The research team at BICEPS and SSE Riga is working on a two-year project "Institutions and Tax Enforcement in Latvia", which focuses on studying the role of policies in combating various forms of tax evasion.
It has long been accepted that tax evasion has been widely prevalent in Latvia. While the exact estimates of the size of undeclared economy vary, all suggest that Latvia ranks among the top countries in the European Union in terms of its scope. Available cross-country evidence suggests that the share of employees who admit having evaded payroll taxes is 11% in Latvia, the highest share among the EU countries (European Commission, “Undeclared Work in European Union”, Special Eurobarometer 402). Moreover, the amount of lost revenues to tax authorities is quite substantial — 40% of employees who have evaded payroll taxes have not declared between 50% and 100% of their reported gross wages. Similar results are obtained by Putniņš and Sauka (“Shadow Economy Index for the Baltic Countries 2009–2017,” Centre for Sustainable Business, SSE Riga), who focus exclusively on the Baltic states. They provide a survey evidence on the payroll tax evasion in the three Baltic countries showing that in recent years the share of unreported wages in Latvian private sector have varied between 18% and 35%, the highest share in the Baltics. Available evidence on VAT evasion also suggests that the degree of VAT underreporting in Latvia is among the highest in the EU.
Even though Latvia is estimated to have experienced a contraction in undeclared economy after the peak reached during the financial crisis of 2008-2009, its size remains considerable and, according to the latest estimates, it has reversed to an uptrend. This increase occurred at the time when the economy was rapidly growing and therefore is of particular concern and can be indicative of inadequate government policy actions that have been taken so far.
There are two important factors that make it difficult to effectively reduce tax evasion. First, it comes in different shapes and sizes and second — the participation is also diverse. Even though previous research already addressed some of these challenges and focused on a number of issues, in particular on measuring the scope and identifying the main groups engaged in tax evasion in Latvia, there is still a gap in research that examines policies on combating tax evasion.
This research project will address this gap by giving a central role to policies. It will study four of different kinds of tax evasion and the role of policies in improving tax compliance in Latvia. First, our research will shed light on whether participation in tax evasion is affected by financial incentives and gains from employment. We will address this question by studying the effect of the pension reform that was implemented in Latvia as part of the austerity measures in 2009, and will study the effect of financial incentives on formal employment. Second, we will focus on the effects of the minimum wage on the scope of income and employment underreporting. This question is of particular importance in the Latvian context, given the numerous minimum wage hikes in recent years and the plans to further increase the minimum wage in coming years. Third, we will study the impact of favourable tax regimes that are implemented to promote entrepreneurship, and their potential abuse by firms. Finally, we will provide a quantitative analysis of the role of Latvian banks in tax evasion.