Claus Larsen

Defining and Measuring Undeclared Work

Undeclared work as to the definition used subsequently describe income from productive economic activities which are legal and taxable, but on which income tax, social security contributions, VAT, etc., are not paid, because they are not reported to the tax, social security or customs authorities (Feld and Larsen 2005). These activities are not only deliberately concealed from public authorities in order to save taxes, but also to avoid certain legal labor market standards, such as minimum wages, maximum working hours, safety standards, etc., and to avoid certain administrative obligations, such as completing statistical questionnaires or other administrative forms (Feld and Schneider 2010). The prices and wages paid are less than the full market price, and buyer and seller are both aware of this and obtain an extra economic advantage in this way. Only activities which violate the German law against “Schwarzarbeit” are included in the definition. A direct translation of “Schwarzarbeit” is “black work” or “black activities”, but in this report we use the term “undeclared work” for “Schwarzarbeit”.

Design of the Survey

Our empirical investigation is based on data on undeclared work collected in 12 surveys of individuals in Germany from April 2001 through March 2007. A survey is the only approach based on field data that allows the testing of the impact of deterrence on such activities, given the current state of research in this field in Germany. Due to the German tax secrecy laws, no individual data, e.g. data comparable to that collected in the U.S. Taxpayer Compliance Measurement Program (TCMP), are available from the fiscal authorities that would allow the analysis of that relationship. Moreover, aggregate data, at the German state level, for example, do not help to get any information on the influence of deterrence, because the state fiscal authorities do not provide satisfactory data on the size of fines and the intensity of control. In the survey approach, however, it is possible to ask respondents about their perception of the risk of being detected and of the size of fines, in addition to their undeclared work. This possibility of measuring deterrence and other not immediately observable factors like social norms is one of the most important advantages of the survey method as compared to the other methods used to measure the shadow economy.

The Incidence of Undeclared Work in Germany 2001–2007

It should be recalled that undeclared work in our surveys consisted of two components: someone is working for somebody else (1) for payment in cash or (2) for payment in kind or in the form of a quid pro quo or return service in order to save tax payments, VAT, and social security contributions and both parties in the transaction are aware of that.

The Impact of Social Norms on Undeclared Work

In this chapter, we turn to the last of the main factors which, according to the economic theory of tax evasion, affect the extent of undeclared work. In the approach used by Allingham and Sandmo (1972), tax morale residually explains the level of tax compliance independent of tax policy and the behavior of state authorities. This argument is consistent with the view that fundamental social norms, such as religion or civic duty, shape tax morale. Feld and Frey (2007) provide a more elaborate discussion on which factors shape tax morale by establishing a relationship of social exchange. According to their approach, tax morale is endogenously driven by government behavior.

The Extent of Undeclared Work in Germany 2001–2007

In Chap. 6 we calculated the incidence of undeclared work, i.e. how many people are involved, how much time they spend on such activities each week, and how much they are paid or receive in return. With this information we have a means of estimating the total extent of undeclared work. One way is to calculate the total number of hours spent on such activities in 1 year as a proportion of the total number of declared hours worked in the formal economy. This corresponds to measuring the undeclared sector relative to official GDP on the assumption that productivity is the same in the informal sector as in the formal economy within the various trades and industries or sectors, and also that overall average productivity or value added across trades and industries is the same.

Deterrence in Germany: A Primer

If the theoretical models are correct, a reduction in the size of the shadow economy, if it indicates a trend reversal, could be the result of increased deterrence, tax or social policy reforms, or additional pressure from social norms. As the last of these develops slowly over time and is influenced by more important institutional changes, such as a shift in the tax authorities’ treatment of taxpayers (Feld and Frey 2002b) or the introduction of direct democracy (Weck-Hannemann and Pommerehne 1989), we leave this possible explanation aside for the moment. We will focus first on changes in deterrence. This is, however, rather difficult to do, because the administration of the German tax system is not uniform across the country, due both to German administrative federalism, i.e., the strong role that the state administrations have in auditing and tax investigations, and to the differences in the sentences imposed by the courts in different states.

The Impact of Deterrence on Undeclared Work

Given the mainly descriptive evidence in the previous chapters, the most important question is whether a policy of deterrence is actually a suitable means with which to fight undeclared work in Germany. The German Federal government and in particular the German Finance Ministry is convinced of the effectiveness of such policies. As outlined in the introduction and in Chap. 4, deterrence has increased across time in Germany. A whole sequence of steps has been carried out in order to raise deterrence levels considerably. Such initiatives are founded on economic theory according to which the risk of sanctions and the size of fines are expected to have a significant impact on tax evasion and thereby also undeclared work. In this chapter we look into whether this is the case.

The Size of the German Shadow Economy and Tax Morale According to Various Methods and Definitions

Different estimates obtained with the methods described above are summarized in Tables 3.1, 3.2 and 3.3. In Table 3.1, we show estimates of the shadow economy measured relative to official GDP, rates of participation in undeclared work are shown in Table 3.2, tax morale in Table 3.3. The tables build on and extend Table 3.1 in Feld and Larsen (2005, p. 32) and Table 12 in Feld and Schneider (2010, p. 132), and we add own estimates which have not been published before. The tables cover the period 1970 up to and including 2007. As the definitions used differ, estimates presented in the same table may not be directly comparable.

The Impact of Tax Policy on Undeclared Work

According to the economic theory of tax evasion, the extent of undeclared work could also – in addition to deterrence – be affected by either tax policies or tax morale. The possibility has already been mentioned that the German tax reform act of 2000, which has been implemented in stages up until 2005, could have affected the pattern of undeclared activities between 2001 and 2004. And when the tax reform was fully implemented in 2005, income taxes in Germany had been cut considerably from a marginal tax rate going from 22.9% for the lowest taxable income bracket to 51% for the highest income bracket in the year 2000 to 15% and 42% respectively. Taxpayers have to pay the solidarity surcharge and social security contributions, both of which increase the tax burden on labor income, but nevertheless the overall reduction in income taxes has been considerable in the recent past.