Thursday, November 7, 2013

Ireland's Black Economy: Sunday Times, October 27, 2013


This is the unedited version of my Sunday Times column from October 27th.

In four and a half years through June 2013, Irish personal and public consumption of goods and services has declined on a cumulative basis by EUR 78.4 billion. Over the same period, Irish black economy has gained around EUR 1.2 billion worth of new business. Today, the unofficial shadow economy in Ireland runs at around EUR20 billion per annum.
Much of the recent activity in this economy is courtesy of our budgetary policies pursued since the onset of the crisis. And much of the growth is in the areas relating to the illegal supply of goods and services that are supplied also via the legitimate retail trade. In simple terms, virtually all of the growth in our shadow economy is down to high costs of State regulations, price controls and taxes. The balance of the demand increases in the grey and black markets is down to the households’ responses to changes in income taxation and the crisis impact on our earnings and employment.

The classic definition of the black markets covers a range of activities from trade in illegal drugs to money laundering, from untaxed cash transactions to underground employment, from intellectual property theft to contraband and/or illegal manufacturing of goods and services. One is tempted to depict the black market economy as being a part of urban markets, such as Dublin’s Moore Street or Meath Street, where shifty-looking characters offer illegal wares, ranging from controlled substances to contraband cigarettes. In reality, many more transactions in the black markets take place by private delivery and reach across all socio-economic demographics and into various urban and rural geographies.

In contrast, grey markets include goods legally purchased and imported by individuals, which do not register in the official accounts and as the result do not contribute to the Exchequer balance and the wholesale and retail trade revenues. The best examples of these are goods purchased for personal consumption outside Ireland. Some are imported legally, within the strict limits on values and quantities stipulated by the customs laws. Others are brought in excess of the personal allowances and can be resold or bartered to relatives and friends. Whilst illegal, such transactions are largely undetectable and these laws and regulations are not easily enforceable once the border is crossed. Grey market is the domain of the middle and upper-middle classes: from the South Dublin set’s stereotypical shopping trips to London or New York, to Middle-Ireland’s excursions into the Northern Ireland for a spot of bargains hunting.

The costs of illicit and unofficial trade also reach deeper than the headline numbers suggest. At the top of the pyramid sits the Exchequer with an estimated loss of some EUR 7 billion per annum in revenues – an amount equal to almost 3 years of austerity measures.

Beyond that, shadow economy imposes losses on consumers, legitimate producers and the society at large. The former arise from the poorer quality of counterfeit goods and services supplied and the risks inherent in illegal transactions. Included are the health and safety risks linked to consumption of counterfeit medicines and consumer goods. Losses to legitimate producers of goods and services come from the fact that black market economy takes custom from the legitimate domestic retailers and producers. In many cases, ordinary customers are reluctant to frequent areas where illegal trade takes place. Further losses arise from Intellectual Property theft, and loss of demand for officially-supplied goods and services to cheaper substitutes sold under the counter. Social losses - compounding those listed above - include increased organised crime, links between illegal financial flows and international terrorism, prostitution, and human trafficking, rise in crimes associated with drugs abuse and so on.


In Ireland's case, we are witnessing a rather unique dynamic in the growth of the black markets, courtesy of the current crisis. During the Celtic Tiger period, rising incomes and employment, and declines in personal taxes partially helped to offset the impact of higher consumer prices and hikes in excise taxes on alcohol and tobacco - the two staple goods traded in the grey and black markets. With the onset of the crisis, lost earnings and jobs were compounded by higher taxes, including VAT and excise rates. This resulted in an increased demand for illegally sold goods, but also for legal goods purchased in the Northern Ireland and the rest of Europe.

The composition of the shadow economy in Ireland also changed. Prior to the bust, majority of the losses in economic activity to grey and black markets related to cash-based construction and household maintenance activities. Since 2008, the focal point of growth in the shadow economy shifted to supplying substitutes to goods where Irish regulatory and tax-induced prices have by far exceeded European norms, such as pharmaceuticals, alcohol, tobacco and premium consumption goods.

Construction and property-related services still play significant role in driving black economy, but their overall importance in the illicit trade has declined mirroring the fortunes of the legitimate construction sector.


To see how tax-induced growth in the shadow economy has become a quintessential feature of our reality, consider Irish fiscal policies in relation to alcohol and tobacco taxation. Over the last seven budgets, increases in alcohol and tobacco taxes were supposed to raise additional EUR 494 million in revenues. Instead, the measures fuelled an already sizeable trade in illicit goods. Official consumption of these goods declined, and revenue collected fell short of targets.

Based on recently published research by Grant Thornton, losses to the Exchequer from illegal sales and personal importation of tobacco products for personal use in 2012 amounted to between EUR 240 million and EUR 569 million.
Over the last 11 years, all increases in the cost of tobacco products to consumers came from the hikes in taxes. Post-Budget 2014, Ireland will have the highest retail price of tobacco in the entire EU27, while some 80 percent of every pack of tobacco legally sold in the Republic will go to the Exchequer. Based on KPMG data, almost one in every five cigarettes consumed in Ireland in 2012 were counterfeit and contraband – second highest in the Euro area. In his three budgets, Minister Noonan ‘contributed’ some 40 cents or 9 percent profit premium to the bottom line of the criminals illegally importing goods into the country.

My estimates suggest that post-Budget 2014, total economy’s losses from illicit sales of tobacco products will rise to EUR760 million per annum. In addition, estimates based on the data from the Revenue Commissioners and the World Health Organisation suggest that illicit trade in alcohol will cost us close to EUR125-130 million in lost economic activity in 2013. Budget 2014 is expected to push this out toward EUR160 million.

Research shows that increased taxation of alcohol is driving more drinking into homes and out of public view. Much of this shift in drinking patterns falls outside the data we collect from the licensed sales. With both the state policies and the recession increasing the incentives to purchase cheaper and often illegal alcohol, actual consumption of alcohol per person in Ireland might be well above the currently reported levels. In January-July 2013, Irish Revenue seized some 3.5 times more illegal alcohol than in the full year 2012.

Overall, based on the study by Grant Thornton, my own estimates, and using data from various other sources referenced above, illicit trade in fuel, tobacco, pirated software and digital economy services, pharmaceuticals and alcohol in Ireland accounted for some EUR1.5-1.6 billion in 2013. Post-Budget 2014, this figure can rise to over EUR1.7 billion.

Last, but not least, the same forces that propel growth in the shadow markets for alcohol, tobacco, fuel, pharmaceuticals and healthcare, and digital economy services will also act to draw more purchases of other goods out of the Republic and into Northern Ireland and off-shored on-line trade.

Behavioural research shows that when people take targeted trips to purchase specific large-ticket items, they tend to ‘load up’ on other purchases along the way, especially if their trip takes them to diversified retail locations. Thus, a family travelling to Northern Ireland to shop for alcohol in bulk will also be likely to stock up on other goods, such as groceries, household equipment, car parts, fuel and so on, to ‘cover’ the cost of travel. Retail substitution in alcohol purchasing away from Irish stores will lead to compounded losses due to other purchases made abroad.


In his Budget speech, Minister for Finance Michael Noonan referenced the shadow economy on three occasions, including a direct reference to the VAT fraud, illegal tobacco selling, unlicensed trading in alcohol products, and fuel laundering. In line with these concerns, the Minister unveiled a host of policy measures aimed at targeting illegal tobacco and alcohol sales and fuel laundering. So optimistic was Minister Noonan that his measures will bear fruit that he penciled in EUR20 million in added Exchequer revenues from increased enforcement measures. Yet, both the Department of Finance and the Revenue are well aware of the fact that the current state policy on excise taxation of alcohol and tobacco contributes to the growth of the illicit trade. Both know that any measures to combat this trade are not cost-effective, requiring more spending on policing than the revenues such policing helps to generate. In other words, if we want to make a dent in shadow economy, we need to re-think our excise tax policies and markets regulations.




Box-out:

Media analysis of the Budget 2014 placed significant focus on the impact of the changes to the pensions levies. Overlooked by the majority of the analysts, however, was the issue of longer-term sustainability of our pensions system. Irish pensions remain grossly underfunded in the private sector. On the other side of the economy, State’s social insurance funds are projected to hit deficit of EUR9 billion in 5 years rising to EUR 20 billion within the decade, according to the OECD latest research. Taking into the account current deficits in private and semi-state sectors, we are facing an economy-wide pensions crisis. Unfunded pensions liabilities for those who do have some retirement savings or pensions contracts will rise from the total deficit in excess of 15 percent of our GDP today to over 75 percent in 20 years time. The impact will be equivalent to the banking sector crisis experienced in 2007-2011. Beyond this, hundreds of thousands of families will be left without any pensions provisions. The only ‘solution’ to the pensions crisis proposed by anyone to-date involves compulsory pensions enrolment whereby the state mandates required minimum levels of ‘savings’ for households. While good in theory, such a solution presents a number of problems in the case of Ireland. In today’s world, who can afford setting aside some EUR500-700 per month per person into a pensions pot to assure modest retirement 20 years after?  How will such a scheme help those who are currently in their 40s and older and have total assets with negative or near-zero net worth?

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