with below replacement fertility rates is likely to increase the need for participation in the formal economy in the future decades. The sustainability of the welfare state, and the pension system in particular, will require activating economically inactive population and formalizing informal workers so that more workers contribute to the system by paying taxes and social security contributions.

The general literature on informality indicates several reasons why employers and workers might prefer to stay out of formal economy. These include strict regulations in the labor market (e.g. employment protection, minimum wages), complicated administrative procedures related to registering with tax authorities, high opportunity costs of entering formal employment due to high taxes or low social benefits, and weak law enforcement which allows for tax avoidance. Experience from developing countries shows that labor market regulations, however, have ambiguous effects on efficiency of labor allocation and workers’ well-being. Betcherman (2014) summarizes these findings. According to this review, the efficiency effects of these regulations are usually small if significant and are not found in many cases. The distributional effects vary by groups of workers, they are usually positive for those who have formal jobs but might be negative for those who are not covered by labor market regulations. And those who are not covered are in many cases low-skilled, young workers and women – the groups that that are more vulnerable in general.

Rigid labor market institutions could lead to higher informality, but previous studies suggest that a combination of weak enforcement and universal access to basic pension and health care are important drivers of informality in Russia **.** Contrary to the widely held belief that Russia had very rigid employment protection legislation (EPL), internationally comparable estimates showed that Russia’s labor law is not particularly restrictive (Lehmann, et al., 2013). Notably, institutional stringencies appear to have shaped the labor market adjustment model observed in Russia. That is, the Russian labor market responds to output falls during economic crises more through lower wages and hours of work, rather than less employment. This is made possible by low minimum wages, low unemployment benefits and weak enforcement of wage and employment regulations, that altogether support flexible wages and flexible working hours (Gimpelson & Kapeliushnikov, 2011). The combination of a weak regulatory environment and low unemployment benefits makes informal employment an attractive option, especially in Russia where access to basic pension and health care is not dependent upon formal employment. Gimpelson and Kapeliushnikov (2014) argue that there is, in addition, a political economy challenge: as informality grows as a consequence of regulatory failure, a vicious circle of more regulatory failure and more informality leads to a break of the social contract.

The “tax maneuver 22/22” was a policy under consideration by authorities envisaging a shift from labor to consumption taxes. It recommended a simultaneous increase in the VAT rate from 18 to 22 percent and a reduction in the main (upper) social insurance contribution (SIC) rate from 30 percent currently to 22 percent.<sup>11</sup> This proposal was not implemented at this stage. Instead, the government decided just to increase the VAT rate by 2 percentage points in 2019. However, this policy change

> percent in 2002 to 19.5 percent in 2008, then fell to 16.4 percent in 2010, to rise again to 21.2 percent in 2016. Other surveys -using different definitions and sources of data- show qualitatively similar trends. See for instance, Kim at al. (forthcoming) and Lehmann and Zaiceva (2013).

> 11 Another proposed change is the unification of the tax base for all SIC payments. We have run the scenarios including the tax maneuver and unification of the tax base; however, their results were not significantly different from the results obtained without the unification. For that reason, they were not included in the paper, but are available from the authors on request.

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