News

It is a challenging task to estimate the scope of the shadow economy either globally or in Russia. Some researchers rank Russia among top five countries with the largest shadow economies; others do not even include Russia among the top ten.

The Russian Central Bank recently published quite an interesting research report showing the percentage shares of various sectors in the country’s shadow economy. The regulator’s estimates are based on cash flows which are as transparent for the Central Bank as they can possibly be. Predictably enough, the largest segment is construction (30%), followed by the service sector (21%) and distribution of construction and industrial goods (which is not that easily distinguishable from construction) with a 20% share.

One may think that the shadow economy doesn’t present much of a threat. Many still remember receiving undeclared “envelope” cash wages as recently as ten years ago, when official employment and fully declared salaries were still rare. This worked for everyone, except the government, as both the employer and the employee saved on taxes. If we dig deeper, though, it becomes apparent that the shadow economy – particularly with cash flows distributed across segments as the Russian Central Bank describes – poses a number of threats for society as a whole.  

The Construction Industry as a Source of Undeclared Cash

It is easy to understand why the service sector has been won over by the shadow economy. In this segment, hard cash transactions enable tax evasion. Unlike goods, services are intangible, and it practically impossible to reliably establish that a service was rendered in the past at a certain price. However, tax authorities have been quite successful in combating cash payments in service industry.

Construction, however, which, together with materials and equipment, accounts for as much as 50% of the shadow economy, is a cause for serious concern. The enormous flow of undeclared cash means that there is significant demand for it and many people are willing to be paid in cash. In practice, this is an indication of tax evasion practices and the government’s complete lack of control over the construction industry.

It is not a secret that construction companies prefer cash payments, while cashless flows with declared formal payment purpose are often converted into cash.

Why Does This Matter?

It is a well-known fact that the construction industry employs many unqualified workers. If these workers are paid in cash, it is impossible to check whether they are officially employed and whether their work complies with health and safety standards.

Cash jobs are often filled by undocumented immigrants who are interested in such sources of income. The abundance of a cheap, illegal workforce makes it harder for law-abiding citizens to find jobs.

In addition, unqualified workers often live in dense concentrations, do not have any legally documented status, are very poor, and have no legal rights which tends to drive up the crime rate. These people have nothing to lose: they are not afraid of imprisonment (at least in prison they are regularly fed) and are surrounded by a lot of temptations. This situation results in a rising number of violent crimes both against property and against people.

Another negative aspect of the shadow economy is a lack of control over the quality of construction. If a developer buys material for cash, it is tempted to cut costs on these purchases. Illegal practices used during construction push large construction groups to liquidate project companies as soon as possible. After the project company is liquidated, there is no one left to be held responsible for the quality of the development; in the meantime, it may take years for construction defects to surface.

Under such circumstances, investing in construction projects has become a source of higher risk. In the segment of so-called “shared construction projects”, every couple of months a developer goes bankrupt, and homeowners-to-be protest and block national highways. The fact of the matter is, however, that after a construction company has it hands on the investors’ money, cash transactions are absolutely disconnected from real life. It is next to impossible to control or track cash flows. Law enforcement agencies are only able to state the fact of embezzlement.

In the cash economy, bribery thrives. Where illegal transactions and undocumented cash come to play, regulators cannot help but become corrupt too; to pay bribes, cash is required, which starts a vicious circle.

Dividends under the Table

The government has long declared a war on the black economy, but has failed for a long time to select the right approach. It was not until recently that, thanks to thorough supervision of cash flows, the volume of cash conversion started to shrink. The cash-starved shadow economy will inevitably struggle.

Now, when a large company needs cash (possibly, for not so legal purposes) it cashes out by paying dividends to individual shareholders. In doing so, the company pays all taxes, both corporate and individual. Five years ago, this scheme would have been a nightmare for any player in the shadow segment, which means that the government is on the right path.

A trade-off for the government’s quest is full transparency. All out transactions are monitored, analyzed, and stored in databases, making the notions of privacy and business secrets less likely.