Imagine a couple running a street stall in Sarajevo, the capital of Bosnia. They do not have a permit to operate the stall and do not pay taxes. They procure and sell their goods in cash and do not issue receipts to customers. Nearby, there is also a man hired as a day laborer at a construction site. He, too, is paid in cash for that day’s work, leaving no record. Businesses like these make up the “informal economy.” The Western Balkans, including Bosnia, have a particularly high share within Europe, to the European Union (EU) accession hindrance.
The informal economy refers to economic activities carried out by workers or entities that are not protected or recognized by a legal framework. At first glance, being informal may seem advantageous for workers, but is that really the case? And what are the implications for towns, cities, and entire countries?
In this article, after reiterating what the informal economy is, we look at cases in the Western Balkans.
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The informal economy and its problems
First, let us look at a more detailed definition of the informal economy. According to the International Labour Organization (ILO)’s definition, “the informal economy comprises all economic activities by workers and economic units that are, in law or in practice, not covered or insufficiently covered by formal arrangements (excluding illicit activities such as criminal acts).” The boundary between the formal and informal economies is blurry. This is because both completely unreported production and business entities and those that are only partially reported coexist.
For people engaged in the informal economy, there are also advantages such as not having to go through cumbersome procedures like company registration or detailed bookkeeping, and not having to pay taxes. In this sense, it can be said that entry is easier than in the formal economy.
Moreover, for low-income countries, regulating the informal economy is costly and difficult to implement. In fact, there is a history in many countries of the informal economy being tacitly tolerated or openly accepted by the authorities.
However, the informal economy naturally has many problems. One major issue is that people working in the informal economy are not protected by legal labor standards or social security systems. As a result, there is no guarantee that wages will be paid properly, there is no oversight to regulate poor working conditions, and unilateral exploitation, abuse, and harassment of workers become more likely.
There are also problems not only for workers engaged in such jobs but also for customers. For example, in restaurants, legal hygiene standards may not be in place, forcing customers to buy food prepared in unsanitary conditions. In addition, since quality standards are not applied to products, the likelihood of receiving defective or dangerous goods may increase.
A shop selling umbrellas in Bosnia and Herzegovina (Andrew Curran / Flickr [CC BY-NC-SA 2.0])
In addition, the impact of the informal economy is not limited to citizens. The International Monetary Fund (IMF) defines the informal economy as “activities that have market value and, if properly recorded, would contribute to government tax revenues and gross domestic product (GDP).” Because taxes are not properly paid in proportion to the scale of economic activity, tax revenues that should otherwise be collected are lost, which can lead to problems such as a decline in the quality and scale of public services. Furthermore, because parts of the economy are not recorded, it is impossible to grasp the exact scale and content of economic activity in society. This makes it difficult to plan public services such as infrastructure and to formulate and implement policies to regulate or promote economic activities. This is a major concern for national governments and policymakers.
In this way, the informal economy negatively affects a variety of actors, including workers, customers, and national and local governments.
Global trends in the informal economy
We have discussed what the informal economy is, but how large is it?ILO estimates that about 2 billion people, or 60% of the world’s labor force aged 15 and over, work in the informal economy worldwide. However, its size varies by country. On average, the share of economic activity in the informal economy as a percentage of GDP is 15% in high-income countries, while it rises to 35% in low- and middle-income countries on average.
At the individual level, wages for people working in the informal economy are lower than those of people working in the formal economy. Reasons include the fact that workers in the informal economy are not legally protected, and therefore cannot receive wages in accordance with minimum wage laws or labor standards, and that relatively few are members of labor unions, giving them weak bargaining power.
A farmer in Montenegro leveling hay with agricultural tools (Photo: Adam Cohn / Flickr [CC BY-NC-ND 2.0])
Gender disparities are also noticeable. Although women’s participation in society has been advancing in many countries, women are still often in a disadvantaged position in terms of their share of total formal employment, pay, and working conditions. The share of women working in the informal economy is also high: in South Asia, 95% of female workers are in informal employment, in sub-Saharan Africa 89%, and in Latin America and the Caribbean 59% work informally. One underlying factor is that many women are compelled to perform domestic work. It is estimated that women account for 80% of domestic workers worldwide. Because household chores and childcare make it difficult to secure sufficient working hours outside the home, access to the formal economy is limited. For women who nevertheless must earn their own living, a flexible working environment that fits their schedules is necessary. As a result, entering the informal economy has become one of the options.1.
The informal economy in the Western Balkans
So far, we have covered an overview of the informal economy and global trends; in this section we focus on the Western Balkans, which aim to join the EU but are said to face many issues related to the informal economy. The Western Balkan countries are the seven countries of Albania, North Macedonia, Croatia, Kosovo (※1), Serbia, Bosnia and Herzegovina, and Montenegro on the western side of the Balkan Peninsula (※2). In many of these countries, the share of the informal economy as a percentage of GDP is about 30%, far exceeding the EU average of 17.9%.
There are also cases where the very employment relationship between companies and individuals is ambiguous. The share of workers employed without labor contracts is 51.6% in Montenegro, 47.9% in Serbia, and 29% in Bosnia and Herzegovina. Among other workers, many are engaged in jobs with insufficient reporting, such as having part of their wages unreported. The shares are 40.6% in Montenegro and 72.4% in Croatia respectively. By sector, partially reported work is particularly common in agriculture and in retail and wholesale trade.
The reasons for the high share of the informal economy in Western Balkan countries are diverse, including high unemployment and low trust in governments and public institutions. In many Western Balkan countries, tax authorities and tax systems are widely perceived to be corrupt, and tax evasion is rarely condemned. In Montenegro, the budget audit system has long been in a state of dysfunction. Thus, governments and public institutions are failing to earn citizens’ trust.
The seriousness of the informal economy in Western Balkan countries became apparent during the COVID-19 pandemic. Because people working in the informal economy were not adequately covered by healthcare, the share of workers without health insurance was high—60% in Kosovo in 2019 for example. The large number of people unable to access medical care revealed how many businesses operate within the informal economy there.
The informal economy in Croatia
In this section, we focus on Croatia, the only EU member state in the Western Balkans. Croatia’s informal economy amounts to about 27% of total GDP, the third highest in the EU. Although its share of the overall economy has gradually decreased since 2000, this relative decline is due to the rapid growth of the overall economy, and the absolute size of the informal economy itself has not necessarily shrunk, according to one analysis.
As noted earlier, the informal economy comprises both completely unreported and partially reported activities, and Croatia shows the same pattern. By industry, the share of informal work is highest in construction, but it is also common in hospitality, customer service, and other service sectors. In addition, a quarter of people have purchased goods or services that were not properly reported, and in some cases these purchases are from close contacts such as relatives, friends, or acquaintances, which may make regulation even more difficult.
Workers at a construction site in Croatia (Photo: Miroslav Vajdić / Flickr [CC BY-SA 2.0])
As in other Western Balkan countries, Croatia is marked by low citizen motivation to pay taxes due to low trust in government institutions. Widespread tax evasion and underreporting have also fostered a social perception among citizens that “it’s fine because everyone around me is doing it,” which contributes to the informal economy. The risk of facing strict enforcement for underreporting is low, and the government cannot be said to be fully fulfilling its role.
Addressing the informal economy in the Western Balkans
Although the informal economy offers little net benefit to workers, customers, or governments, it is not the case that governments have taken no action. However, these measures are often not comprehensive or consistent, a key problem.
For example, action plans to tackle the informal economy have been developed since 2015 under the ILO in Montenegro and North Macedonia, and under the IMF in Albania. While tax reforms and stricter fines for tax evasion were introduced, the lack of specificity in these plans led some in the business community to criticize them as ad hoc measures. Montenegro reduced health insurance contributions, and Bosnia and Herzegovina cut income taxes. By lowering the hurdles to paying taxes, these policies aim to encourage compliance and reduce illicit business activity. In Serbia, penalties for tax evasion were made stricter in 2019 to increase deterrence—an approach that seeks to promote tax payment by raising the cost of noncompliance.
Serbian dinar banknotes, the currency of Serbia (Photo: Forextime.com / Flickr [CC BY 2.0])
Alongside stronger audits and enforcement, efforts are also being made to give businesses incentives to prevent illicit activity. For example, in 2015 Albania simplified company registration to reduce the scale of the informal economy. By establishing the “National Business Center (QKB)” to centralize procedures such as company registration, tax registration, and social insurance registration, it lowered the barriers to formalizing economic activity. Serbia has implemented a similar policy to simplify company registration procedures.
Outlook
As discussed above, the informal economy is a phenomenon observed around the world, and it brings with it various problems. Its formalization will require fundamental reforms and will likely be costly. All the measures currently underway in the Western Balkans still face challenges. To resolve this issue, it is essential both to lower the cost and procedural hurdles to formalizing economic activity and to impose strict penalties for tax evasion and regulatory violations.
However, to make these systems work properly, citizens’ trust in governments and public institutions must also be raised. To that end, corruption must be eradicated, and governments must show citizens that their taxes are being used effectively. Through these measures, formalization of economic activity may progress and public attitudes may begin to change.
※1 Declared independence in 2008, but is not currently a member of the United Nations.
※2 Of the seven countries, only Croatia is an EU member.
Writer: Tsugumi SUZUKI
Graphics: Ayane Ishida
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