How Participating In The Shadow Economy Affects the Growth of Latvian Firms

Authors: Ketevani Kapanadze, Irakli Barbakadze, Nino Kokashvili
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Abstract:

This paper examines the relationship between the growth of Latvian firms and their involvement in the shadow economy in 2015. When up to 10% of the overall economic activity of firms is in the shadow economy, this had a growth-enhancing effect on firms that recorded non-positive growth during the last five years. Using the perceptions of corruption and interview languages as instruments of measuring the shadow economy participation rate, the authors conclude that there is a positive relationship between perceptions of corruption and the shadow economy participation rate. 

Summary: 
Informal firms hamper the economic performance of countries in two main ways. First, informal firms are small and unproductive. Second, they compete with productive formal firms for their share of the market (Gomory, 1994). This paper elaborates on the first way, and how participation in the shadow economy affects firm growth in Latvia. The Baltic region is a good location in which to study the reasons for and consequences of the shadow economy. Among the Baltic states, the shadow economy is biggest in Latvia. In this region, Latvian firms are the most dissatisfied with their national tax system and government (Sauka and Putniṇš, 2011). This could explain why the size of the shadow economy is significantly larger in Latvia (21.3%) than in Estonia (14.9%) and Lithuania (15.0%) (Putniņš and Sauka, 2015).

The impact of participation in the shadow economy on firm performance is a topic requiring investigation. The novelty of this research lies in its effort to study this relationship based on firm-level data using survey data[1] from company managers in Latvia in 2015. A survey of company managers provides information not only on misreported business income, but also misreported wages and the number of employees. In order to calculate the shadow economy participation rate in firms, this paper uses the methodology provided by Putniņš and Sauka (2015). The reasoning behind the decision to participate in the shadow economy is not exogenously given and depends on various political, economic, social and institutional factors. This paper uses interview languages and perceptions of corruption as instruments to measure the shadow economy participation rate and address the problem of possible endogeneity. Hypothetically, high corruption encourages firms to operate in the shadow economy (Johnson et al., 1998).

In addition to political, economic, social and institutional factors, Tanzi (1982) highlights the attitudes of company managers, as well as basic religious and cultural characteristics. The data do not provide information about the nationality of company managers. However, the interview language, which is an appropriate proxy for socialization, is used instead. Theoretically, in business operations foreign managers behave differently to their local counterparts. Examining the relationship between participation in the shadow economy and firm growth shows that firms involved in shadow economic activity for up to 10% of the overall economic activity of the firm experience higher growth. The study shows that participation in the shadow economy has a growth-enhancing effect only for firms that have non-positive growth. These firms are more flexible in crises. At the same time, 10% of the shadow economy participation rate does not exclude them from the financial market. In addition, these firms also take advantage of public goods and services. This result corresponds with the idea that for poorly performing firms, the shadow economy represents a means of survival. This paper also concludes that there is a positive correlation between perceptions of corruption and the shadow economy participation rate.

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[1] The survey is conducted by the Baltic International Centre of Policy Study (BICEPS).