg Italy France Sweden United Kingdom Greece United States Iceland Australia Canada Czech Republic Portugal Slovak Republic Switzerland New Zealand Spain Japan Ireland Korea Mexico 5,25 13,92 11,89 31,13 30,34 30,13 29,54 29,10 28,51 27,80 27,64 27,00 26,09 24,53 24,43 23,39 23,35 22,87 22,54 22,41 21,82 21,54 20,44 20,13 35,44 33,55 38,66 42,84 41,97 40,99 Figure 5: Tax wedge in OECD countries, ,00 40,00 35,00 30,00 25,00 20,00 15,00 10,00 5,00 0,00 Source: OECD Labor market regulations In addition to high tax wedge, rigid or protective labor market regulations contribute to the increase of informal employment. Labor market regulations cover many areas such as the establishment and protection of universal workers rights, working conditions, employment protection rules, the protection of vulnerable groups of workers. Among them the most important is the employment protection legislation (EPL). EPL covers the kinds of contracts permitted; the conditions under which employees can be dismissed for economic reasons; requirements for severance and advance notice of dismissal; rules for mass layoffs; and redundancy procedures. All these regulations complicate the processes of hiring and firing and increase the costs of these processes. Box: 1 The EPL regulations in the 2003 Labor Code (Act 4857) are as follows: Notice period for no-fault dismissals of indeterminate employees (i.e. those with openended contracts) is 2 weeks if tenure is less than 6 months, 4 weeks if tenure is between 6 to 18 months; 6 weeks if tenure is between 18 months and 3 years; and 8 weeks if tenure is more than 3 years. If an employer wants to cancel a work contract, he has to pay the employee s check for his entire tenure. After one year of tenure, severance pay for no-fault dismissals of indeterminate employees is 30 day salary for each year of service (its ceiling is equal to the retirement bonus for highest-ranking civil servant amounting to , in ) Job security which requires a valid reason (including economic reasons) for dismissal. This regulation is valid for enterprises that employ 30 or more employees and only for employees who are in tenure for at least 6 months. A valid reason for dismissal must be connected to the capacity or conduct of the employee or based on the operational requirements of the establishment or service. If the court or the arbitrator concludes 18