Shadow Economy and Non-Observed Economy: Accounting Features and Analysis Results

Introduction

Modern global and nation labor markets are undergoing major structural shifts in sectoral proportions and trends in new business types and labor development. Primarily, these trends are associated with the active digitalization of manufacturing, trade and service activities. Secondly, the COVID-19 pandemic period consequences of 2019-2020 should be taken into consideration for active implementation of a remote workplace. For many countries, it is also relevant to use the institution of the self-employed to formalize the entrepreneurial activities of households traditionally represented in the non-observed economy, the problem is aggravated by the fact that households are a separate sector of the economy, the role of which for economic processes is underestimated and traditionally, including on the example of statistical standards. in relation to the informal sector, presented by the International Labor Organization (ILO) in 2022 [12], is divided into the informal sector and the production sector for HH own consumption and community consumption.

Taking into consideration measurement and classification practice in the non-observed economy, varying scientific opinions on the difference between the non-observed and the shadow economy, it is necessary to draw a clear line between these phenomena in terms of their assessment, administration and the status attribution either to informal or shadow economy.

The relevance of this task is confirmed by government actions liberating the self-employed from taxation. These measures are aimed at gradual identification of most responsible non-observed economy entrepreneurs and helping their transition to the formal economy, while taking into account the existing systems of measurement, accounting, registration, identification. Further methods of “interaction” with them should be determine by the state either limited to regulation at the level of standardization and quality control, or tax liability introduction in view of the social justice principle through the redistribution of taxes in the national tax system. Both international institutions such as the UN, the OECD and individual independent researcher conduct studies of the non-observed economy in order to assess the existing trends and to determine positive and negative consequences for the economy and its participants. Thus, the issue of the shadow economy identification and, most importantly, measurement is no longer purely economic theory of traditional economic analysis that determines the conditions for equilibrium, crisis and cyclicality. The shadow economy study has moved into the sphere of interests of economic security, affecting, among others, national safety and assessing strengths and effectiveness of national financial system.

Materials and methods

The authors of the study have analyzed the UN [17; 26], ILO [10-12, 20; 21; 23], and OECD [9; 16] materials containing the definition of the non-observed economy, presenting an overview of identification and measurement of the non-observed economy and its structure, employment, transition from the informal to the formal labor market and economy, and some scientific studies evaluating the official approach to this accounting system (György Gyomai and Peter van de Ven [9], Schnaider F., Enste D. [22]).

As part of the shadow economy measurement, the present paper is based on the statistical accounting data of the Russian Federal State Statistics Service (Rosstat) [4], the Federal Financial Monitoring Service of the Russian Federation (Rosfinmonitoring) and the Federal Tax Service of Russia [5].

The research outcomes and the expressed views on the shadow economy and its place in the national economic system of foreign authors were also taken into account, including the material of the report by D.Kar and S.Freitas on the shadow economy and its shadow financial flows [14]. Another important aspect that correlates with the position of the author of the theory of institutional change D. North [18] and the research of M. Weber [27] in the field of the influence of religion on the content and foundations of economic processes is presented in Kanyama [13], where the author correlates the quality of institutions with the quality of intellectual property capital. Among the works of Russian authors on the topic of the shadow economy measurement and evaluation, the studies by D.G. Lomsadze [15], Fedorov M.A., Ermakova E.A., Gureeva O.V. [6] and Nureev R.M. [19] had the most profound influence on the paper.

The authors have applied traditional methods of scientific research based on methods of historical analysis, examination of dynamics, the tax method for shadow economy measurement, the comparison grouping and index methods. The special methodology and improvement of approaches to monitoring and controlling economy players at the regional levels are the authors' proposals presented within the framework of the tax method for measuring the shadow economy.

Results

Dramatic changes affecting national labor markets enable interpretation of labor as a factor of production. These are not only consequences of automation and digitalization of some labor functions, but also incentives for labor activity determining potential motivational performance and efficiency of the implemented business model and business processes.

On the one hand, there is a trend of transition to a remote labor format, on the other, a growing unemployment due to the economy automation and digitalization. This has made the gig economy and its role in freelance employment more in demand and larger in scale. The emergence of large digital intermediaries between a customer and a professional contractor (mainly in the service market) has taken the first step towards a full-fledged database formation of such participants, their terms, the extent of unobservable income, cash flows and created economic benefits.

The process is similar at the regional level: there is no concept of territorial boundaries in digital platforms` activities within the national economic system. There is a notion of participants` location in a one-time (recurring) transaction, its security for participants, implementation conditions and quality assurance. The state participates in these processes as a regulator of the market and a guarantor of the contractual obligations fulfillment as a result the unemployment rate within the framework of the ILO methodology will have a steady downward trend.

However, regional economy and the labor market will be influenced by labor migration flows, tendencies of intellectual workforce brain drain into larger agglomerations against the backdrop of a reduction in the total number of scientific personnel, “depressed region” presence. According to the Russian Ministry of Economic Development, some constituent entities are annually classified as ‘depressive’ according on the basis of 4 indicators: unemployment rate, average annual household income per capita, share of the population with incomes below the subsistence level and capital investment. The above mentioned factors make it difficult to maintain attractive and decent conditions in the labor market.

If we characterize the self-employed, for them such a status may be an opportunity to legally gain extra income or to be a full-fledged format for doing business, it is important to clarify that this activity is independent, free, at one1own risk and for the sake of realizing personal economic interest such as revenue increase. Therefore, it is logical and fair on the part of the state to introduce special taxation for the self-employed using a unified approach to business taxation. However, it should be pointed out that in order for shadow business to transit into the formal economy, the conditions should be attractive and beneficial.

Analyzing the UN classification of the non-observed economy [17], we should note that in the practice of applying such a classification to measure and evaluate the dynamics of the national non-observed economy, different countries use different types. For instance in the US, only N₆ measurement are applied, in other word, of manufacturers deliberately distorting data; in Austria and Russia, from N₁ to N₇ measurements are used except for N₂ (illegal deliberately not registered producers). As a result, it is not possible to objectively assess the difference in the volume and structure of the non-observed economy. The process gives some freedom (outside the system of national accounts and OKVED) in determining the status of an organization to monitor its possible transition from the shadow economy to the non-observed economy and vice versa.

Table 1 presents the comparison of the non-observed economy structure of the OECD and the UN source.

Table 1 - OECD and UN Statistical Accounting System of the Non-Observed Economy

Source: compiled by authors based on sources [16; 17]

According to the UN approach, we should note that only N₃ cannot be attributed to the shadow economy in the block of unregistered producers. Precisely this method within the framework of the tax method of measuring the shadow economy produces no contradiction between accounting systems such as for instance Rosstat and the Russian Federal Tax Service. Similarly, we should comment on the content of the unexamined producers block. Here, on the contrary, out of all the types presented, only N₆ can be considered as an element of the shadow economy. N₆ contains a deliberate distortion of official accounting data at the level of statistical and tax accounting.

As a result, the presented typology of the non-observed economy comprises not only informal economy participants cluster which officially includes manufacturers selling their products in accordance with the law, but also enterprises avoiding full participation in legal economic activities which reduce their costs and tax liabilities in order to obtain “competitive advantages”. According to the 2022 ILO Report “Statistics on the informal economy”, the informal sector includes economic units whose “production is mainly intended for the market with the purpose of generating income and profit, but that are not formally recognized as producers of goods and services distinct from the own-use production of the owner-operators’ household (informal household unincorporated market enterprises)” [12].

The identification algorithm of an enterprise relation to the non-observed or shadow economy includes the following steps:

1. The formal status of the economic unit (or lack of such) including Individual Entrepreneur status (except for the self-employed) for maximum coverage of business participants.

2. After revealing the producers that do not have the formal status of the economic unit, to exclude non-observed economy unites that are not directly related to the shadow economy (N₃, N₄, N₅, N₇) in order to identify the status of the remaining types N₁, N₂ and N₆.

3. The tax method application for measuring the shadow economy: the task is implemented not of individual, but of the aggregate identification of the share of the shadow economy in GDP (GRP), which is based on the ratio of statistical and tax accounting data on profit taxation [2].

Figure 1 presents stages, in the algorithmic form, for identifying the status and the role of economic units of the national economy in the shadow economy.

Figure 1 - Algorithm for a Non-Observed or Shadow Economy Units` Identification

Source: compiled by authors

The presented algorithm requires an assessment tool in the national control and monitoring system of macroeconomic processes. It identifies types of non-observed economy both through statistical or tax reporting, and through selective observation, census and direct observation with a detailed map of producers up to the micro-district level (for example, a business portal navigator for small and medium enterprises in Russia).

In order to specify the final stage content of the considered algorithm, we present its calculation part description with the authors' proposals for optimizing it and increasing the accuracy, correctness of application in the current system of macroeconomic accounting and analysis:

- the shadow economy share in GDP (GRP) is officially determined by using the tax method (Model 1) [6]. The method is based on Rosstat data indicators such as GDP (GRP), wages of employees, net production profit, and the data of the Federal Tax Service of Russia on the amount of legal profit included in the tax base for corporate income tax:

where

GDP (or GRP) - gross domestic product (or gross regional product;

W - wages of employees at the national or regional level;

T_prod - net production taxes on the scale of the national or regional economy;

P_tax - legal income included in the tax base for corporate income tax.

- in order to develop of the tax method for measuring the shadow economy, the authors propose to correct the calculation of the numerator in Model 1 by the value of the accounting depreciation of fixed assets of commercial organizations accrued in a year (excluding small and medium-sized businesses):

where

OF - accounting depreciation of fixed assets of commercial organizations accrued in a year (excluding small businesses)

A number of comments should be made as a result of comparing Model 1 and Model 2:

- Gross economy profit and Gross mixed income P=GRP–W–Т_prod is included in Model 1 and includes the OF value:

- In compliance with the Rosstat methodological guidelines, Gross economy profit and Gross mixed income measure the profit (or loss) received from production, before taking into account the payment or receipt of property income.

- Gross profit in the System of National Accounts (SNA) does not contain elements of wages, does not include profits generated by asset owners as a result of price increases, and includes the consumption of fixed capital.

- The amount of legal profit included in the tax base for corporate income tax is determined already without taking into account the value of the OF indicator:

- In compliance with Article 253 “Expenses related to production and sale” of Chapter 25 of the Tax Code of the Russian Federation, such expenses are divided into Material Expenses, Labor Costs, accrued Depreciation and other expenses;

- Due to the fact that labor costs are not included in the SNA gross profit, subtracting the amount of depreciation of fixed assets of commercial organizations OF from the gross profit indicator P, one gets a closer estimate of the net profit of the region to its real net profit [2].

The approbation of these models on Russia`s southern regions (in Southern Federal District) has shown that, primarily, the obtained data indicate a significant share of the shadow economy amounting from 30 to 60% of GRP, and secondly, the shadow economy share in a crisis has an upward trend [1].

Discussion

The debating points under the declared topic include the following:

- The current state and future prospects assessment for the self-employed institution development, taking into account its role in managing the processes of informal, shadow employment, distortion of accounting, reporting, taxation systems and the implementation of the principles of fair competition and equality of all producers in terms of responsibility to society in the process of creating and functioning of public production;

- Transformation of legal regulation of decent work conditions and guarantees for all the labor market participants regardless of their legal status; steady trend to minimize shadow employment particularly in some notorious areas such as construction, trade, transport, etc.; according to Rosfinmonitoring data, those entrepreneurs at the same time form the demand for shadow financial services (%), since they obtain unaccounted income requiring further use outside the legal field (Fig. 2).

Figure 2 - Economy Sectors forming the demand for Shadow Financial Services (%) in the early 2022 and in the early 2024

The self-employed are the key representatives of the labor market in the gig economy, which is determined by the very format of the contractual relationship between the participants in the transaction for the provision of services (work performance). In the context of digital platforms active development and their implementation as "intermediaries" in the service market, the scale and problems of regulating transactions in this area are growing rapidly. The improvement of rules governing the safety, quality and legality of participants in the gig-economy are required. Most of the representatives of the professional community providing such services could be attributed to informal employment, since; on the one hand, this is a transaction between two individuals for the provision of a service that does not require other conditions for implementation, except for the mutual consent of the parties. On the other hand, this part of the non-observed economy traditionally sets the created value added to zero, thus, the question arises on real volumes of economic processes and their outcomes.

The state has the opportunity to obtain some information about the transactions due to the market legalization and the transaction inclusion of such intermediary as a digital platform that provides the search and conclusion of a transaction. It is nowadays possible to assess the “average cost” of the transactions and scale for the national economic system. Nevertheless, it is important to understand that the status of self-employed is chosen by conscientious participants in professional activities, including those with positive experience in the labor market. The majority of the shadow employment representatives do not have incentives and obligations to come out of the shadows, which are a factor of unfair competition, a threat to economic security and transaction security.

The gradual legalization of this labor market share and the increase in both incentives for obtaining such an official status and the consequences in case of legalization evasion are the main conditions for successful state policy to minimize informal employment and maximize the country's GDP in terms of matching the potential and actual measurement of the added value and its taxation created.

One of the incentives that encourage self-employed status is introduction of decent work indicators system for freelance employment and creation of favorable conditions in case of legalization for individuals:

- Generally, it should be stated that for the national labor market there are serious problems in achieving the goals of creating decent working conditions that are being formed at the international level, starting with the ILO Decent Work Concept (detailed in the 2008 ILO Declaration “On Social Justice for the Purpose of Fair globalization” [11] и and in Sectoral conventions on safety and health at work (example of the 2001 Convention in Agriculture No.184) and ending with initiatives at the national level for the internal labor market, for example Trade Unions and the national government aimed at realizing joint obligations on decent wages, etc.

- “Decent work” is referred to ad free, fairly paid, safe, socially protected work which does not degrade human dignity, provides equal starting opportunities for everyone, guarantees participation in managerial decision-making and self-development.

- According to Rosstat, a number of indicators of decent work in Russia [3] can be characterized by the following trends: there are 3 groups of indicators - M (main indicators), A (additional indicators), C (socio-economic context), however, in this paper only main indicators are presented:

• Informal sector share in total employment, % (Fig. 3);

• Employees share with excessive working hours (more than 48 hours per week; "actual" number of hours), % (Fig. 4);

Figure 3 - Change in the values of M indicator " Informal sector share in total employment,%" in Russia for 2001-2022

Source: [3].

Figure 4 - Change in the values of M indicator “Employees share with excessive working hours (more than 48 hours per week; “actual” number of hours),%” in Russia for 2001-2022.

Source: [3].

On a regular basis, general agreements on cooperation in the field of ensuring conditions for decent work are concluded at the federal level between Russian Government and all-Russian trade unions or employers associations. For instance, in the field of national monetary policy there is a monitoring program implemented on concessional lending to enterprises that ensure the preservation of employment. Another example is insurance of state wage guarantees aimed at guaranteeing decent living standards for employees and their families is implemented through monitoring of timely and in full payment of wages in the course of procedures for changing the legal form of an organization, reorganization (merger, accession, takeover, separation, transformation), privatization, re-profiling, insolvency, as well as in cases of termination of the employer's activity and its insolvency [7-8].

Furthermore, the trade union movements initiated the decent wages standardization on the basis of which there is a need to regulate and normalize wage conditions without discrimination between full-time and freelance employment. Those actions are to be taken in addition to the traditional gender wage gap measures, most flexible approach application to minimum wage taking into account international experience and labor market changes (introduction at the state level of monthly, daily and hourly forms of the minimum wage, which is actively used in the most dynamically developing economies such as China and India.

Conclusion

Common market mechanisms, actual conditions for doing business and the permanent conflict between public (state) and personal economic interests determine the fact that the shadow employment and informal participants in the producer market have become typical phenomena.

International practice for measuring and accounting for the non-observed economy indicates legal and illegal signs of attributing producers to one or another type of non-observed economy according to the UN classification. The fact that each country implements its own approach to measuring the non-observed economy, which manifests itself in considering either one type (the example of the United States), or several, or all 7, indicates the need to achieve unity in this matter and a stricter separation of the types of non-observed economy containing elements of the shadow economy and employment. These measures are aimed at most correct accounting and analysis at the national level, cross-country comparison and effective problems identification.

Households, as one of the sectors of the market economy are referred to informal economy, in accordance with the concept of the System of National Accounts and All-Russian Classifier of Economic Activities. The approach to the accounting system does not change here, however, the implementation of the self-employed tax regime can be considered a way to legalize conscientious households participating in labor and professional relations in the format of a gig economy or e-commerce without individual entrepreneurship. Furthermore, it is important to simultaneously tighten control and consequences for participants in the non-observed economy who deliberately distort or hide information about their economic activities. Both the state and the corporate management system are facing such tasks as fair competition, equal conditions in pricing and access to key information on the market, ensuring decent work conditions and transparency.