Shadow Economy in Latvian Construction
This study aims to explore the amount and key determinants of the shadow economy, specifically in the construction industry in Latvia. The results of the study “Shadow economy in Latvian construction 2015-2018” suggest that the size of the shadow economy in the Latvian construction sector since 2015 has decreased by 5.9 %, having declined to 34.1 % of GDP. It is essential, that there is a significant reduction in envelope wages in construction – from 36.3% in 2015 it dropped to 28.2 % in 2018.
Arnis Sauka, SSE Riga professor: “The construction sector is developing rapidly and it is a significant driving force of economic growth. In addition, according to the study results, the shadow economy in the sector is decreasing, and in 2018 it was mainly promoted by the decrease in envelope salaries. However, the study also points to several challenges that should be addressed directly by the Latvian policy makers. Among them, a smarter and more efficient immigration policy, allowing the labour force to flow in Latvia (and flow out of it) in a legal way and when it is needed, where there is great demand in the industry, should be mentioned. The sector is looking forward to more rapid progress in terms of the successful introduction of a collective agreement, issues relating to the introduction of electronic working hour accounting, introduction of standard contracts and transition to cost-benefit evaluation in public procurement. Similarly, the building professionals point to the necessity to have more certainty, less bureaucracy and more successful cooperation with the controlling authorities.”
The study (please read below) was carried out by SSE Riga professor Arnis Sauka according to a contract by the Latvian building contractors’ partnership. The goal of this study is, by summarising the available statistics, the opinions of construction enterprises, as well as sectoral experts, to provide in-depth knowledge of the problems of the shadow economy in the Latvian construction sector.
As indicated by the available statistical data, after a significant decline of the construction production volume in 2016, if compared to 2015 (decrease –16.6%) and increase in 2017 (+18.6%), the volume of the sector has continued to increase in 2018 as well: 21.9% in comparison with 2017 (CSB, 2019). The total increase of the sectoral volume in 2018 was significantly affected by the increase of the construction volume in building construction (+25.6%). In turn, the volumes of engineering constructions increased by +11.6% in 2018. The total share of the construction sector in the economy (at current prices) reached 7.1% in 2018, which is an increase of 1.1% compared to the year 2017.
According to the latest study results, obtained by a representative survey of Latvian construction sector company executives, the size of the shadow economy in the sector still remains relatively high, however, with positive dynamics. Namely, in 2015 the size of the shadow economy in the construction sector was 40.0%, in 2016: 38.5%, in 2017: 35.2%. In turn, in 2018 the size of the shadow economy in the construction sector decreased further by 1.1%, reaching 34.1% of GDP.
The study results suggest that the size of the shadow economy has decreased in one of its most important components – envelope wages: from 32.1% in 2017 to 28.2% in 2018. Thus, the level of envelope wages in the construction sector is drawing nearer to the average envelope wage level in Latvia, which reached 20.9% in 2017 (Putniņš and Sauka, 2018). However, in 2018, compared to 2017, both the level of the non-reporting of the sectoral company income – the average income part in %, that companies hide from the state (respectively: 27.1% and 26.7%), and the non-reporting of the number of employees in the sector – in % of the actual number of employees in the respective year per the reporting year (respectively: 18.8% and 17.6%) has increased. Also the level of corruption has increased in the sector (in % of the respective year’s turnover for “sorting things out”, on average): from 15.5% in 2017 to 16.4% in 2018. The main conclusion: despite the rapid growth in the construction sector, the shadow economy in general and in some of its components separately is still high in the sector – significantly higher than the average in Latvia.
In a study of 2019, we asked a representative sample of Latvian construction companies to evaluate, how effectively the state has implemented the policy (i.e., initiated, developed and/or implemented different instruments) for the reduction of the shadow economy in the construction sector in Latvia in 2018. We asked to provide an evaluation on a scale from 1 to 7, where “1” means “very inefficiently”, obtaining the result of 3.6. For comparison, the company executives evaluated the work by the policy makers for the reduction of the shadow economy in the construction sector in 2017 with 3.3, but in 2016 – 2.8.
The study results indicate that, according to the entrepreneurs, in 2018 the policy makers in Latvia worked most efficiently to develop and implement a regulatory framework for an electronic working hour accounting system of persons employed at a construction site (the average evaluation 4.4 on a scale from 1 to 7, where ‘7’ means the highest evaluation: a year earlier the evaluation was 3.8, but in 2016 it was only 2.9). This is followed by work to promote refusal of the application of the lowest price principle in public procurement and transition to the cost-benefit assessment (evaluation 4.3: both in 2018 and 2017, but only 2.9 in 2016) and the development and introduction of construction standard or model contracts in state and municipal public contracts (4.2 compared to 4.1 in 2017 and 3.1 in 2016). In turn, the activity: “improvement of the accounting of the construction sector – to develop and implement a regulatory framework that would define information in the accompanying documents of the construction products in more detail” was evaluated with 4.1 (compared to 3.7 a year earlier). The surveyed entrepreneurs of the sector also evaluated the most part of other activities by the policy makers for the reduction of the shadow economy in the construction sector in the range from 3.7 to 4.0, i.e., above average.
Similarly to the study of the previous year, also this year the surveyed experts – the large Latvian construction companies, generally agree, that the shadow economy, even though slowly, is decreasing in the sector and the initiatives launched are a good basis for the much faster reduction of the shadow economy in the following years. However, the experts also point to a number of deficiencies. Among others, that there is sometimes a lack of active action on the state’s part, for instance, regarding the improvement of the electronic working hour accounting system: “We, the building professionals, have invested tremendous work and resources in this and we are doing everything that is needed. The parts from the SRS and the MoE are those that are skidding... It is neither fair, nor correct and it does not indicate that we are going towards a common goal together.”; or “This matter is unfortunately standing still, even though everything has been done from the sector so that the system worked. Sometimes it seems that the builders need it, not the state – it is a matter of attitude.”. The most part of the experts also think that the introduction of a collective agreement (the minimum wages in a sector) will have huge added value and they praise the progress achieved in this area. The following quotes from interviews testify to this: “There is nothing much to be highlighted (from the policy initiatives), and it could not be said also, that there is much done in 2018 in order to improve the overall situation in the sector. Collective agreements are one of the most visible aspects, but it has not been finalised either: ¾ of the road has been walked and it looks promising. This is a significant matter and would give a positive effect to putting the sector in order.”, and: “I think that this matter is moving towards being solved.”.
Similarly, the surveyed experts point to the problems with the introduction of standard contracts. For example: “There has been some kind of movement in this regard. At the end of the previous year, however, the MoE discarded the progress of one of the internationally widely distributed contract types – FIDIC ... They declared it to be complicated. It is strange, this contract works worldwide. In addition, it adequately divides the responsibilities of all the parties, which is what everybody in Latvia wants to achieve. The experts also emphasise problems in relation to the bureaucracy: “There is a bigger emphasis on papers and the process than on the result. And this trend is continuing, including all the introduced requirements from the controlling authorities – for example, about accountants, protection of personal data etc. – it is the resource of administration that does not add value.”, and the control: “Unfortunately, punishment and threats on the part of the state are still more common, but advances in terms of work, such as by implementing electronic work accounting, but not only this, – are lacking to a great extent. It could be wished to have such relationships that befit ‘equal’ partners.”.
The surveyed experts also highlight problems with the quality of construction projects and specifically emphasise the problem with uncertainty: “Sometimes there is a feeling that the new government wants to make a new start, from the beginning. This can slow down many good initiatives.”; “It is very good that the digitisation of building documentation is moving forward, but it is difficult to understand when it is going to happen and how. The flow of information is a bigger problem – everybody knows that something will be done, but nobody knows when and how.”.
The study results of a representative sample of Latvian construction companies suggest that the entrepreneurs of the sector are slightly more satisfied with the activity of the State Revenue Services (the evaluation 3.6 in the scale 1-5, where 5 is ‘very satisfied’), compared to the national tax policy, the overall quality of business legislation in Latvia, the specific quality of the construction sector legislation and the total state aid to entrepreneurs (respectively: 2.25, 2.92, 2.79 and 2.22). The previous studies suggest that all the above mentioned factors have an impact on the involvement in the shadow economy – the more entrepreneurs that are satisfied with these factors, the less involvement in the shadow economy. In turn, the probability of being caught for tax avoidance in the sector is assessed at approximately 50%, indicating that on average the consequences of being caught will be rather significant – at least a fine, which would impact the company’s competitiveness.
In the study carried out this year we asked the entrepreneurs of the construction sector to evaluate the extent to which they are facing the labour problem, as well as to assess the proportion of illegal labour in the sector. The results of the study, unfortunately, are very alarming. Namely, on average – if the labour force were available – the entrepreneurs of the sector would additionally hire almost 50% of employees (of the number presently employed). In turn, the volume of illegal labour in the sector reaches 18.1% of the total number of employees. Namely, approximately 10,500 employees are employed illegally in the sector.
We also asked the opinion of the surveyed experts regarding the availability of labour in the construction sector. The overall conclusion is that there is, of course, a shortage of labour: large business executives would be ready to hire from 25% up to the doubling of employees in individual companies – if only employees were available. The surveyed experts are confused about the state policy regarding the attraction of labour from the third countries and point to big problems in this respect: “We cannot really deal with the bureaucratic part, it is not possible! In order to officially hire one guest worker in Latvia, 90-180 days are required. If we need a guest worker for half a year, it takes at least the same amount of time to get him here on the whole.”. At the same time, the experts emphasise that already now, foreign (i.e., third country) labour is being widely used in Latvia, arriving in the country via Poland, where there are no such restrictions. “At present, out of the total number of the employees working in the sector, on average it could be that 5-8% and up to 10% of those who work in Latvia, are brought via Poland – they have contracts with work placement agencies.”.
In the study we also asked the companies of the sector to evaluate, how does the lowest price as the only criterion in public procurement affect the competitiveness of the enterprises of the construction sector and also the involvement in the shadow economy? The study results suggest that the impact is negative: the average evaluation on a scale from 1 to 5, where 5 indicates negative impact, is 3.95 and 4.01 respectively.
We also asked the following: “In the cases when cost-benefit is applied in public procurement, which of the other criteria below – and how often, according to your experience, are used when the tenders are assessed?”, as well as to evaluate, what extent does the application of these other criteria promote, respectively, an increase in quality, innovation, environmental protection, social responsibility, tax payments in the construction sector? The study results suggest that slightly more often for the assessment of tenders, criteria such as guarantees and experience, staff qualification (1.96 and 2.06 respectively on a scale of 1-5, where 1 means that this criterion is used very often) are used. In turn, the extent that the application of different criteria promotes, respectively, an increase in quality, innovation, environmental protection, social responsibility, tax payments in the construction sector, was evaluated within the range from 2.28 to 3.04 (on a scale where 5 means “does not promote at all”). Finally, we asked the entrepreneurs of the sector, to what extent, when publishing public procurement, does the contracting authority define the estimated contract price according to the current market situation? 8.8% of respondents and 36.7% of respondents respectively admitted that when launching public procurements, contracting authorities do not generally consider the real market situation or do not consider it often.
We hope that the conclusions and suggestions summarised in the study will help Latvian policy makers to continue working with more analytical and successful solutions for the reduction of the shadow economy and the increase of productivity in the construction sector. We also hope that the policy makers will continue a constructive dialogue with the representatives of the sector to reach these goals.