and growth of the economy, as informal firms are generally less productive than formal firms because they prefer to remain small and ―invisible‖ and because informal workers tend to receive less training than formal workers. The incidence of informal activities should therefore be considered when making economic analysis and designing policies.

5. This paper examines the incentives and distortions created by tax policy and administration structures that motivate individuals to un- (or under-) declare work in the new EU member countries and Croatia (to be referred to as NM-EU even if Croatia is not yet a member). As a multi-country, regional paper, certain countries among this group will be selected as archetypes for in-depth analysis and distilling of lessons learned. While crosscountry benchmarking of taxation and tax policy indicators is critical, not all countries will be covered comprehensively or uniformly in this analysis. This paper seeks to provide answers to the following questions:

- To what extent is the level and ―mix‖ of tax instruments deployed by governments - and the relative reliance of certain instruments over others, such as taxes on earnings versus other taxes – responsible for the size of undeclared work?

- Are most of these countries making the same ―mistakes‖ with respect to tax policy and administration and the disincentives to formalize?

- What has been the experience with special taxation regimes set up to attract workers and entrepreneurs back into the formal economy? What are the failures, successes, and lessons for policymakers?

- How has the introduction of a ―flat tax‖ on income from labor and capital impacted workers and entrepreneurs in terms of formalizing work?

- Are there successful experiences (inside or outside the region) with shifting away from an ―over reliance‖ on labor taxes to a more efficient tax mix?  Has such a shift led to an increase of the formal economies?

6. The following sections first look at the extent of undeclared work in the NM-EU countries (Section 2) and how – according to opinion polls – people in these countries perceive the role of taxation in undeclared work (Section 3). This is followed by a description of the various channels through which taxes may affect undeclared work (Section 4) and by cross-country comparisons of these potential sources for undeclared work, namely the overall tax burden (Section 5), the tax mix (Section 6), labor tax wedges (Section 7), and the design of taxation within the broad tax categories, which may encourage or discourage undeclared work (Sections 8 - 11). This is followed by an attempt to gain insight into the effectiveness of tax administration by comparing some input and output measures (Section 12). As non-tax factors can amplify the adverse effects of taxes on the labor market and reduce the effectiveness of tax reform, some of these other economic framework conditions are briefly discussed (Section 13). This paper concludes by refining the main results and possible best practices for tackling undeclared work (Section 14).

7. This paper argues that NM-EU countries have had mixed success tackling undeclared work. While taxation matters, other underlying conditions for formal sector activity are also important. Addressing the problem of undeclared work therefore requires a broad policy 2