Mike Collier in Riga -

With cash a scarce commodity these days, policymakers are rummaging through the cutlery draws and feeling down the back of the sofa for any spare bits of revenue they might have misplaced during the boom years. Latvia is hoping to find something more valuable than breadcrumbs and old buttons - by using a carrot and stick policy to rein in the shadow economy.

Shadow economies matter for several reasons. Most obviously they make no contribution to the official statistics on growth, consumption, taxation and so on, skewing results and giving a false picture of what's really happening. If everyone buys their strawberries from stalls by the side of the road in preference to a registered grocer, the official figures say no-one is eating strawberries - even though sales of cream have mysteriously rocketed.

Economies can end up in a vicious cycle: individuals go underground to escape taxes and social welfare contributions, eroding the tax and social security bases. That, in turn, causes increases in tax rates and budget deficits, pushing even more production underground.

In Central and Eastern Europe, the assumption has always been that the shadow economy is large compared with economies further to the west, partly as a hangover from the Soviet era, when getting hold of many goods and services was a case of knowing the right person in the right job, and partly an understandable reaction to taxation systems that often demand a lot but give little in return. Research by Friedrich Schneider released in December 2011 stated frankly: "The new European Union members ... have higher shadow economies than the "old" European Union countries."

Trust in the figures

According to Schneider, in 2012 the Bulgarian shadow economy will be worth 32.3% of GDP. It is followed by Romania at 29.6%, Croatia (29.5%), Lithuania (29.0%), Estonia (28.6%), Turkey (27.7%) and Latvia (26.5%). In contrast, the grey economy in Germany equals just 13.5% of GDP, with the UK at 10.5% and Switzerland 7.8%. However, new research by Latvian academics Talis Putnins and Arnis Sauka challenges those figures, and seems more persuasive, partly because it shows subtler variations, but also because it's based on direct interviews with hundreds of businesses rather than relying purely on macro data.

"We've seen big differences between Latvia, Lithuania and Estonia over several years, so I no longer have any doubts they exist," Sauka tells bne. "If we can't trust what entrepreneurs are actually saying, then we definitely can't trust macro data. I might trust such data from Sweden or Germany, but I wouldn't necessarily trust it from Central and Eastern Europe."

According to Sauka and Putnins, the size of the shadow economy in 2011 was notably higher in Latvia (30.2%) than either Estonia (18.9%) or Lithuania (17.1%). Although all three Baltic countries decreased the size of their shadow economies from 2010 to 2011, the reduction in Latvia (8.6 percentage points) was much larger than those seen in its neighbours (1.7 pp and 0.5 pp, respectively). Meanwhile, Lithuania and Latvia share the similarity that the size of their shadow economies actually expanded from 2009 to 2010, followed by a contraction in 2011, whereas in Estonia it has followed a more consistent path of modest contraction in both 2010 and 2011.

Sauka says Latvia's recovery from crisis was the main reason it managed such a marked decease last year. "When an economy gets back to normal, the figures of the shadow economy should also get more normal, although if you are talking about one third of GDP it's still a lot. Another explanation is that the Minister of Finance has been implementing a lot of action. However, I don't think this is directly impacting the figures yet; that may happen after a couple of years as they tend to be long-term measures."

Trust in the authorities

Also worthy of note are some startling variations between Latvia's regions. In 2010, more than 40% of Riga's economy was unreported, compared with just 17% in the northern Vidzeme region. A key aspect is people's perception of the likelihood of getting caught. "Latvian entrepreneurs still believe that they won't be caught, and in particular small companies feel they are protected because no-one really cares about them. This shows in the data: bigger companies have reduced their share in the shadow economy but micro-companies are still much more involved," Sauka asserts.

"The level of trust businesses and entrepreneurs have in the government and institutions is also crucial," Sauka says. "It is of utmost importance that entrepreneurs feel the tax system is fair, that it won't change and is predictable. This is also one of the things that explains the huge difference between Latvia, and Estonia and Lithuania, where entrepreneurs seem to trust the government more and perceive tax policies as fairer."

The good news for Latvia is that Finance Minister Andris Vilks consistently tops polls of the most trustworthy politicians in the country. "The figure of 30% is probably realistic," admits Vilks, "but the major point is that the situation is improving. We are getting results, partly because we opened a real dialogue with businesses. It's very important to keep this trend as there is still a significant gap between us and our Baltic neighbours. We need to get the figure down to 20% and things like the Latgale development plan [which aims to boost jobs in a region more in shadow than most] could be crucial. I am quite confident, if we can keep good growth in the economy this year and next. It would be good to see the figure down to around 25% this year and maybe hit 20% in three years' time."

"A stick and carrot approach should give results," the minister continues. "We're proposing reductions of the tax burden which should be very helpful to entrepreneurs, and we're trying to deliver much more transparent distribution of tax revenues. But punishments should also be very strict. Fines should be much higher and that would send an important signal to all tax cheaters."

However, not everyone is convinced. As one self-styled "businesswoman and entrepreneur" asked at a sparsely-attended May 30 conference on the shadow economy run by the Latvian Chamber of Commerce: "This is all very well, but look around you. Why isn't anyone here? Because they're all out working, a lot of them in the shadow economy."