workers thus recoup the relatively low income from their regular jobs, which arises from both from their low bargaining power and their high labor tax burden, by evading taxes.

99. In order to guarantee minimum living standards, several countries, including those in Central and Eastern Europe, are setting minimum wages through legislation or social agreements. Minimum wages can affect undeclared income in various ways, depending on their level. When minimum wages are set at a relatively low level, they are not detrimental for job creation in the formal sector. If firms only declare the minimum wage and pay an additional undeclared ―envelope‖ wage, the potential for this type of undeclared work is higher the lower the minimum wage is set. This has led some countries to raise the minimum wage as a measure to reduce under-declaration of income. But this policy is risky. The reason is that firms may evade the higher minimum wage (which is set per hour) by showing in their books less hours than have actually been worked; for these firms, the minimum wage is just another level of bureaucracy that has to be dealt with (Ram et al. 2004). Other firms are forced by the higher minimum wage to increase prices in order to cover cost and if this is not possible due to intense competition they will have to reduce employment.<sup>12</sup> As a result, unemployment increases and workers will turn to the informal sector. The increase in the minimum wage also increases the pressure on workers to work as self-employed. The net effect of the higher minimum wage on tax revenue is therefore not clear, as the gain in tax revenue due to lower undeclared income of some firms must be weighed against the risks of evading the higher minimum wage and the decline in regular jobs. These considerations suggest that it is better to keep the average minimum wage relatively low, and perhaps differentiate it according to qualifications and regions, for example setting a reduced minimum wage in less developed regions (see Tonin, 2008).

100. In a cross-country regression analysis Schneider and Dreher (2006) find that stronger minimum wage regulation tends to increase the shadow economy. The European Employment Observatory (European Commission 2007) has also explored the impact of the minimum wage on the prevalence of undeclared work. Among the new EU countries, experiences differ with respect to the impact of the minimum wage on undeclared work and attitudes towards using the minimum wage for combating under-declaration of income also differs. The European Employment Observatory finds that that:

- In _Hungary_ , it is likely that the relatively high minimum wage contributes to undeclared work. Its increase has discouraged formal employment of lower-skilled workers and employment in small firms.<sup>13</sup>

- In _Poland_ , where relatively few workers are on the minimum wage, the impact on undeclared work appears to be more limited.

- In _Latvia_ , the minimum wage has been increased with the aim to reduce underdeclaration of income but it remains close to the subsistence level and is thought to still provide incentives to underdeclare income. There is a discussion among policy makers to reduce the minimum wage in order to become more competitive, but it is feared that this would  increase under-declaration of earnings.

> 12 The minimum wage sets a floor to the gross wage, so that the employer contribution cannot be shifted back onto workers and has to be borne by firms through higher wage costs.

> 13 Kertesi and Köllö (2003) found that the increase in the minimum wage in Hungary increased labor costs and reduced employment in small firms and also in poorer regions while large firms were not affected.  On the other hand, Tonin (2007) found that the 2001 increase of the minimum wage reduced tax evasion by reducing net earnings of workers between the old and the new minimum wage.

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