SHADES OF GRAY: BULGARIA'S UNDERGROUND ECONOMY

UNCLAS SECTION 01 OF 02 SOFIA 002089

SIPDIS

E.O. 12958: N/A
TAGS: ECON ETRD KCOR KCRM BU EUN
SUBJECT: SHADES OF GRAY: BULGARIA'S UNDERGROUND ECONOMY


1. (SBU) SUMMARY: Bulgaria's thriving underground economy
is one of the few cloudy areas in an otherwise bright
macroeconomic outlook. Most experts estimate the gray
economy is responsible for 30-40 percent of GDP. Likewise 14
to 25 percent of the labor force are employed in the gray
economy, suggesting Bulgaria's unemployment rate of 10.4
percent is actually lower. Bulgaria's underground economy
has enabled those who are not benefiting from the booming
legitimate economy to survive or even prosper. However, the
gray market's existence has starved the state of significant
revenues and acts as an impediment to economic growth.
Reforms implemented ahead of Bulgaria's EU accession should
improve the situation as more businesses are forced into the
formal sector. END SUMMARY.

MAGNITUDE OF THE GRAY ECONOMY
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2. (U) Despite Bulgaria's impressive macroeconomic
stability and a record 5.6 percent GDP growth in 2004, the
size of its shadow economy appears to be expanding. Experts
estimate the gray economy produces between 30-40 percent of
Bulgaria's GDP. While other observers believe this
percentage to be much higher - up to 50 percent - most agree
that the size of the gray economy has been increasing since
its 1990 level of 26 percent.

THE NATURE OF THE GRAY ECONOMY
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3. (U) A recent conference on the Hidden Economy and
Transborder Crime in South Eastern Europe organized by the
Center for the Study of Democracy (CSD) noted that the gray
economy in Bulgaria includes activities such as the
production of homemade foodstuffs (which are legal but not
registered) as well as domestic and imported goods that are
sold illegally, such as tobacco and alcoholic beverages.
Additionally, informal professional services including
doctors' or lawyers' services represent a key part of the
shadow economy. The bulk of Bulgaria's gray economy
activities, however, involve avoidance of import duties,
such as the sale of Chinese manufactured consumer goods
smuggled into the country. This trade in consumer goods is
actually far more lucrative than the black market in, e.g.,
drugs. Another, highlighted to us recently by Deputy
Finance Minister Kadiev, is the abuse of duty-free shops on
Bulgaria's borders, which has served as a mechanism for
avoiding customs duties and excise taxes on fuel, cigarettes
and alcohol. Kadiev told us the Finance Minister foregoes
some 400 million euros a year as a result of these duty-free
shops, and lamented the fact that powerful political and
economic interests have so far blocked efforts to close
them.


4. (U) According to a study commissioned by CSD, companies
considered to be part of the gray economy include those that
evade taxes and fail to comply with business regulations.
Tax evasion includes employment without contracts,
underreporting of income for social security (pension and
health insurance),and turnover suppression (not issuing
receipts for VAT payment and income tax reporting). Larger
companies tend to be more transparent in this regard, as
they are better able to absorb the costs of paying taxes and
complying with regulations. Gray sector business practices,
particularly salary discrepancies, are most evident in Sofia
and other large cities where firms can hide the practices
more easily. Outright VAT fraud - as opposed to avoidance of
payment -- is also a huge business, accounting for some USD
375-750 million a year in lost revenues, according to the
government.


5. (U) Though Bulgarian tax rates are low compared to many
countries in the region, they are a heavy burden for a
workforce whose average wage is only 164 Euros per month.
VAT and social security payments are also frequently
avoided, according to the Institute for Market Economics
(IME),particularly in the construction, agriculture,
tourism, and wholesale and retail trade sectors. These
companies maintain two sets of books: one containing
financial transactions up to the minimum income required for
VAT registration (25,566 Euro),and a hidden one for income
over the minimum.


6. (U) Other businesses go "gray" due to noncompliance with
licensing and registration requirements. Registering a new
business in Bulgaria can require at least ten administrative
procedures. Many businesses comply with some regulations
but not all, such as a tour company obtaining, but not
renewing, an operating license. This is most apparent in
tourism and subsistence-level businesses, such as family-
owned grocery shops. According to the IME, weak enforcement
of existing business regulations is also a problem,
particularly in the labor market. In 2003 the GOB passed
legislation requiring the registration of labor contracts.
The level of unregistered work activity initially decreased,
but the CSD found the level increased again after one year,
suggesting the need for stronger enforcement of the new
regulations.

CONSEQUENCES OF THE GRAY ECONOMY IN BULGARIA
--------------


7. (U) The gray sector reduces the overall efficiency of
Bulgaria's economy and its ability to boost exports.
Reduced revenue due to tax evasion results in fewer
resources devoted to developing Bulgaria's infrastructure
and public services. Informal businesses have limited
access to capital, thereby restricting their potential to
invest in new technologies and to compete effectively on
external markets. Experts claim that for a small and open
economy like Bulgaria, which should pursue an export-
oriented policy, the existence of such a high level of gray-
market activity is one of the key impediments to growth.


8. (U) An additional result of the gray economy is the
underreporting of the number of employed people. About 14
to 25 percent of working-age people in Bulgaria are
estimated to participate in the gray economy, which suggests
that the unemployment rate--10.4 percent in October--is
actually lower than reported. Given the widespread practice
of salary discrepancies in labor contracts, incomes in
Bulgaria are likely higher than what is officially reported,
as the minimum wage is supplemented by amounts agreed to in
"secret clauses."

COMMENT
--------------


9. (U) Foreign investment has begun entering sectors once
dominated by the gray economy. This has already occurred in
the retail sector following the establishment of major
European chains. Yet Bulgaria's sizeable gray economy
remains a significant barrier for international businesses,
particularly small and medium enterprises, due to unfair
competitive advantages held by local informal businesses.
Larger investors are most likely to overcome this obstacle,
using their substantial resources to cut through
administrative barriers and negotiate favorable terms of
trade. But as more multi-national firms enter Bulgaria,
pressure will build to eliminate the gray economy's
competitive advantage. Many working in the gray economy may
be unable to make the transition and could bring new
unemployment problems.

LEVINE