Article on Undeclared Work from SYSDEM Correspondent (Update of EEO Review: Autumn 2004)

Transcription

1 EUROPEAN EMPLOYMENT OBSERVATORY Article on Undeclared Work from SYSDEM Correspondent (Update of EEO Review: Autumn 2004) UNDECLARED WORK IN THE REPUBLIC OF CYPRUS by Louis N. Christofides University of Cyprus and University of Guelph Guelph, Ontario, CANADA May 21, 2007

2 Introduction The Communication of the Commission on Undeclared Work (Brussels, COM (1998)) launched a debate on the causes of undeclared work and on ways to combat it. The European Parliament in Report on the Commission Communication on Undeclared Work (Brussels, Committee on Employment and Social Affairs, A5-0220/2000), urged the Commission to review measures taken by Member States. The Commission funded Mateman and Renooy (2001) Undeclared Labour in Europe, who reported on this issue for France, Germany, Italy, The Netherlands, Spain, Sweden and the United Kingdom. The more recent study by Renooy et al (2004) broadened its span but nevertheless contained little on the Republic of Cyprus (Cyprus). Undeclared work (UDW) is defined by the Commission (1998) and the studies referred to in the first paragraph as any paid activities that are lawful as regards their nature but not declared to the public authorities, bearing in mind that differences in the regulatory systems of Member States must be taken into account. In the previous Thematic Article for SYSDEM of August 2004, the then available information was examined in detail, commenting on the issues involved, including the dissonance of the above definition of undeclared work with the one prevailing locally. It was shown that at least one local definition is broader and encompasses unpaid home production, unpaid activities such as sport fishing and hunting as well as some illegal activities such as drug dealing and copyright violations. The earlier report reconciled the two definitions and commented on the available guesstimates. In this report, we adopt the Commission s definition (paid, legal, work that is not reported). This definition is interpreted to include paid, legal, work carried out by individuals who are not legally able to work (e.g. publicly employed doctors who work on their own account, publicly employed teachers who tutor pupils, illegal immigrants and refugee claimants who engage in paid legal activities when they are not supposed to). The information previously reported is reviewed and updated, new studies are considered and new developments are examined, particularly with regard to undeclared work by foreign workers. As noted in the previous report, combating undeclared work has, traditionally, not been given very high priority. Since the previous report and since the new Lisbon Strategy of 2005, more activity in the direction of combating UDW can be reported. New legislation (described below) was passed in 2005 to discourage tax evasion. Attempts have been made to limit the amount of private tutoring by school teachers. A tax amnesty programme has been completed. Some public discussion of UDW occurs from time to time but there has been no dramatic change in the landscape. There is no appetite for dealing aggressively with the politically hot issue of getting self-employed individuals to pay income tax. Some attempts to deal with illegal immigrants are being made. Efforts to limit the illegal labour market participation of foreign workers and refugee claimants have been stepped up. It should be noted that Cyprus faces an unusually difficult problem with regard to illegal immigration. It is closer to a number of political 2

3 hot spots than many other member states. Its jurisdiction does not extend to the northern part of the island, where behind the façade of democracy the Turkish Army has a major say on how the area under its occupation is run. Entry from Turkey itself into the north is said to be easy and the green line separating the north from the south is permeable. Thus, anyone who manages to get into Turkey or the occupied areas can find his/her way into the Republic of Cyprus relatively easily. Once there, many seek political asylum, taxing the resources that are available to deal with the genuine refugees. The Prevalence of Undeclared Work in the Economy From the point of view of the employers, UDW pays because of unskilled labour shortages, because illegal workers offer flexibility in terms of when and for how long they are employed, because they are (likely) paid less than unionized labour and because social security and other contributions are not paid. From the point of view of the worker involved in UDW, the motives include securing work and after tax income at terms which are preferable to those they could secure at home or in another country. In the case of Cypriot workers engaged in UDW, the motives include adding to their after tax income through flexible forms of employment. This is a form of employment that is particularly scarce in the formal labour market and one that is resisted by some unions. Given the definition adopted, the main types of workers engaged in UDW include: Illegal immigrants who are employed in legal work, such as construction; the self-employed whose work is not reported or is underreported; paid workers (including teachers, doctors and other public servants) who hold second jobs that are not declared; retirees and students who are gainfully employed but who do not declare these activities; and those receiving unemployment benefit and social security who hold jobs. The first two groups are likely to account for most of the UDW in Cyprus but no real evidence is available. These categories are considered in turn. Illegal immigrants are thought to be of the order of 30-40,000, or about 10% of the gainfully employed. It must be stressed that these are guesstimates. They consist of once legal workers who break their contracts, individuals arriving as tourists or students who stay on, asylum seekers who arrive at the legal ports of Cyprus and are not supposed to work (except under certain circumstances), and individuals who cross the Green Line from the north undetected. They are probably employed in the various sectors of the economy in the same proportions as legal foreign workers, most likely in home service, construction, the food and restaurant sectors, the hospitality business, in retail trade and in other services. Their total earnings are likely to be in the order of CYP 210 million (CYP500 per month, or 6000 per annum, times 35,000 individuals) or Euro 361 million. This is roughly 3.5% of GDP (say CYP 6 billion). It should be stressed that this percentage does not indicate the percentage of GDP due to illegal immigration for a variety of reasons see Besin and Jenkins (2006) for a careful explanation. Georgiou (2007) reviews the available methods for estimating underground activity and notes that there are problems with all of them, while OECD (2004) provides a good general discussion on the issues involved. 3

4 Christofides and Pashardes (2002, p. 742) report a rate of self-employment of 23% for Cyprus, while 1986 data in Blanchflower (2000) suggest a rate of 11.5% for the UK. Thus the rate of self-employment is relatively high. Self-employment includes not only tradesmen (electricians, plumbers, painters, construction and repair people), many of whom now employ the illegal immigrants referred to above, but also professionals such as lawyers, doctors, private tutors and other service providers. The high incidence of self employment not only reflects the rather lax tax regime under which they have, until now, been able to operate, but also means that the amount of tax that they escape is probably substantial. Of the 2004 projected revenues from direct taxation, 30% will come from income tax for paid workers but only 1.75% will come from the self-employed see Polites May 30, This figure, noted in the last report, is not likely to have changed appreciably. Dual job holding is also prevalent. Public servants generally work from 7.30 am to 2.30 pm, leaving afternoons (except Thursdays) free. Some of them engage in selfemployment, income from which may not be reported. Some high school teachers run private tutoring enterprises after school. Publicly employed doctors are also said to engage in private account business. The activities of teachers and doctors contravene their terms of employment and create serious moral hazard problems noted in the earlier report. That is, the system provides clear incentives to both teachers and doctors to underperform during regular hours in order to boost their private account businesses. The cost of this undeclared work is not only the loss of tax revenue on undeclared incomes but, more importantly, the destructive forces that are unleashed on the school and medical care systems. Where unscrupulous individuals are involved, pupils may be left undertaught and patients under-treated. These mechanisms may also have distributional effects if the poor are under-provided. The size of the tutoring and medical services activities (excluding the effects of moral hazard) was estimated by AKEL (2003) to be approximately CYP 27 million in 2000, most of this being due to tutoring rather than medical services. This works out to about 0.5% of GDP. In the earlier report, reference was made to abuses of the unemployment insurance and welfare schemes, some of them officially sanctioned. One such category is public sector employees who, on retirement, are able to collect unemployment insurance for six months. In general, these abuses are thought to be rare and pale relative to the underreporting that is estimated to be done by the self-employed and the work carried out by illegal workers. It should be noted that the amounts of income and the percentages of GDP given in this section are not meant as estimates of the size of the informal sector. Instead they are compared to GDP only to give an indication of their size relative to a well-recognised total, such as GDP. By contrast, the AKEL (2003) study sums the total size of the para-economy (defined to include some unpaid and some illegal work) to 9.2% of GDP in The figure of 9.2%, based on the AKEL (2003) para-economy definition, is broadly in line with the estimate of 8.8% of GNP during the 1980s by Georgiou and Syrichas (1994). They rely 4

5 on the Tanzi method which uses the demand for currency as a proxy for underground activity and so their methodology is broadly consistent with the definitions in AKEL (2003). On the other hand, the estimate of 21% of GDP for reported by Schneider (2000) may be too high. Given the growth in the number of illegal immigrants in recent years, there is no doubt that the importance of undeclared work has increased substantially, though it is doubtful that it has reached the levels suggested by Schneider (2000). Renooy et al (2004, p. 139 and footnote 55) mention a figure of 4.2% of GDP for Cyprus. However, a clear distinction between the Republic of Cyprus in the south and the occupied north is not drawn and it is not clear what part of the island this figure refers to. A more recent, careful, study by Besim and Jenkins (2006), two economists who work in the north, examines specifically the situation in the north. They estimate the number of unregistered workers by (i) comparing the work force with those registered in various insurance funds and by (ii) counting the number of unregistered immigrants. They conclude that the number of workers in the informal sector is in the region of 35-40% of the total labour force. Their contribution to GNP is of the order of 12-17% of GNP. They note (p. 3) that the official statistics for income considerably understate it and that the gap in the incomes of permanent residents of north and south Cyprus could be significantly smaller than what was reported in the official statistics for north Cyprus. Returning to the reasons for UDW in the first paragraph of this section and some of the questions raised in the template, it is clear that income taxes and social security contributions are important determinants of the extent of UDW. No tax and no contributions are clearly preferable for the individuals involved to positive taxes and contributions. That said, it must be emphasized that the authorities in Cyprus have done an excellent job of reducing the burden of direct taxation, particularly in light of the substantial defense expenditures and political infrastructure needed to ensure the political survival of the Republic of Cyprus. In the 2002 tax year, taxable income up to CYP 9,000 (1 CYP = 1.72 Euro) was tax exempt. Between CYP 9,001-12,000, the marginal rate was 30% and above CYP 12,000 it was 40%. These were fairly high rates, particularly given the size of the publicly provided services in Cyprus. However, in 2004, the marginal tax rate became zero for taxable income up to CYP 10,000, 20% between CYP 10,001-15,000, 25% between CYP 15,001-20,000 and 30% above CYP 20,000. The income tax schedule in 2002 imposed a stiff marginal tax rate on income above CYP 9,000 but the 2004 changes reduced the marginal tax rate on income significantly, reducing the incentive to underreport. By contrast, indirect taxation has increased in recent years (see previous report), providing an incentive for the service sector to engage in UDW. Social security contributions are fixed at 6.3% of insurable earnings for each side of the market - the government contributes an additional 4% (total of 16.6%). Discussions are under way at the moment to increase these contributions in order to improve the viability of the social insurance scheme but, from the point of view of UDW, it would be better to explore other means to improve the health of the fund, such as an increase in the retirement age. 5

6 Thus, the reasons for the importance of UDW in Cyprus must be sought in the tightness of the labour market, the high growth in real wages relative to productivity growth in recent years, the continued increase in the minimum wage (which, in Cyprus, applies only to the non-unionised sector), and to the relative scarcity of formally flexible forms of employment. It is not known whether small firms are more prone to UDW than large ones. Concerning the matter of wage growth, Polites (2007) reports that over the period , nominal wages increased by 30.6% in Cyprus and 18.8% in the EE, while productivity grew by 5.14% in Cyprus and 7.21% in the EE. Inflation does not explain the difference between the experience in Cyprus and the EE. Measures Taken to Combat Undeclared Work It is fair to say that, until recently, UDW was not considered a high priority issue. It was taken for granted that self-employed persons would not pay income taxes. Indeed, a number of personal expenses would normally be charged to the business, reducing possible revenues from the taxation of profits. Consistent with this benign neglect, penalties for fraudulent declarations and the extent to which monitoring and spot checks were done seemed modest. The second major aspect of UDW, i.e. work by illegal immigrants, is a relatively recent phenomenon. Many employers are complicit and many landlords make accommodation available to illegal workers. Clearly, illegal immigrants are a source of cheaper and more flexible labour than can be obtained in the formal, largely unionized, sector. In addition, if illegal immigrants can be employed to do the work, company profits from such jobs can be more easily left undeclared. Thus, the problem of UDW is not only related to the cost of labour but the willingness of employing firms to declare income and be taxed. There are signs that more is beginning to be done, either because of the new Lisbon Strategy or, more likely, because the government, intent as it is on fiscal stringency, is beginning to realize that largely untapped sources of tax revenue are available. A tax amnesty programme exceeded all expectations of revenue but must also have made the government realize that many fish have been escaping the tax collector s net. The Assessment and Collection of Taxes (Amending) Law 135 (I)/2005 came into force on January 1, It provides for (i) the compulsory submission of tax returns for those earning more than the personal exemption rate (currently CYP 10,000 or approximately Euro 17,200), (ii) the introduction of self-assessment by the self-employed, (iii) the keeping and submission of audited accounts by self-employed individuals earning more than CYP 40,000 (or Euro 68,800), and (iv) the introduction of penalties for the late submission of tax returns and for the non-payment of taxes by the self-assessed. Whether this new legislation will pay dividends is doubtful. A self-employed person can easily persuade even him/her self that his/her earnings do not exceed the CYP 10,000 cutoff. Suggestions that the cutoff may be increased to CYP 12,000 are of concern in this connection. The introduction of penalties is certainly helpful but these are only as good as the enforcement that goes with them and it is not clear that more resources are being 6

7 directed to this cause. Thus, while the moves made are in the right direction, their effectiveness should, at this stage, not be taken for granted. There are also some indications that the government is clamping down on the employment of illegal workers. Raids on workplaces are increasing and employers are being prosecuted. However, the mindset needs to change on all these issues, a point also raised by Mateman and Renooy (2001) for the EU countries more broadly. Until now, there have been no real attempts to educate the public as to the problems involved with UDW. Efforts to reduce illegal employment are hampered by the societal mindset and the amount of resources that relevant ministries can devote to dealing with this issue. Conclusion The extent of UDW in Cyprus is estimated by some to approach 10% of GDP. It has almost certainly been increasing recently due to the increasing importance of paid legal work carried out by illegal immigrants. Another important type of UDW involves the income underreporting by the large self-employed sector whose members pay virtually no income tax. In the occupied north, a careful study by two economists who work there estimates the size of the unregistered sector to be between 12-17% of GNP. These estimates are roughly double those that are being suggested for the south. If true, they call into question the reported differences in the standard of living between the communities in the north and the south. The costs of UDW have not been widely discussed and explained to the public while the benefits are all too evident to the tax-avoiding self-employed individuals and to those employers who have come to rely on cheap illegal labour. The government has been relying on growth and ad hoc measures to fund its own activities. There has, therefore, not been a very strong reason to try to raise tax revenues through tighter enforcement of the tax code. Some indications have appeared that more is being done to combat UDW. A tax amnesty was very successful in raising one-time revenues but must also have highlighted the amount of underreporting that is taking place. New legislation has been put into place that may help reduce tax evasion by the self-employed. However, the prospects of a sea change from the new legislation appear modest. Illegal immigration into Cyprus is thought to have reached historical highs. Unemployment has been rising somewhat and illegal immigrants may, therefore, be regarded with less understanding. The police claim that a large proportion of offences is being committed by illegal workers and there is increased stress on the possible social problems that may accompany imported and, particularly, illegal labour. Few prospects for success in curbing illegal immigration exist in light of the ease with which entry, through Turkey, to the occupied areas can be secured and the ease with which the Green Line can be crossed. 7

8 Bibliography AKEL (2003) E Paraoikonomia sten Kypro: Melete (Nicosia, Grafeio Oikonomikon kai Koinonikon Meleton, AKEL). Besim, M. and G. P. Jenkins (2006), Informal but not Insignificant: Unregistered Workers in North Cyprus, unpublished mimeograph. Blanchflower, D. G. (2000) Self-Employment in OECD Countries, Labour Economics, 7, pp (Special Issue on Self-Employment). Brussels, COM (1998) C4-0566/ /2082 (COS) Brussels, Committee on Employment and Social Affairs, A5-0220/2000 Christofides, L. N. and P. Pashardes (2002) Self/Paid Employment, Public/Private Sector Selection and Wage Differentials, Labour Economics, 9, pp Georgiou G. M. (2007) Measuring the size of the Informal Economy: A Critical Review, Central Bank of Cyprus, Occasional papers in Economics, 07/01. Georgiou G. M. and G. L. Syrichas (1994) The Underground Economy : An Overview and Estimates for Cyprus, Cyprus Journal of Economics, Vol 7. No. 2, December, pp Mateman S. and P. H. Renooy (2001) Undeclared Labour in Europe (Amsterdam, Regioplan Publication nr. 424, October). Organisation for Economic Cooperation and Development (2004), Employment Outlook. Polites (2004), Daily Newspaper, May 30, 2004, p. 3. Polites (2007), Daily Newspaper, May 20, 2007, p. 88. Renoy Piet, S. Ivarsson, O. van der Wusten-Gritsai, R. Meijer (2004) Undeclared Work in an Enlarged Union. An Analysis of Undeclared Work: An In-Depth Study of Specific Items, Final Report (European Commission, Directorate-General for Employment and Social Affairs). Republic of Cyprus (2006) National Reform Programme of Cyprus Progress Report, October. Schneider F. (2000) The Value Added of Underground Activities: Size and Measurement of the Shadow Economies and Shadow Economy Labor Force All Over the World, Mimeograph, July. 8