Roosevelt Institute | Cornell University

Greece's Shadow Economy

By Hamdan Al YousefiPublished October 24, 2014

With the Greek economy still suffering the effects of the 2008 recession more and more people are taking liberties and exploiting loopholes to improve their financial situation "” namely tax evasion, creating a shadow economy and depriving the government of tax revenue, adding a burden to the government's debt repayment.

By Hamdan Al Yousefi, 10/24/14

Seven years after the international economy suffered the largest downturn since the Great Depression; signs are still not looking up for some countries. Greece, one of the worst hit in both the Eurozone and the world, is still feeling the effects of the crisis with a new study reporting that the country has a shadow economy of 24% of its GDP.

A shadow economy — otherwise known as an informal or underground economy — is an illicit, undeclared economy that exists alongside the formal economy where transactions occur "off the books". Since the government cannot tax these transactions, they represent a huge loss in revenue, with some reports stating that the global shadow economy is worth around $10 trillion.

Shadow economies tend to emerge when taxation is considered to be high — at the moment Value Added Tax (or VAT) in Greece is at 23%. VAT is a consumption tax that is added to the price of a product when it is being purchased.

In a shadow economy a phenomenon called underreporting occurs — when income at mostly cash-heavy businesses is not recorded correctly. This prevents the income being declared to state authorities. If a sale is not declared then tax does not have to be paid on it, allowing sellers to reduce the price of the product.

It is often difficult for government agencies to monitor such transactions and to prove tax fraud. A heavily indebted economy provides the incentive for suppliers to avoid tax and price their products at a more competitive pricing, risking any consequences that might arise. Competitors often have to follow suit and not declare transactions to remain competitive, hence causing the creation of a shadow economy.

The second segment of the shadow economy is undeclared work, which consists of wages that workers and businesses do not declare to avoid paying tax.

To put a 23% VAT into perspective, a service can be provided at 100 euros without a receipt and 123 euros with a receipt. However, while Greek VAT rate is on the higher end in the EU, there are countries with even higher tax rates — such as Ireland — that manage to avoid the creation of such a proportionally large shadow economy. A high tax rate has to be coupled with poor economic conditions to also see such large growth.

Shadow economies are present throughout Europe, even in the more developed nations of Western Europe. However, shadow economies in other areas of Europe form a much bigger part of the economy in relation to the official economy.

At 24%, Greece has one of the bigger shadow economies in Southern Europe. While it is not as big as some shadow economies in Eastern Europe, the Greek case is significant for the speed at which the shadow economy grew. Shadow economies also exist when economies are booming, suggesting that the Greek shadow economy is as much a function of the shrinking official economy as it is of the growth of illicit activities.

Shadow economies have existed throughout history and were prominent in Latin America in the early 1990s, in places like Peru and Bolivia, though they had their roots in mass political movements and urbanization.

But for Greece the problem is a structural one, inherent within its economy, rather than a political one. The country has already suffered through two bailouts and numerous rescue packages. Greece also has a budget deficit of 13% of GDP, government debt at 174% of GDP and official unemployment at 25%.

While the EU may never let Greece default on its debts if its economy keeps contracting, people may not even be able to afford hiring workers in the informal economy, putting the economy in more dire straits. Having a shadow economy is preferable to a lack of any economy.

Greece is currently in a period of economic austerity — taxes are high and fiscal spending is low. Any extra revenue gained from the elimination of the shadow can contribute to paying off debt and quickly lowering taxes to ease the burden on the population.

Greece have had to make major budget cutbacks as part of their austerity measures to qualify for bailout packages. If they do not qualify for these packages, they risk default. The budget cuts have meant significant reduction in government spending on pensions, benefits, civil servant salaries and health care amongst others. In addition taxes on both the rich and average consumers have seen significant increases.

With so much of these policies focussed on tax and revenue increases and with the government giving very little in return this has provided the incentive for many people to engage in illicit activity and grow the shadow economy. Not only, with the added bureaucracy, is it now easier to avoid taxes but people feel that they are not getting anything in return by paying the taxes.

Policies with too narrow a focus are unlikely to solve the situation, causing more harm than good. Amnesty laws are more susceptible to be taken advantage of and draconian laws will simply damage the economy even more. Rather a change in mentality in society needs to take place — at the moment 75% of the Greek population feels that informal labor is cheaper than official labor and 64% think that informal labor increases the standard of living.

In 2011 the Italian government hired advertising firms to try and create campaigns to spread awareness of tax evasion, a policy that reaped results. Eliminating loopholes in tax policy can work but only if they're coupled with cutting tax rates to prevent further attempts at evasion.

Other policies include further implementation of electronic payment systems to cut out paperwork and make it harder to underreport income.

Above all the Greek government needs to take responsibility for the state of the economy. Corruption within the government stemming back to 2010 led to statistic cheating, with the government paying firms such as Goldman Sachs to hide their debt. How can citizens be expected to abide by the law when the moral standing of their own government is so questionable?