Shadow Economy Reserve for Growth. Q. — Mr. Rühl, how would you define the term «shadow economy»? A. — It relates to all economic activity that is not registered in official statistics, including the data used to calculate taxes. The shadow, or non-observed economy includes both unregistered economic activity (the so-called «black» market) but also partially unregistered activity (the «gray» economy). For example if someone works for a registered company, and gets parts of his wages or profits under the table, i. e. declares less income than he actually earns to save on taxes and security payments, that is gray economic activity. I would distinguish «black» and «gray» economic activities from illegal activities, which are criminal in the sense that the activity itself violates the law, such as drug smuggling. While part of the shadow economy, these illegal activities are raising problems outside the economic domain. Q. — According to GOSKOMSTAT, the contribution of the shadow economy to Russia's GDP ranges from 20 to 25 percent. Does the World Bank have any judgments about the size of Russia's «shadow economy» sector? A. — Not yet. By its nature, this is an extremely difficult task — obviously, participants in the shadow economy are reluctant to reveal the extent of their activity. GOSKOMSTAT currently adjusts GDP by 23 percent, while according to other experts, this indicator is likely to be in the 40 — 50 percent range. However, if we compare this with the situation in other countries — in Italy, for example, the shadow economy is officially estimated to contribute 17 percent to GDP — then I would think in Russia 40 to 50 percent is more plausible than the official estimate. I hope we will be able to give you a more precise estimate soon. We have started a research project on the shadow economy, together with the Bureau of Economic Analysis (which also works on this question at the request of the Government), and the Higher School of Economics, which will give us more information on the role of this phenomenon, and on its size and composition. Q. — In the World Bank's latest Economic Report, you state that the shadow economy plays a role in absorbing labor which has disappeared from the statistics. Where do all these people go, and why do they remain «in the shadow»? A. — Mostly, they leave traditional and statistically well covered sectors such as big and medium enterprises, and they turn into retail trade, small business, and services in general. The shadow economy, of course, contributes to a lack of tax collection, it contributes to underestimating economic data, and so on. This in itself would be good reasons to do something about it and to try to estimate its size. However, I would also submit that it is an important economic phenomenon for two much more fundamental reasons. First, it indicates structural change and diversification in the economy — many people in the shadow economy operate exactly in the kind of «new» economic sectors, which will become more important as Russia's market economy develops, and they have left the sectors which will become less important. Also regionally, the shadow economy is more important in regions where people move to than in regions people have left. The shadow economy, in other words, follows market incentives. And these incentives reflect the general dynamics of structural change which need to happen to better diversify Russia's economy. Most people would agree that Russia needs more diversification away from the energy-exporting sectors and the government-dominated sectors: To some extent, the shadow economy actually represents these shifts toward a more sustainable economic structure, and this is positive. However, under conditions of half-legality, always trying to remain undetected, easily vulnerable to blackmail and harassment, this shift toward greater diversification is more difficult if it takes place in the shadow, than if it could be done in an open fashion. Diversification takes place, in other words, but slower than it would under clean competitive conditions. The second reason why the shadow economy matters is related: It reflects much of Russia's potential for future growth, and it limits the realization of this potential. Q. — From what you said, the shadow economy seems to contribute to real growth, even if statistics may not show this. How would it constrain the potential of Russia's economy to grow? A. — For many of the reasons just outlined. Living and working in the shadow makes it harder to establish efficient enterprises: One has to spend resources in avoiding detection, often this will limit the size of the enterprise and affect its capacity to grow, to hire people, to implement technological modernization. Often it will also give an advantage to those firms which are better at surviving under half-legal conditions — those firms who invest more to have good relations with the bureaucracy, for example. These need not be the firms which would have been best suited to survive under clean competitive conditions. As a result, potentially more efficient «clean» firms find it hard to compete. The black economy, in other words, distorts the competition which leads to growth. This also holds in another respect: Since the shadow economy does not contribute to tax revenues but at the same time uses many of the resources paid for by tax revenues — such as roads and other infrastructure — it actually imposes costs on the official economy without contributing, that is it increases the tax burden for everyone. Finally, the network of informal relations established in the shadow has become one of the main stumbling blocks to successful implementation of the Government's reforms to improve the business climate. Vested interests and corrupt public servants make for strong opponents of reform. Q. — If the size of the shadow economy is 40 to 50 percent of GDP, do you have any estimates how much growth is lost due to it remaining in the shadow? A. — Again, not yet. The answer obviously depends on two factors: Is the shadow economy more or less productive than the registered part of the economy? and is its share in the entire economy increasing or decreasing? We know that much of the shadow economy is in the service industry which has large potential for rapid productivity advances and fast growth, but we do not know how productive the shadow economy is. Can it compete because these are the most clever entrepreneurs or can it compete because they do not pay taxes, social security contributions and the like? We do not know. Also on the second question, does its size increase or do people come out of the shadow, the data is very sketchy. GOSKOMSTAT supposes that the size of the shadow economy declines, partially as a result of measures such as tax reform and deregulation, partially because the official part of the economy is growing. To find out more we need to do more research. Q. — Mr. Rühl, is the increase in tax receipts, which has been observed recently, an indicator of Russia's economy stepping out of the «shadow»? What do you think? A. — Perhaps not as much as we would wish. Some people may have gradually increased the «official» part of their incomes they report. But frankly, I have not yet met one of them. I think the increase in tax receipts is related to better tax administration, high oil prices and favorable economic developments rather than to a downsizing of the «shadow economy» sector. Since 1999 Russia's economy has undergone a number of positive changes that could not but result in greater tax receipts: barter trading diminished, the economy became monetized, and the expanded use of money as a means of payment resulted in growing tax receipts. Unfortunately, by itself this does not yet signify that the share of the «shadow economy» sector in the entire economy has dropped. Q. — What can be done to move people out of the shadow economy? Is the Government doing it and are those reforms effective? A. — To a large extent, these are measures which are being implemented. For example, tax structures must be simple and taxes sufficiently low to provide incentives to report honestly. Deregulation legislation needs to ensure that bureaucratic and administrative costs are low, and that people and capital are free to move. This is being done. However, it is difficult: Even with a simple tax structure, for example, without enforcement, people will tend to stay in the shadow as long as they perceive this to be advantageous. For the most part, the success of measures to limit the shadow economy therefore depend on something else: namely on the extent to which a more effective, professional and service oriented public administration emerges. This is to say that to me, efforts in keeping the private sector honest, are related to the way the public sector operates. It is the public sector which determines the framework in which the private sector operates. This points at the need for public sector reform, and this, as we all know, is perhaps the most difficult of all the reform areas. Christof Rühl, Chief Economist, Russia Country Office, World Bank