ALTERNATIVE STRATEGIES FOR FIRMS IN OPPRESSIVE AND CORRUPT STATES: INFORMALITY OR FORMALITY VIA BUSINESS ASSOCIATIONS?

I. INTRODUCTION Firms in oppressive environments such as those of the transition economies face a variety of problems, including the high cost of complying with regulations, frequent changes in those regulations, and hence lack of knowledge about current regulations and policies; difficulties in gaining access to telephones, electricity, and infrastructure; inefficient and corrupt judicial systems; and cumbersome and non-transparent licensing, customs procedures, and rule making. As a result, it is common for firms in transition economies to make unofficial payments to officials to obtain needed services and avoid taxes and regulations (Djankov et al., 2002; Johnson, Kaufmann, and Schleifer, 1997). While there are oppressive and corrupt regimes in many parts of the world, a survey by the European Bank for Reconstruction and Development (EBRD, 1999) showed the transition economies to have the highest scores for corruption among public officials of all country groupings. As recently as 2001, only 1 of the 25 transition countries included in this study (Slovenia) had a score for control of corruption of 5.0 or more on the widely used 0-10 scale of the Corruption Perception Index (CPI) of Transparency International. 1 Even after some improvement in corruption control or freedom from corruption in the region since then, in 2007 there were still only three transition countries with scores of 5.0 or more, and half of the rest had scores of 3.0 or below (Corruption Perception Index website). These scores are based on the perceptions of a wide variety of people. Using data from the first year (2002) of the two rounds of the survey used in this study for 25 transition countries, Campos and Giovanoni (2008) assert that some 18% of the firms in the sample say that 10% or more of their revenues are spent on unofficial payments to officials. Based on a still earlier round (1999) of the same data set, Hellman, Jones, and Kaufmann (2000) find that the percentage of firms in each transition country admitting to ever having paid bribes ranged from 45% (Belarus and Slovenia) to 90% (Kyrgyzstan). With respect to the frequency of such payments, Tanzi and Tsibouris (2000) report that as much as 59.3% of firms (for Azerbaijan) admitted to making these unofficial payments "frequently or more often." Somewhat surprisingly, even with improving economic conditions in transition economies and their success in attracting foreign direct investment (FDI), firms in transition economies with FDI are reported to be even more prone than other domestic firms to make unofficial payments (Anderson, 2005). Tax evasion is another huge and endemic problem in the transition economies. Uslaner (forthcoming) cites numerous sources stating the extent of tax evasion to be extremely high in most transition countries, ranging up to 40% of gross domestic product (GDP). He also shows that "tax morale" (as measured by questions on the World Value Surveys concerning the acceptability of tax cheating) is typically much lower for people in transition countries than for those in other countries. (See also Hanousek and Palda, 2004.) When citizens deem their governments to be corrupt, implying that funds are diverted from their intended public purposes to the private ones of bureaucrats and their friends, they see nothing wrong with not paying their taxes. This makes these two distinguishing characteristics of transition countries, high corruption and tax evasion, interrelated. If judges are corrupt, firms know that the court system will not be fair. If tax officials are corrupt, tax enforcement is likely to be sporadic and inefficient. With corruption and stiflingly rigid regulations and tax rates, a common strategy for firms is to operate outside the official economy. Indeed, Johnson, Kaufmann, and Schleifer (1997) reported the shadow economies of the countries of the former Soviet Union to average 34% of their respective GDPs and corruption to be related to tax evasion. …