Evaluating the prevalence of the undeclared economy in Central and Eastern Europe: An institutional asymmetry perspective

Abstract

This article examines the undeclared economy in general, and envelope wages more particularly, in 10 Central and East European countries, drawing on a 2013 Eurobarometer survey. The explanatory approach focuses on the asymmetry between the codified laws and regulations of the formal institutions and the unwritten socially shared rules of informal institutions. A strong association is revealed between the prevalence of envelope wage payments and the degree of asymmetry between formal and informal institutions at both the individual and country levels. We explore the implications for theorising and for tackling undeclared work practices.

Keywords

envelope wages informal economy institutional analysis post-Soviet societies tax evasion transition economies

Introduction

A burgeoning literature reveals the multifarious ways whereby employers in Central and East Europe (CEE) use the undeclared economy to reduce their labour costs, ranging from employing undeclared workers, through outsourcing work to the ‘bogus self-employed’ to under-reporting the wages of their formal employees (Abbot and Wallace, 2009; Kukk and Staehr, 2014; Morris and Polese, 2014; Sauka and Putniņš, 2011; Wallace and Latcheva, 2006; Williams et al., 2013a, 2014b). Roughly, a quarter of national income in CEE nations is not declared to the authorities and an equivalent proportion of jobs are in the undeclared economy (Schneider and Williams, 2013). Unless this problem is addressed, there will be a lack of control over the quality of working conditions, weakened trade union and collective bargaining, unfair competition for legitimate businesses and pressure on them to evade regulatory standards, and limited public finances available for social cohesion projects (Andrews et al., 2011; ILO, 2014; TUC, 2008).

The aim of this article is to advance and evaluate a new way of explaining and tackling the undeclared economy. Drawing inspiration from institutional theory (Baumol and Blinder, 2008; Helmke and Levitsky, 2004; North, 1990), we attribute undeclared work practices to the asymmetry in a society between the codified laws and regulations of its formal institutions and the socially shared unwritten rules of its informal institutions. The greater the institutional asymmetry, the higher the likelihood of undeclared work practices. This helps explain at both the individual and societal levels why some employers and employees engage in undeclared work practices and others do not. Previous explanations, in stark contrast, have been unable to take agency into account. Instead, and as Williams (2013) highlights, they have explained the undeclared economy solely in terms of country-level structural conditions, including underdevelopment (modernization theory); high taxes, state corruption and burdensome regulations and controls (neoliberal theory), or inadequate state intervention and protection of workers (political economy theory). Nevertheless, this does not mean that these various structural conditions are unimportant, but for our purpose, their main significance is not as free-standing explanations of the undeclared economy in their own right, but in indicating structural sources of institutional symmetry.

To advance and evaluate the institutional asymmetry thesis, we do not focus upon all undeclared practices but rather analyse one in particular which is prominent in CEE nations. This is the practice where employers pay their employees an official declared salary and an additional undeclared (‘envelope’) wage in order to reduce their tax and social security payments. In the next section, we briefly review the previous literature on envelope wages and propose a set of hypotheses regarding, first, the relationship between the prevalence of such payments and the degree of institutional asymmetry, and second, what needs to be done to reduce this institutional asymmetry, drawing upon previous explanations. The third section then introduces the methodology and data set used to test these hypotheses, namely, a 2013 survey involving 4670 face-to-face interviews with formal employees in 11 CEE countries, followed in the fourth section by the results on the relationship between the propensity to pay envelope wages and institutional asymmetry, and how this institutional incongruence and thus the prevalence of envelope wages might be reduced. The final section draws conclusions on the theoretical and policy implications of the findings.

Explaining the undeclared economy: an institutional asymmetry approach

A substantial literature has revealed how formal employers in CEE nations often seek to reduce their tax and social security payments and thus labour costs by paying their formal employees two salaries, one officially declared and a second which is hidden from the authorities for tax and social security purposes. This has been identified in studies conducted in Estonia (Meriküll and Staehr, 2010), Latvia (Meriküll and Staehr, 2010; Sedlenieks, 2003; Žabko and Rajevska, 2007), Lithuania (Karpuskiene, 2007; Meriküll and Staehr, 2010; Woolfson, 2007), Romania (Neef, 2002), Russia (Williams and Round, 2007) and Ukraine (Williams, 2007).

This illegitimate wage arrangement is usually agreed when employment commences: The official declared salary is detailed in a formal written contract and an additional undeclared (envelope) wage in an unwritten agreement (Chavdarova, 2014; Williams, 2009; Woolfson, 2007). Sometimes, this verbal agreement is simply that the employee will be paid more than the written formal contract states. Usually, however, conditions are attached, such as the employee agreeing not to take their full entitlement to annual leave, to work longer hours (which might take them over the maximum in the working hours directive or result in being paid below the minimum hourly wage) or to do a different job than specified in their formal contract (Chavdarova, 2014; Williams, 2014a). In all cases, however, both the employer and employee understand that this verbal contract supersedes the formal written contract and constitutes the unwritten ‘psychological contract’ regarding their conditions of employment (Rousseau, 1995). Of course, verbal agreements per se are not illegitimate. However, a verbal agreement to pay an undeclared (envelope) wage is illegitimate because both parties fraudulently agree to under-report the salary earned by the employee in order to evade their full tax and social security obligations.

Institutional theory (Baumol and Blinder, 2008; Helmke and Levitsky, 2004; North, 1990) provides a useful lens for explaining this undeclared work practice. All societies have formal institutions (codified laws and regulations) that define the legal rules of the game. They also have informal institutions which are the ‘socially shared rules, usually unwritten, that are created, communicated and enforced outside of officially sanctioned channels’ (Helmke and Levitsky, 2004: 727). When symmetry exists between these formal and informal institutions, little or no undeclared work will exist. However, when there is asymmetry, as when there is a lack of trust in government and the rule of law, practices will emerge grounded in the socially shared norms which, although socially legitimate, are illegal in terms of the formal rules (van Schendel and Abraham, 2005).

Envelope wages are an exemplar. The payment of an envelope wage means that individual employers and employees do not adhere to the formally codified laws and regulations and instead adopt unwritten socially shared rules agreed via a verbal agreement. At the societal level meanwhile, it can similarly be argued that the greater the institutional asymmetry, the greater will be the prevalence of envelope wages. To evaluate this at both the individual and societal levels, the degree of institutional asymmetry needs to be measured. This can be achieved in relation to undeclared work practices by examining the level of tax morality of a person or population, meaning their acceptance of a normative obligation to pay taxes owed (McKerchar et al., 2013; Torgler, 2011; Torgler and Schneider, 2007). We propose the following hypothesis to test the institutional asymmetry thesis:

H1. The prevalence of envelope wages will be greater in populations expressing lower levels of tax morality.

Previous studies reveal that envelope wages are more common in smaller businesses and the construction sector, and among men, younger persons and the lower paid (Williams and Padmore, 2013), whether these populations also have lower tax morality can be evaluated. Similarly, previous studies reveal that envelope wages are more prevalent in CEE and Southern Europe than in West European and Nordic nations (Williams, 2009). We can also test whether such cross-national variations are associated with cross-national variations in the degree of institutional asymmetry (as measured by tax morality).

It is important, however, not only to test this institutional asymmetry thesis but also the previous perspectives focusing upon various structural conditions when explaining the prevalence of undeclared work practices. Given that from our perspective, changing various structural conditions (such as tax rates) may reduce asymmetry (and improve tax morality), these previous competing perspectives are evaluated here not as free-standing explanations but to identify the country-level structural conditions that are associated with greater institutional symmetry. As Williams (2014b) highlights, there have been three major competing explanations for undeclared work practices.

First, the ‘modernization’ thesis holds that undeclared work practices are more prevalent in less developed economies and reduce with economic development and the modernization of government (Geertz, 1963; Lewis, 1959). This perspective would thus view envelope wages as more widespread in economies with low gross national product (GNP) per capita, and societies in which there is a lack of modernization of the state bureaucracy. To explore this, therefore, the following hypothesis can be tested:

H2. The prevalence of envelope wages is lower in wealthier economies with modern state bureaucracies.

Second, a ‘neoliberal’ school of thought regards undeclared work practices as a result of high taxes and too much state interference in the free market (De Soto, 1989, 2001; London and Hart, 2004; Nwabuzor, 2005; Schneider and Williams, 2013). From this viewpoint, envelope wages will be more prevalent in nations with higher taxes and levels of state interference in work and welfare systems. The following hypothesis can therefore be tested:

H3. The prevalence of envelope wages is lower in economies with lower tax rates and lower levels of state interference in the free market.

Third and finally, a ‘political economy’ thesis has asserted, in stark contrast, that envelope wages result from inadequate state intervention in work and welfare arrangements, which leaves workers less than fully protected. From this perspective, envelope wages can be tackled by increasing expenditure on social protection, reducing inequality and the effectiveness of social transfers to help vulnerable groups (Davis, 2006; Gallin, 2001; ILO, 2014; Slavnic, 2010; Taiwo, 2013). As such, envelope wages will be more prevalent in countries with relatively low levels of such state interventions. Hence, the following hypothesis can be tested:

H4. The prevalence of envelope wages is lower in more equal economies with higher tax rates, greater levels of social protection and more effective redistribution via social transfers to protect workers from poverty.

Until now, these competing explanations have only been evaluated using simple bivariate correlations between cross-national variations in envelope wages (and undeclared work) and cross-national variations in potential independent variables (European Commission, 2013; Eurofound, 2013; Williams, 2013, 2014b). These reveal support for the modernization and political economy theses but no support for the neoliberal thesis. This simplistic analytical method, however, fails to analyse whether these associations remain significant when other variables are held constant. Nor do these previous analyses either consider or evaluate the relationship between envelope wages and the level of institutional asymmetry, which this article argues is central to understanding this wage arrangement. To fill this gap, therefore, a logistic regression analysis is here used to evaluate not only this institutional asymmetry explanation for envelope wages but also the previous explanations.

Methodology

To analyse the relationship between envelope wages and institutional asymmetry (as well as the other explanations), we use data from special Eurobarometer survey 402, which involved 11,131 face-to-face interviews in 11 CEE nations in 2013. A multi-stage random (probability) sampling methodology ensures that for gender, age, region and locality size, each country as well as each level of sample is representative in proportion to its population size. Thus, for univariate analysis, we employ the sample weighting scheme as recommended in both the wider literature (Sharon and Liu, 1994; Solon et al., 2013; Winship and Radbill, 1994) and the Eurobarometer methodology, to obtain meaningful descriptive results. For the multivariate analysis, however, a debate exists over whether to use a weighting scheme. Reflecting the dominant viewpoint, we decided not to do so (Pfeffermann, 1993; Sharon and Liu, 1994; Solon et al., 2013; Winship and Radbill, 1994).

The interviews covered attitudinal questions about undeclared work followed by questions on whether participants purchased goods and services on an undeclared basis, received envelope wages and participated in undeclared work. In this article, we focus on envelope wages. First, the 4670 participants reporting that they were formal employees were asked whether they had received an envelope wage from their employer in addition to their official declared wage in the prior 12 months; second, whether this envelope wage was for their regular work, as payment for overtime hours, or both; and, third, what percentage of their gross yearly income from their job was received as an envelope wage.

To analyse the above hypotheses, the dependent variable is whether employees received envelope wages. This is based on their response to the question:

sometimes employers prefer to pay all or part of the salary or the remuneration (for extra work, overtime hours or the part above a legal minimum) in cash and without declaring it to tax or social security authorities. Has your employer paid you any of your income in the last 12 months in this way?

To analyse H1 regarding institutional asymmetry, a tax morality index for each survey participant and country is constructed. This examines responses to attitudinal questions about how acceptable employees view six non-compliant tax behaviours using a 10-point scale (where 1 means ‘absolutely unacceptable’ and 10 means ‘absolutely acceptable’): receiving welfare payments without entitlement, a firm hired by another firm not reporting earnings, a private person not declaring all or part of their salary, a firm hired by a household not reporting earnings, evading taxes by not or only partially declaring income and a person hired by a household not declaring earnings. The tax morality index for each individual and nation is calculated using the mean score across these six attitudinal questions.

Meanwhile, to analyse hypotheses H2–H4, the association between cross-national variations in the prevalence of envelope wages and various country-level structural conditions is considered, while holding constant tax morality and a range of individual-level socio-demographic, occupational and socio-economic characteristics described in Table 1. To evaluate the modernization hypothesis (H2), the indicators used are as follows:

Gross domestic product (GDP) per capita in purchasing power standards (Eurostat, 2014a).

European Quality of Government Index – this includes both perceptions and experiences with public sector corruption, along with the extent to which citizens believe various public sector services are impartially allocated and of good quality. The index is standardized with a mean of zero, with higher scores marking a higher quality of government (Charron et al., 2014).

Table 1.

Employees receiving envelope wages in last 12 months by company size, employee group and country: (a) percent of employees paid envelope wages, (b) median percent of gross salary paid as envelope wages for those affected, (c) percent of all employees receiving envelope wages, (d) percent of all employees, and (e) tax morality index.

	a	b	c	d	e
All CEE	6	30	100	100	2.81
Company size:
1–4 employees	12	25	17	9	2.84
5–9	8	40	15	11	3.09
10–19	11	30	27	16	3.39
20–49	7	20	23	22	2.84
50–99	3	45	7	15	2.61
100–499	3	30	7	15	2.53
500 or more	2	30	4	12	2.45
Occupation:
Employed professional	6	25	9	9	2.88
General management, etc.		45	5	9	2.59
Employed, desk work	2	20	7	19	2.78
Employed, travelling	5	25	8	10	2.96
Employed, service job	7	23	16	14	2.59
Supervisor	9	40	4	2	2.96
Skilled manual	8	40	41	31	2.88
Unskilled manual, etc.	10	35	10	6	2.93
Gender:
Men	8	30	68	54	2.88
Women	4	30	32	46	2.72
Age:
15–24	9	30	15	9	3.15
25–34	6	28	27	28	2.87
35–44	6	20	30	29	2.77
45–54	5	35	21	24	2.76
55–64	4	50	6	9	2.50
65+	7	25	1	1	2.62
Age education ended:
<15	6	25	3	3	2.84
16–19	7	30	75	60	2.90
20+	4	20	22	37	2.61
Difficulties paying bills:
Most of the time	9	30	12	8	2.79
From time to time	8	30	49	35	3.11
Almost never/never	4	20	39	57	2.62
Country:
Latvia	11	50	4	2	3.95
Croatia	8	35	5	3	2.15
Romania	7	9	23	19	2.29
Slovakia	7	20	7	6	3.17
Bulgaria	6	30	8	7	2.46
Hungary	6	20	9	10	2.95
Lithuania	6	20	3	3	3.09
Czech Republic	5	25	9	12	3.10
Estonia	5	40	1	1	2.82
Poland	5	20	30	35	2.96
Slovenia	4	20	1	2	2.20

To evaluate the tax tenet of the neoliberal hypothesis (H3), the indicator previously employed when evaluating this perspective in relation to wholly undeclared work (European Commission, 2013; Williams, 2013) is used:

The implicit tax rate (ITR) on labour, which approximates to the average effective tax burden on labour, and is the sum of all direct and indirect taxes and employees’ and employers’ social contributions levied on employed labour income divided by the total compensation of employees (Eurostat, 2014b).

To evaluate the contrasting views regarding state intervention of the neoliberal (H3) and political economy (H4) hypotheses, the indicators analysed, akin to previous studies on wholly undeclared work in Europe (Eurofound, 2013; European Commission, 2013; Williams, 2013), are as follows:

Income inequality, measured using the income quintile share ratio S80/S20, which is the ratio of total income received by the 20 percent of the population with the highest income (the top quintile) to that received by the 20 percent of the population with the lowest income (the bottom quintile; Eurostat, 2014c);

Social protection expenditure. Social benefits, which consist of transfers, in cash or in kind, to households and individuals to relieve them of the burden of a defined set of risks or needs; administration costs, which represent the costs charged to the scheme for its management and administration; other expenditure, which consists of miscellaneous expenditure by social protection schemes (payment of property income and other). It is calculated in current prices as percentage of GDP (Eurostat, 2014d);

The impact of social transfers, which is a computed indicator based on the formula, 100*(B−A)/B, where B is the proportion at-risk of poverty before social transfers excluding pensions (which is the share of people having an equivalized disposable income before social transfers that is below the at-risk-of-poverty threshold calculated after social transfers), and A is the proportion at risk-of-poverty (which is the share of people with an equivalized disposable income (after social transfers) below the at-risk-of-poverty threshold, which is set at 60 percent of the national median equivalized disposable income after social transfers; European Commission, 2013).

To analyse the institutional asymmetry hypothesis (H1), and given the nonparametric nature of the data, first, a two-sample Wilcoxon rank-sum (Mann–Whitney) test is used to evaluate whether the median tax morality score of those receiving envelope wages significantly differs to the median score of those not receiving envelope wages, and second, a Spearman’s bivariate correlation is used to evaluate whether a statistically significant relationship exists between cross-national variations in tax morality and cross-national variations in envelope wages. To evaluate whether H1 remains valid when a range of individual- and country-level variables are introduced, a logistic regression analysis is provided.

To evaluate the three hypotheses (H2–H4) investigating the country-level structural conditions associated with a higher propensity to pay envelope wages meanwhile, and given the significant correlation between these country-level structural conditions, a logistic regression analysis is employed, adding each structural condition in turn to the individual-level variables to evaluate whether they are significantly associated with the propensity to pay envelope wages.

Findings

Of the 11,131 interviewed, 4670 were formal employees, of whom 1 in 17 (6%) received envelope wages in the prior 12 months, amounting on average to 30 percent of their gross annual salary. Not all businesses display the same propensity to pay envelope wages and not all employee groups are equally likely to receive such wages. As Table 1 shows, smaller businesses are more likely to pay envelope wages, doubtless in part because of the absence of dedicated HRM staff and formal HRM practices (Barrett and Mayson, 2007; Benmore and Palmer, 1996), making it easier to introduce unwritten verbal contracts that contravene the formal written contract.

Envelope wages are most prevalent among manual workers, and also among younger people, whose rate of joblessness is much higher than average (European Commission, 2013). Those of retirement age are also relatively likely to receive informal payments, as are those with fewer years in formal education and those who have difficulties paying the household bills most of the time, who also receive a greater proportion of their income in this manner. The tentative finding is therefore that weaker and more vulnerable employees are more likely to be targeted by employers, who may also be more likely to view the formal rules of the game as being for the benefit of others rather than them, thus resulting in less allegiance to these formal rules. Indeed, this is tentatively supported by a Wilcoxon Rank Sum test which reveals that those receiving envelope wages have a lower tax morality, with a median score of 3.83 compared with 2.33 for those not receiving envelope wages (where 1 = totally unacceptable and 10 = totally acceptable across six tax non-compliance behaviours).

Table 1 also reveals cross-national variations in the prevalence of envelope wages. To evaluate whether these variations are associated with levels of institutional asymmetry (measured by tax morality), a Spearman’s bivariate analysis reveals a statistically significant association (p < 0.001***). The lower the tax morality in a country, the greater the prevalence of envelope wages. Therefore, the envelope wages appear to be significantly associated with the level of institutional symmetry at not only the individual but also societal level.

To determine whether this association remains significant when other characteristics are taken into account and held constant, Table 2 reports the results of a logistic regression analysis. Model 1 examines whether this association remains significant when purely individual-level characteristics are analysed, and Models 2–8 when various country-level variables are added. The first row in Models 1–8 reveal that the propensity to receive envelope wages remains strongly associated with lower levels of tax morality across all models, whether individual-level characteristics alone are analysed, or country-level structural conditions are added. A strong association thus exists between tax morality and the prevalence of envelope wages. As tax morality improves, and thus institutional asymmetry decreases, the prevalence of envelope wages significantly declines. As such, this further validates the institutional asymmetry hypothesis (H1).

Table 2.

Logistic regressions of the propensity to receive envelope wages.

		Model 1	Model 2	Model 3	Model 4	Model 5	Model 6	Model 7	Model 8
Tax morality (centred)		0.240*** (0.034)	0.247*** (0.036)	0.249*** (0.034)	0.248*** (0.034)	0.247*** (0.034)	0.235*** (0.034)	0.229*** (0.034)	0.239*** (0.034)
Gender (women)	Men	0.452*** (0.152)	0.442*** (0.154)	0.460*** (0.152)	0.446*** (0.152)	0.450*** (0.152)	0.441*** (0.152)	0.444*** (0.152)	0.462*** (0.152)
Age (centred age: 41)		−0.027*** (0.007)	−0.026*** (0.007)	−0.027*** (0.007)	−0.027*** (0.007)	−0.028*** (0.007)	−0.027*** (0.007)	−0.028*** (0.007)	−0.027*** (0.007)
Formal education (15 and under)	16–19	0.457 (0.506)	0.525 (0.508)	0.497 (0.512)	0.475 (0.511)	0.446 (0.511)	0.446 (0.507)	0.382 (0.507)	0.429 (0.509)
Formal education (15 and under)	20+	−0.028 (0.531)	−0.029 (0.535)	−0.026 (0.537)	−0.042 (0.536)	−0.078 (0.536)	−0.125 (0.532)	−0.148 (0.533)	−0.126 (0.535)
Difficulties paying bills (most of the time)	From time to time	−0.458** (0.194)	−0.424** (0.198)	−0.428** (0.195)	−0.425** (0.195)	−0.427** (0.195)	−0.397** (0.195)	−0.441** (0.194)	−0.443** (0.195)
Difficulties paying bills (most of the time)	Almost never/never	−1.028*** (0.209)	−1.009*** (0.219)	−0.961*** (0.212)	−0.955*** (0.212)	−0.966*** (0.212)	−0.944*** (0.211)	−1.014*** (0.210)	−1.009*** (0.210)
Occupation (desk work)	Employed professional	0.855** (0.333)	0.740** (0.339)	0.800** (0.334)	0.827** (0.334)	0.777** (0.334)	0.723** (0.335)	0.782** (0.335)	0.737** (0.335)
	Management etc.	0.277 (0.345)	0.173 (0.350)	0.268 (0.345)	0.291 (0.345)	0.229 (0.345)	0.187 (0.346)	0.226 (0.346)	0.207 (0.346)
	Employed, travelling	0.706** (0.306)	0.623** (0.312)	0.674** (0.307)	0.710** (0.307)	0.667** (0.307)	0.626** (0.308)	0.657** (0.308)	0.619** (0.308)
	Employed, service job	0.528* (0.284)	0.376 (0.291)	0.467 (0.286)	0.485* (0.285)	0.437 (0.287)	0.382 (0.289)	0.450 (0.286)	0.408 (0.287)
	Supervisor	1.105** (0.438)	0.915** (0.449)	0.994** (0.441)	1.003** (0.441)	1.026** (0.440)	0.976** (0.441)	1.044** (0.440)	0.971** (0.442)
	Skilled manual	0.746*** (0.259)	0.672** (0.265)	0.704*** (0.259)	0.729*** (0.259)	0.708*** (0.259)	0.664** (0.261)	0.710*** (0.259)	0.674*** (0.260)
	Unskilled manual, etc.	0.505 (0.364)	0.444 (0.370)	0.437 (0.366)	0.466 (0.366)	0.411 (0.367)	0.381 (0.366)	0.435 (0.365)	0.384 (0.367)
Company size (1–4 employees)	5–9	−0.371 (0.255)	−0.350 (0.257)	−0.383 (0.255)	−0.382 (0.255)	−0.373 (0.256)	−0.370 (0.256)	−0.385 (0.256)	−0.381 (0.256)
	10–19	−0.607** (0.239)	−0.597** (0.242)	−0.629*** (0.239)	−0.621*** (0.239)	−0.624*** (0.239)	−0.628*** (0.239)	−0.639*** (0.240)	−0.642*** (0.240)
	20–49	−0.669*** (0.236)	−0.616** (0.240)	−0.675*** (0.236)	−0.683*** (0.236)	−0.676*** (0.236)	−0.645*** (0.236)	−0.682*** (0.236)	−0.668*** (0.236)
	50–99	−1.161*** (0.284)	−1.113*** (0.287)	−1.172*** (0.284)	−1.173*** (0.285)	−1.171*** (0.285)	−1.146*** (0.285)	−1.170*** (0.285)	−1.155*** (0.285)
	100–499	−1.521*** (0.310)	−1.501*** (0.312)	−1.497*** (0.310)	−1.508*** (0.311)	−1.510*** (0.311)	−1.517*** (0.311)	−1.545*** (0.311)	−1.508*** (0.311)
	500 or more	−1.527*** (0.351)	−1.510*** (0.353)	−1.495*** (0.352)	−1.507*** (0.352)	−1.509*** (0.352)	−1.496*** (0.352)	−1.524*** (0.352)	−1.499*** (0.352)
Country (Lithuania)	Latvia		0.762** (0.317)
	Croatia		0.789** (0.362)
	Romania		0.975*** (0.376)
	Slovakia		0.437 (0.348)
	Bulgaria		0.551 (0.355)
	Hungary		0.063 (0.368)
	Czech Republic		−0.033 (0.381)
	Estonia		0.433 (0.372)
	Poland		0.288 (0.395)
	Slovenia		0.381 (0.424)
GDP per capita in PPS 2013 (centred)				−0.018** (0.007)
European Quality of Government Index 2013 (Centred)					−0.349** (0.144)
Implicit tax rate on labour 2012 (centred)						−0.044** (0.017)
Income inequality 2012 (centred)							0.204*** (0.067)
Social protection expenditure 2011 (centred)								−0.057** (0.027)
Impact of social transfers 2012 (centred)									−0.023*** (0.008)
Constant		−2.488*** (0.601)	−2.936*** (0.675)	−2.483*** (0.607)	−2.483*** (0.606)	−2.465*** (0.606)	−2.433*** (0.602)	−2.364*** (0.602)	−2.316*** (0.606)
N		3675	3675	3675	3675	3675	3675	3675	3675
Pseudo R²		0.1304	0.1413	0.1338	0.1337	0.1340	0.1358	0.1330	0.1359
Log likelihood		−759.6241	−750.0599	−756.6471	−756.7318	−756.4207	−754.8923	−757.3142	−754.8115
χ²		227.76	246.89	233.72	233.55	234.17	237.23	232.38	237.39
p >		0.0000	0.0000	0.0000	0.0000	0.0000	0.0000	0.0000	0.0000

All coefficients are compared to the benchmark category, shown in parentheses. Indicators were centred to the mean obtained using the weighting scheme.

Significant at ***p < 0.01, **p < 0.05, *p < 0.1 (standard errors in parentheses).

Moreover, Model 1 also identifies the types of business and employee groups in which the prevalence of envelope wages is higher when other factors are held constant. Smaller firms are significantly more likely to pay envelope wages and skilled manual workers, supervisors, professionals and those who travel for their jobs more likely to receive envelope wages than those with desk jobs, perhaps reflecting how unwritten contracts amongst these groups treat working hours more flexibly than the formal written contract stipulates. Men are also significantly more likely to receive envelope wages than women, and the likelihood decreases significantly with age. Strong evidence also exists that envelope wages are more prevalent among those who have difficulties most of the time in paying their household bills. Model 2 similarly reveals that employees in Latvia, Croatia and Romania are more likely to receive envelope wages than those in the reference country (Lithuania), even when individual-level factors are taken into account; thus, CEE countries cannot be treated as a ‘bloc’. There are significant cross-national variations in the prevalence of envelope wages.

Models 3–8 test the hypotheses H2–H4 regarding explanations for these cross-national variations. Each country-level variable refers to a particular structural condition that the competing perspectives use to explain the cross-national variations in envelope wages. Given that partial correlations reveal that these variables are strongly correlated with each other, each is here analysed in separate models, providing alternative perspectives on the reasons for paying envelope wages.

Starting with the modernization thesis (H2), Model 3 provides good evidence that envelope wages are more prevalent in countries with lower levels of GDP per capita, and Model 4 provides good evidence that they are more likely in countries with lower qualities of government. These models thus support the modernization thesis. To evaluate the neoliberal thesis (H3), Model 5 reveals a significant relationship between envelope wages and the ITR on labour. However, this is in the opposite direction to that suggested by the neoliberal thesis: the prevalence of envelope wages decreases as the ITR on labour increases, providing support for the political economy thesis (H4). Similarly, and further analysing the state intervention tenets of H3 and H4, Model 6 provides strong evidence that envelope wages are more likely in countries with higher income inequalities, Model 7 good evidence that the propensity to receive envelope wages is higher in countries with lower levels of social protection expenditure and Model 8 strong evidence that the prevalence of envelope wages is more likely in countries with less effective redistribution via social transfers.

Discussion

Evaluating H1, the analysis reveals a strong association between envelope wages and institutional asymmetry as measured by tax morality. Not only are envelope wages more likely amongst those whose beliefs regarding tax compliance are more at odds with the formal rules, but also in countries where the level of institutional incongruence is higher, and this remains a strongly significant association when other individual- and country-level variables are introduced and held constant. In consequence, the higher the asymmetry between formal and informal institutions, the greater the likelihood of this undeclared practice. This institutional asymmetry thesis is valid therefore, not only across individuals, business types and employee groups but also countries.

As such, and unlike previous explanations for undeclared work, this institutional asymmetry thesis explains why some individuals and groups of employers and employees within a country engage in undeclared work practices and others do not. However, this does not mean that previous explanations are therefore irrelevant. Given that from this perspective, changing various structural conditions (e.g. tax rates) are ways of reducing institutional symmetry (and improving tax morality), the previous competing theories provide a conceptual framework for identifying country-level structural conditions which might engender greater institutional symmetry. Testing each of these competing theories, the above analysis positively confirms the modernization and political economy theses and disconfirms the neoliberal thesis. CEE countries with more modernized governance, higher tax rates, greater income equality, higher expenditure on social protection and more effective redistribution via social transfers have a lower prevalence of envelope wages.

This analysis, therefore, not only provides a new way of explaining the prevalence of envelope wages but also suggests the need for change in how such practices are tackled and identifies a way forward. Conventionally, governments have used direct controls to ensure that the cost of detection and punishment is greater than the pay-off from undeclared work, largely achieved by increasing the actual and perceived risks and costs associated with participation (Allingham and Sandmo, 1972; Williams, 2014a). More recently, moreover, greater attention has been given to making the full declaration of salaries more beneficial (Williams, 2014a). The above findings, however, suggest the need for a rather different policy approach.

Undeclared work in CEE countries, as shown here with the example of envelope wages, results from employers and employees not adhering to the written codified laws and regulations and adopting unwritten verbal agreements that violate the formal written agreement, and the likelihood of undeclared work increases as the degree of institutional incongruence increases. What is thus required is a focus on reducing institutional asymmetry.

To achieve this, and drawing inspiration from how this is achieved at the organizational level where there has been a shift from ‘hard’ to ‘soft’ HRM, and from bureaucratic to post-bureaucratic management (Legge, 1995; Thompson and Alvesson, 2005; Watson, 2003), a similar shift is here advocated at the societal level. Instead of seeking compliance using close supervision and monitoring, tight rules, prescribed procedures and centralized structures within the context of a low-commitment, low-trust and adversarial culture, a high-trust, high-commitment culture is required that aligns the values of employers and employees with the formal institutions so as to generate self-regulated control. This requires changes in not only informal but also formal institutions.

To alter informal institutions, three policy initiatives can be pursued. First, tax education targeted at both employers and employees is required to align them with the formal rules and elicit self-regulation, such as by providing information on the public goods and services paid for by their taxes (Saeed and Shah, 2011). Second, advertising campaigns (targeting the groups identified above with low tax morality) can be used, which can either inform employees and employers of the costs and risks of envelope wages and/or the benefits of fully declaring salaries (OECD, 2013). And finally, normative appeals to employers and employees can be used (which during 2008 in Estonia resulted in 46 percent of enterprises adjusting their wage levels and paying more taxes; Lill and Nurmela, 2009).

To improve the social (psychological) contract between governments and employers and employees nevertheless, formal institutions also need to change. On the one hand, and as Model 4 in Table 2 clearly reveals, employers and employees will not improve their tax morality if there remain low trust in government and extensive public sector corruption, as is the case in many CEE countries (European Commission, 2014a, 2014b). To tackle this low trust, a modernization of governance is necessary. This requires at least three institutional reforms. First, procedural justice must be improved, which here refers to the tax authority treating employers and employees in a respectful, impartial and responsible manner and thus shifting away from a ‘cops and robbers’ approach and towards a service-orientation (Leventhal, 1980; Murphy, 2005). Second, procedural fairness must be enhanced, which refers to employers and employees believing that they pay their fair share compared with others (Molero and Pujol, 2012), and third, redistributive justice needs improving, which relates to whether employers and employees believe they receive the goods and services they deserve given the taxes they pay (Kirchgässner, 2010).

On the other hand, and as Models 3–8 in Table 2 indicate, the pursuit of wider economic and social developments can also reduce institutional asymmetry. These models clearly reveal how CEE countries with not only more modernized governance but also higher tax rates, greater income equality, higher expenditure on social protection and more effective redistribution via social transfers have a lower prevalence of envelope wages. For CEE countries displaying comparatively little progress on each of these wider economic and social developments, greater attention to their pursuit is required if institutional asymmetry is to be reduced, and thus undeclared work tackled. For countries already relatively ‘progressive’ on these fronts, meanwhile, the policy approach will need to be more attentive to pursuing tax education, advertising campaigns and normative appeals to change informal institutions, and the pursuit of procedural and redistributive justice and fairness to change formal institutions, to reduce institutional asymmetry and thus undeclared work.

Conclusion

This article has advanced a new way of explaining and tackling the undeclared work practice of paying envelope wages. When formal and informal institutions are not aligned, undeclared work practices emerge embedded in unwritten socially shared rules which, although socially legitimate, are illegal in terms of the formal written rules since they fraudulently evade the rules of the game. The greater the institutional asymmetry, the higher the likelihood of such practices. Using logistic regression analysis, this has been shown to be the case for both the individuals engaged in such activity and for the countries with a greater propensity to use envelope wages.

To reduce the prevalence of envelope wages, it has been argued that a shift is needed away from direct controls that seek to detect and punish this practice and towards eliciting a high-trust high-commitment culture where the values of employers and employees are aligned with the formal institutions. This requires alterations not only in the informal institutions, using measures such as tax education, awareness raising campaigns and normative appeals, but also and importantly, changes in formal institutions so as to improve trust in government by developing, first, greater procedural justice, procedural fairness and redistributive justice and second, lower poverty levels, more equality, more effective redistribution via social transfers and greater state intervention in the labour market to protect vulnerable groups.

Whether this institutional approach is also relevant when explaining and tackling other forms of undeclared work in CEE nations and beyond now needs to be evaluated. If this article stimulates such evaluations, then it will have fulfilled one of our intentions. If it also encourages governments to recognize how the undeclared economy results from such institutional incongruence and to explore how this can be tackled, rather than simply continuing to detect and punish such practices, then this article will have achieved its broader intention.

Footnotes

Declaration of Conflicting Interests

The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.

Funding

The author(s) received no financial support for the research, authorship, and/or publication of this article.

Author biographies

Colin C Williams is Professor of Public Policy at the Management School, University of Sheffield, UK.

Ioana A Horodnic is Lecturer in the Faculty of Economics and Business Administration at the Alexandru Ioan Cuza University of Iasi, Romania.

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