income ceilings of social insurance contributions). As a result, most of the burden of redistribution through the state appears to fall on middle-income wage earners while higher wage earners and receivers of capital income contribute relatively little, thus violating the equity objective.

108. The tax system could be made both less distorting and more equitable by:

- a. Reducing labor taxes, notably for low-skilled workers by financing part of social benefits, such as basic pensions and, perhaps, also part of basic healthcare, by general taxation, in particular by base-broadening measures. It could also be considered to raise property taxation which is extremely low in NM-EU countries and which is among the least distorting taxes.

- b. Linking the non-redistributive part of social security benefits better with contributions, for example by transforming defined benefit pension systems in defined contribution schemes so that this part of contributions would be perceived less as taxes, which would encourage compliance.

- c. Eliminating regressivity of labor taxation by shifting the burden more towards higher income brackets, i.e. making it (mildly) progressive.

109. Tax administration could be made more effective by making it more independent from political interference and provide adequate resources, notably in auditing. Penalties for non-compliance should be sufficiently high to raise the potential costs of tax evaders. Tax education should be improved and awareness should be raised, about the benefits of formal employment and the costs of underreporting. For example in spring 2006 and again in 2007, Latvia has launched the campaign, entitled ―The employment contract works‖, which explains the labor law, the importance of the employment contract and the consequences of illegal or undeclared work (Eurofound 2009) and has recently launched new measures based on a broad approach (Box 1). In the UK it has been found that campaigns explaining the benefits of declared work were more efficient than punitative measures (Willliams, 2008).

# **Box 1 Recent measures in Latvia to combat the shadow economy**

In April 2010, the government of Latvia approved a set of measures to reduce the shadow economy. The government emphasized that a broad approach is needed including strengthening tax enforcement but also changing society‘s opinion of the shadow economy and encouraging legal business transactions. The main measures are:

- Reducing cash transactions in wholesale trade from LVL 3 000 (4240 €) to LVL 1000 (1413 €). If cash transactions exceed this amount the taxpayer must provide a declaration on transactions with the given partner in the previous month. The reasoning is that cash transactions are more prone to tax evasion and fraud than bank transactions;

- Providing access to the tax administration (State Revenue Service) to the Loans Register at the central bank.  This measure aims at identifying those persons whose expenditures exceed income;

- Public awareness campaign on how tax revenues are being used, and how paying taxes benefit taxpayers. For this purpose the Finance Ministry‘s website will also be upgraded;

- Encouraging crime reporting to the authorities;

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