Informal economy: the devil on Kosovo’s shoulder

Kosovo’s informal economy, a cycle of tax evasion by businesses, elusive governmental oversight and exploitation of workers, will continue to run until political will to formalize the system emerges.

As the old saying goes, “When a French peasant paints the devil, he paints him in the guise of a tax collector.” A few hundred years later, this expression is as poignant as ever.

Kosovo’s high rate of unemployment and citizens living below the poverty line are infamous. These rates are inflated by the slow development of rule of law and lack of governmental infrastructure to monitor and regulate Kosovo’s economy and taxation framework, leaving many Kosovo citizens in the most precarious of financial situations.

Whether you are selling your trade on the streets of Prishtina, working in a call center with no employment contract or finding work day to day on construction sites around the city, you are participating in what is called the informal economy. 

The informal economy is a part of the economy that is not taxed, either because registered firms avoid paying it or unregistered firms operate their businesses illegally. It also encompasses an economy that lacks adequate government-run checks and balances. Unlike the formal economy, informal economic activities are not included in the gross domestic product, GDP, of a country.

The true nature and scope of the informal economy in Kosovo is not wholly clear. However, local and international reports point out that the informal economy in Kosovo amounts to more than 30 per cent of the country’s GDP, around 1.8 billion euros per year, which is almost identical to the state’s annual budget.

The nature of an informal economy

The informal economy is widespread. Tax evasion has become increasingly evident through smuggling and other illegal activities recently, facilitated by the formal and informal customs points for entering Serbia. But it continues within the territory of Kosovo too, with individuals and companies doing anything they can to avoid paying taxes, resulting in hundreds of millions of euros per year in budgetary damage.

The sectors facing the biggest challenges from the presence of an informal economy are the construction sector, the service industry, especially hotels and restaurants, as well as trade and transport. These sectors employ a large percentage of the Kosovo population, but are plagued by unfair competition and lack of secure opportunities for employees.

The informal economy is at the top of the list of barriers to doing business in Kosovo. Besides the fact that the failure to collect a large chunk of the country’s revenue reduces its wealth, it also has a direct impact on unfair competition between businesses. Harmonized financial regulation remains out of reach, damaging the growth of regular businesses paying taxes to institutions.

Another negative effect concerns foreign direct investment in Kosovo. Serious investors will refuse to invest in a country where fiscal evasion accounts for over 30 per cent of the GDP. On the other hand, an informal economy has the potential to attract unfavorable investors looking to exploit the lack of adequate institutional regulation for their own benefit.

Absence of monitoring processes, inspection and strong legislation present a major hindrance to the measurement of macroeconomic indicators such as GDP, economic growth rate and unemployment, knowledge of which are essential in the creation and development of sound economic policy. 

The informal economy in Kosovo has become a part of society and the business community, coexisting in peace with one another without much interruption. Even worse, there is a worldview among many taxpayers that “everyone is cheating on their taxes,” and this view is strengthened by cases of high-level officials or their relatives who become embroiled in allegations of tax evasion.

The informal economy in Kosovo is sustained by many factors. The low perception of the quality of public governance, tax policy, administration and structure in general as well as the strategy of using coercive measures to enforce it all affect general taxpayer’s hesitance to pay what they are required to.

In the case of Kosovo, the main influencing factors of informal economy in general, and tax evasion in particular, are the poor quality of institutional governance and the lack of rule of law.

Towards a strong, straightforward and permanent rule of law

Absence of adequate rule of law in Kosovo has contributed to the reduction of transparency of the activities of public institutions, increased corruption and increased distrust among taxpayers, who in turn do not wish to finance the government by paying taxes. The end result is proliferation of tax evasion.

Nearly three centuries ago, economist and philosopher Adam Smith said that “Where there is at least a common doubt of unnecessary spending and misconduct of public expenditure, the legislation that maintains it earns little respect.”

If we look back to the history of countries that now have high rates of taxation – France, Germany, Portugal, Sweden – we see that even these countries, at the beginning of their consolidation, suffered from high rates of tax evasion. However, a strong, straightforward and permanent rule of law has led them to become countries with some of the highest tax rates. 

Increasing protection through governance

Responsibility of the institutions lies in the creation of mechanisms that provide quality governance and sustainable fiscal policy. In Kosovo, this has been insufficiently achieved. In the World Bank’s Worldwide Governance Indicators list, Kosovo has received a constant negative indicator of governmental quality. This indicator shows the perception of the quality of public governance, civil service independence and quality of policy-making overall.

The actions of Kosovo’s institutions in combating the informal economy have been weak and uncoordinated by all governments to run the country thus far. The most serious step towards improvement was the adoption of a revised strategy in May of this year, and an action plan to combat the informal economy. 

The adoption of the revised strategy can be considered as a more serious step, since this strategy includes qualitative and quantitative indicators to enhance the monitoring process,  simplifying legislation and establishing a regulatory impact assessment system. This aims to improve evidence-based policy development and legislation drafting, as well as an adequate consultation process across institutions.

However, this strategy will only be considered successful if implemented in practice by undertaking the actions envisaged. Based on the practices of countries struggling against their own informal economy, it is clear that success in combating it only succeeds when strategies for combating this phenomenon are also accompanied by a strong political will from the government and synchronized institutional action.

The EU Enlargement Report dedicated to Kosovo, which was handed over to Kosovo’s institutions in June this year, refers directly to the widespread existence of informal economy in the country. The report notes that fiscal evasion and informality continue to hamper the economy and further efforts are needed, especially related to improving field inspections and inter-institutional cooperation.

The tax administration should further strengthen its administrative and professional capacity and ensure merit-based and transparent selection processes. The EU report recommends that Kosovo “systematically implement the strategy for combating informal economy, money laundering, terrorist financing and financial crime and its action plan; as well as enhancing cooperation with the existing judicial framework to ensure timely adjudication of cases of tax evasion and fraud.”

Formalizing the economy will not only benefit Kosovo’s budget, but also its people. Higher job security and increased protection for employees encourages participation of women in the workforce. More efficient and transparent governmental regulation and the increase in people’s trust in institutions will help with the creation and expansion of small companies and individual businesses.

Therefore, developing a strategy for combating informal economy, money laundering, terrorist financing, and financial crime is something good and necessary, but still needs to be implemented.

Finding solutions to the informal economy is of great importance when viewed from both and economic and socio-political perspective. Drawing from both of these perspectives, designers of fiscal policy in Kosovo will be more successful if they focus on finding ways to gradually incorporate the informal sector into the formal one, rather than eliminating it altogether.

The opinions expressed in the opinion section are those of the authors only and do not necessarily reflect the views of BIRN.

Bedri Peci is a Professor at the Faculty of Law at the University of Prishtina, a permanent associate at the International Bureau of Fiscal Documentation Amsterdam, and a regular member of the European Association of Tax Law Professors in Amsterdam.  

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