The Covid-19 pandemic created one of the most substantial negative exogenous shocks in decades, forcing firms to rapidly adapt. This brief examines an adjustment mechanism that played a significant role in Latvia, and potentially in other countries in Eastern and Central Europe. Specifically, we focus on the role of envelope wages as a buffer for absorbing the shock. Our analysis demonstrates that this form of tax evasion indeed acted as a cushion during the Covid-19 pandemic. Our results indicate that, in the short run, tax-evading firms experienced smaller employment losses in response to the Covid-19 shock compared to compliant firms.
The Covid-19 pandemic generated one of the largest negative, exogenous shocks in decades. To absorb this shock, firms had to swiftly adapt. Prior literature has demonstrated that firms responded by reducing employment and investment (Lastauskas, 2022; Fernández-Cerezo et al., 2023; Buchheim et al., 2020). In this brief, we discuss another margin of adjustment – potentially important for many countries in the region. We focus on the role of envelope wages as a buffer for negative shock absorption.
Envelope wages is a widespread form tax evasion, in which, for employees that are formally registered, a portion of their salary (often at the minimum wage level) is reported to tax authorities, while the remaining ‘envelope’ portion is paid unofficially. The prevalence of this phenomenon has been extensively documented in Eastern and Central Europe (see Kukk and Staehr (2014) and Paulus (2015) for Estonia, Gorodnichenko et al. (2009) for Russia, Putniņš and Sauka (2015) for the Baltic States, Tonin (2011) and Bíró et al. (2022) for Hungary).
In addition to the evident objective of reducing tax obligations, a primary incentive for firms to employ this evasion scheme is the extra flexibility it provides. The unreported portion of wages operates outside of the legal framework, offering firms a means of adaptation in the face of production restrictions, supply chain disruptions, and overall substantial uncertainty caused by the Covid-19 pandemic. In this brief, we argue that firms utilizing envelope wages reduced their employment less than compliant firms during the pandemic in Latvia.
Identifying Firms That Pay Envelope Wages
We identify firms that paid (at least partly) their employees in cash before the pandemic using a rich combination of Latvian administrative and survey data and the methodology proposed by Gavoille and Zasova (2021).
The idea is as follows: We use a subsample of firms for which we can assume that we know whether they pay envelope wages and, using this subsample, train an algorithm that is capable of distinguishing compliant and evading firms based on their observed characteristics and reported financials.
Following Gavoille and Zasova (2021), we use firms owned by Nordic investors as a subsample of tax-compliant firms. To obtain a subsample of non-compliant firms, we combine data on administrative (i.e., reported) wages with several rounds of Labor Force Survey data in order to spot employees who are paid suspiciously little given their personal characteristics (education, experience, etc). Firms employing these employees form the subsample of evading firms. Using these samples of compliant and evading firms, we train a Random Forest algorithm to classify firms according to their type. We then use the algorithm to classify the universe of firms used in this study. Table 1 shows the classification results.
Table 1. Classification results: share of tax-evading firms and employees.
We find that almost 40 percent of firms (employing about 20 percent of employees) underreport at least some of their workers’ wages. The cross-sectoral heterogeneity is consistent with survey evidence: the construction and transport sectors are the sectors with the highest prevalence of envelope payments. Comparing the share of tax-evading firms with the share of workers working within these firms also indicates that on average, tax-evading firms are smaller than tax-compliant ones. This is yet again in accordance with survey evidence.
Employment Response During Covid-19
Figure 1. Average firm-level change in employment during the Covid-19 pandemic.
The Covid-19 crisis had a severe impact on Latvia. The government declared a state of emergency as early as March 13, 2020, which entailed significant restrictions on gatherings and on-site work, leading to a six-fold increase in the proportion of remote workers within a matter of months.
During the second wave, in Autumn 2021, Latvia had the highest ranking in the world in terms of new daily positive cases per capita. A substantial number of firms were directly affected by the pandemic (see Figure 1).
We study firm-level employment response at a monthly frequency in compliant and tax-evading firms, from January 2020 to December 2021. Our empirical approach is in the spirit of Machin et al. (2003) and Harasztosi and Lindner (2019), who study the effect of minimum wage shocks. In essence, this approach consists of a series of cross-section regressions, where the dependent variable is the percentage change in employment in a firm between a reference period (set to January 2020) and any subsequent month until December 2021. Our key interest is the difference in cumulative employment response between tax-compliant and evading firms, controlling for a set of (pre-pandemic) firm characteristics, such as the firm’s age, average profitability, average export share, and average labor share over the 2017-2019 period.
The Aggregate Effect
Figure 2 shows the estimated coefficients that measure the difference between employment effects in compliant and tax-evading firms, aggregate for all sectors. Period 0 denotes our reference period, i.e., January 2020, while the estimated coefficients in other periods show the cumulated difference between tax compliant and tax-evading firms in the respective period relative to January 2020 (e.g., the estimated coefficient in period 10 shows the cumulated differential employment response in October 2020 vis-à-vis January 2020).
We document a noticeable difference in the employment response between the two types of firms starting in April 2020. The positive coefficient associated with evading firms indicates that the change in employment growth was not as negative in evading firms as in compliant firms (see Figure 2). Labor tax-evading firms exhibit, on average, a less sensitive employment response than tax-compliant firms. In March 2021, the point estimates are about 0.025, implying that compared to March 2020, tax-evading firms contracted, on average, 2.5 percentage points less than compliant ones. This difference however fades over time and turns insignificant (at the 95 percent level) about halfway through 2021.
Figure 2. Evasion and total employment.
Differences by Sector
Figure 3 displays the estimated difference in employment response, disaggregating the sample by sector. We show the results for two sectors: trade and transportation. These two sectors exhibited the most significant differences in employment response between evading and non-evading firms.
For trade, evading firms have been able to maintain employment losses at approximately 5 percentage points less than compliant firms (see Figure 3(a)). This is consistent with the envelope wage margin mechanism. Contrary to the aggregate results, the difference in employment response does not fade over time. This suggests that this margin is not a shock absorber only in the very short run.
The decrease of the evader effect at the aggregate level is caused by negative point estimates of the evasion indicator in the transportation sector, starting in the first quarter of 2021 (see Figure 3(b)). In this sector, evading firms have on average experienced a larger employment decline in 2021 than compliant firms.
Figure 3. Employment effect – by sector.
The outcome in the transportation sector is likely influenced by the taxi market. There were two major changes in 2021 that particularly affected taxi drivers receiving a portion of their remuneration through envelopes. Firstly, amendments to State Revenues Service’s (SRS) regulations made it more difficult to underreport the number of taxi trips, as each ride was now automatically recorded in the SRS system through taxi apps. Secondly, commencing in July, legal amendments mandated a minimum social security tax, which had to be paid based on at least the minimum wage. Given that many taxi drivers work part-time, and that those associated with evading firms tend to underreport their rides, this new requirement was more binding for evading firms. Additionally, there was a significant shift of taxi drivers to the food delivery sector, where demand for driver services surged during the pandemic.
Our results indicate that employment losses in response to the Covid-19 shock were smaller in tax-evading firms than in compliant firms in the short run. We also demonstrate that by the end of 2021, the discrepancy between the two types of firms had disappeared. This can be explained by significant heterogeneity in employment responses across sectors.
These findings contribute to our understanding of the pandemic’s impact on the size of the informal sector. Despite tax-evading firms generally having more restricted access to finance, the added flexibility provided by unreported wages may have increased their resilience to the negative shock.
This brief is based on a forthcoming working paper COVID-19 Crisis, Employment, and the Envelope Wage Margin. The authors gratefully acknowledge funding from EEA and Norway, grant project “Micro-level responses to socio-economic challenges in face of global uncertainties” (Grant No. S-BMT-21-8 (LT08-2-LMT-K-01-073)).
- Bíró, A., Prinz, D. and Sándor, L. (2022). The minimum wage, informal pay, and tax enforcement. Journal of Public Economics, 215, 104728.
- Buchheim, L., Dovern, J., Krolage, C. and Link, S. (2020). Firm-level Expectations and Behavior in Response to the COVID-19 Crisis. CESifo Working Paper No. 8304
- Fernández-Cerezo, A., González, B., Izquierdo Peinado, M. and Moral-Benito, E. (2023). Firm-level heterogeneity in the impact of the COVID-19 pandemic. Applied Economics 55(42), 4946-4974.
- Gavoille, N. and Zasova, A. (2021). What we pay in the shadows: Labor tax evasion, minimum wage hike and employment. SSE Riga/BICEPS Research paper No.6.
- Gorodnichenko, Y., Martinez-Vazquez, J. and Sabirianova Peter, K. (2009). Myth and reality of flat tax reform: Micro estimates of tax evasion response and welfare effects in Russia. Journal of Political Economy 117 (3), 504-554.
- Harasztosi, P. and Lindner, A. (2019). Who pays for the minimum wage? American Economic Review, 109, 2693–2727.
- Kukk, M. and Staehr, K. (2014). Income underreporting by households with business income: evidence from Estonia. Post-Communist Economies, 26(2), 257-276.
- Lastauskas, P. (2022). Lockdown, employment adjustment, and financial frictions. Small Business Economics 58(2), 919-942.
- Machin, S., Manning, A. and Rahman, L. (2003). Where the minimum wage bites hard: Introduction of minimum wages to a low wage sector. Journal of the European Economic Association, 1, 154–180.
- Paulus, A. (2015). Tax Evasion and Measurement Error: an Econometric Analysis of Survey Data Linked with Tax Records. ISER Working Paper Series 2015-10.
- Putniņš, T. and Sauka, A. (2015). Measuring the shadow economy using company managers. Journal of Comparative Economics, 43(2), 471-490.
- Tonin, M. (2011). Minimum wage and tax evasion: Theory and evidence. Journal of Public Economics, 95(11-12), 1635-1651.
Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.
In the past three years, the Belarusian private sector appears to have been caught between a hammer and an anvil, experiencing domestic repressions and de-liberalization as well as collateral damage from sanctions and a deterioration of the country’s image. This policy brief discusses the challenges that Belarusian businesses have been facing since the onset of the Covid-19 pandemic and argues that the private sector may be the last hope for sovereignty and transformation of the country.
The years that have passed since the onset of the Covid-19 pandemic and the subsequent economic shocks have significantly altered the entrepreneurial landscape in Belarus. This period has seen the emergence of private businesses’ social and political activation during the pandemic, as well as during the 2020 election campaign and post-election protests (Bornukova & Friedrich, 2021). Businesses have also had to adapt to reactionary government policies, cope with sanctions against Belarus and deal with issues related to the Russian invasion of Ukraine. In the face of these challenges, the reactions and responses from small and medium-sized businesses signals that the private sector still has the potential to remain a driving force for socio-economic development in Belarus – despite the current political forces in power.
Private Sector Development; Liberalization and Regulation
The liberalization of the business environment, which lasted more than a decade and ended in 2020, allowed the private sector (enterprises without any state ownership share) to become the most dynamic part of the economy (see Figure 1).
From 2012 through 2020, the share of the private sector in employment increased by 7.7 percentage points. Similarly, the contribution from the private sector to the export of goods and services, as well as to GDP, exceeded the contribution from state-owned commercial enterprises. Moreover, even in the absence of significant privatization and restructuring of state-owned enterprises, the private sector took over the “social” function as an “employer of last resort”, absorbing workers released from the public sector (including from fully and partly state-owned enterprises) (IPM Research Center, 2020).
In addition, the development of the private sector increased the diversification of Belarus’ foreign trade. Private companies in the IT sector, advanced instrument manufacturing, electronics, and other high-value-added industries shifted their focus to developed countries’ markets, which reduced the dependency on Russian resources and markets. This increased Belarus’ economic sovereignty and its resilience to political tensions and other external shocks. The year 2020 however marked the end of the liberalization of entrepreneurial activities, as private businesses and private capital started to be seen as a threat to the political system (Bornukova & Friedrich, 2021).
Figure 1. Contributions from the Belarusian private sector to main economic indicators.
Although there are no uncontestable figures describing business’ attitudes and activities during the political crisis in 2020, several non-academic projects documented that 58 percent of people protesting the fraud elections in 2020 worked within the private business sector (Devby.io, 2020). Dozens of businesses also openly supported the anti-regime strikes (The Village Belarus, 2020). As a consequence, legislation and law enforcement have since been steadily tightened, the tax burden has increased, and the possibility for using simplified taxation and accounting systems by small-scale businesses, in particular for sole proprietors, have been substantially reduced.
Against this backdrop, the government has also suppressed the publication of detailed statistical data including those on entrepreneurial activity. Since 2020, the Belarusian Research and Outreach Center (BEROC)’s quarterly enterprise surveys have become the main source of information and analysis on the business development situation.
In general, BEROC’s surveys demonstrate that, despite a reduced safety cushion and the lack of substantial state support during the pandemic, Belarusian businesses had, by the end of 2021, adapted to the shocks from the post-election crisis and harsh de-liberalization, by realizing their ability to cope, and finding creative solutions in the turbulent environment (Marozau, Akulava and Panasevich, 2021). Before Russia’s aggression against Ukraine, Belarusian entrepreneurs’ optimism about overcoming external barriers – i.e., factors that are out of a firm’s control such as macroeconomic instability, etc. – was the highest since 2015. However, increased uncertainty forced Belarusian businesses to focus primarily on maintaining the achieved scale of activity, halting investments (Kastrychnicki Economic Forum (KEF) & BEROC, 2022).
Optimism In Challenging Times
In general, the institutional environment for doing business in Belarus has deteriorated in recent years, both due to actions such as changes in tax legislation, price regulation and pressure on disloyal businesses, and due to negligence from the state, such as lack of significant support measures for private business, an outflow of businesses due to sanctions and an increasingly negative image of the country (KEF & BEROC, 2022). The Business Confidence Index (BCI, ranging from 0 – “extremely negative” to 100 – “extremely positive”), developed by BEROC and the Kastrychnicki Economic Forum based on OECD methodology, documented that at the end of 2020, the confidence level of business representatives regarding future developments was in the negative zone – arguably due to the political unrest and the Covid-19 pandemic. As firms accepted a new normality and adjusted their businesses, the BCI steadily grew before comfortably settling in the neutral zone at the end of 2021 (see Figure 2).
In March-April 2022, however, macroeconomic instability, disruption of supply chains, and shortages of raw materials and/or components following the Russian war on Ukraine became serious external barriers for Belarusian businesses. This lowered the BCI and businesses’ perception of their economic situation.
Quite surprisingly, the risks of doing business in Belarus in the second half of 2022, until early 2023, were estimated to be lower than in 2021 (see Figure 3). This may be explained by the fact that (for companies remaining in Belarus) many of the potential risks (inflation, exchange rate instability, sanctions, counter-sanctions, disruption of supply chains, tightening of price regulation, etc.) had already realized (BEROC, 2023).
Figure 2. Business Confidence Index and GDP growth rate, October 2020-March 2023.
Figure 3. Risk perception by Belarusian Businesses.
The New Reality
The reaction from most Belarusian businesses to both pandemic- and war-related challenges has manifested in their search for new business models, an introduction of new products/services, and the entry into new export markets. Despite a bundle of powerful shocks to the economy stemming from the Russian war on Ukraine and related sanctions, some factors have dampened the anticipated drop in the economy: in particular, the increase in Russian support, export re-orientation to Russia and developing markets, alongside monetary stimuli, and interference with the activity of state-owned enterprises as well as artificial price controls (Kruk & Lvovskiy, 2022). As a result, the standard of living has remained at pre-war levels: in January-April 2023, real household disposable income and real salary grew by 1.6 percent and 3.8 percent respectively. With sanctions on Belarus being comparatively softer than those on Russian businesses, Belarusian businesses may have gained a comparative advantage and additional opportunities in both the domestic and Russian markets (BEROC, 2022). This caused optimism among entrepreneurs and in March 2023 – for the first time in the considered period – the composite BCI turned out to substantially exceed the neutral zone (see Figure 2). These positive spillovers are however likely to be bound in time – they will end both if the state of the Russian economy worsens (as this would reduce Russian support and decrease export revenues for Belarusian firms), and in the unlikely scenario that Russia’s current isolation is reduced. Whether Belarusian businesses will withstand the current protracted crisis depends on the ability of state authorities (current or new) to restore a constructive dialogue with the business community, return to the rule of law and create a business environment conducive to entrepreneurship.
According to business, the key factor needed to expand business activity is a reduction of external barriers (such as disruptions to supply chains, shortages of raw materials and/or components), rather than government support (e.g., financial, informational, etc.) (KEF & BEROC, 2022). Thus, “We do not need state support, but need the state not to worsen legal conditions for doing business” has become a motto of Belarusian entrepreneurs. Even in the context of war and political instability in the region, it allows looking at the prospects of the private sector in Belarus with some positive expectations.
At the same time, factors such as political repressions, sanctions against Belarus, problems with logistics, and the refusal of business partners to work with Belarusian companies due to the Russian aggression towards Ukraine have forced many Belarusian businesses, especially in high-tech sectors, to relocate. While the scale and direction of Belarusian business emigration is still difficult to assess (Krasko & Daneyko, 2022), these processes devastate entrepreneurship capital in Belarus and jeopardize the prospect of entire sectors such as the IT sector. In addition, the popular opinion about the lack of business opportunities implies that, unless conditions improve in terms of state policy and public confidence in the future, the socio-economic effects (employment, value added, tax revenue, innovations) from entrepreneurial activity in Belarus will diminish (GEM-Belarus 2021/2022). With operations severely affected by external barriers and restrictive legislation, halted investments and limited, if any, commercial contacts with Western countries and individual businesses, Belarusian private enterprises can hardly be seen as a source of stability for the current regime.
To promote an increased role of the private sector in the Belarusian economy, and to ensure high-quality and sustainable growth of the same, two prerequisites are critically necessary.
Firstly, a resolution of the political crisis and a restoration of authorities’ and state institutions’ legitimacy will significantly increase the populations’ confidence in state policy on business and economics. The principle of rule of law must be recognized and public and private actors must be treated equally in all spheres. It is also necessary to ensure the stability of tax legislation and economic law and the mitigation of excessive state control of business activities. All the above would lower external barriers and create stimuli for long-term business investments that, in turn, would facilitate economic transformation.
Although the sanctions’ packages imposed on Belarus by most developed countries due to domestic repressions, and complicity in the aggression against Ukraine, were directed towards the public sector, the private business suffered substantial macroeconomic and reputational consequences in their wake. The refusal of many foreign partners (suppliers, customers, banks, transport companies etc.) to work with Belarusian businesses – regardless of their affiliation with the state and attitude towards Lukashenko’s regime as well as towards the war on Ukraine – also substantially undermine businesses’ potential and Western soft power in Belarus. Such refusal is often driven by the argument that, by paying taxes, private businesses in Belarus support the current regime, when they should instead undermine the regime by halting operations (and thus tax revenues). At the same time, with the complete liquidation of civil society organizations and the termination of international projects and initiatives, the Belarusian private business may serve as the last resort in the hope of achieving independent, decentralized, and autonomous decision-making – all cornerstones of modern democracy (Audretsch & Moog, 2022).
From this perspective, the preservation of the private sector in Belarus may be of decisive importance in the future political processes, necessary to take into account by policymakers and business elites alike in developed countries.
In addition, relocated Belarusian businesses can play an important role in transforming the country by developing social ties between entrepreneurs and civil society, by providing support when solving problems related to doing business outside of Belarus and by investing in the Belarusian economy in the future. In this regard, establishing non-partisan Belarusian business associations abroad creates preconditions for consolidation of the most active part of the Belarusian community and its involvement in the envisaged economic transformation of the country.
- Audretsch, D. B., & Moog, P. (2022). Democracy and Entrepreneurship. Entrepreneurship Theory and Practice, 46(2), 368–392.
- BEROC. (2022). “Will Entrepreneurs Be Able to Reactivate the Belarusian Economy?”. FREE Policy Brief.
- BEROC. (2023). Bulletin “Small- and Medium-sized Business”. March 2023 (in Russian).
- Bornukova, K. & Friedrich, D. (2021). “Private Sector in Belarus and Political Crisis”. Policy Brief | December 2021
- Chubrik, А. (2021). “Back to the Future or a Short Historical note on the Belarusian Private Sector”. Discussion paper #2021/03 (in Russian).
- GEM-Belarus 2021/2022. (2022). “Global Entrepreneurship Monitor. Belarus Country Report”.
- IPM Research Center. (2020). “Graph of the Month, Table of the Week: Employer of Last Resort”. #6-7, June 2020 (in Russian).
- Kastrychnicki Economic Forum & BEROC. (2022). “Small and Medium-sized Business of Belarus: Situation and Plans on the Eve of Shocks” (in Russian).
- Krasko, N. & Daneyko P. (2022). “Belarusian Business Abroad: Needs, Problems and Potential of Interaction within National Business Communities”. BEROC Working Paper Series, WP no. 80 (in Russian).
- Kruk, D. & Lvovskiy L. (2022). “Belarus Under War Sanctions”. FREE Policy Brief.
- Marozau R., Akulava M., & Panasevich V. (2021). “Did the Government Help Belarusian SMEs to Survive in 2020?”. FREE Policy Brief.
- National Statistical Committee of the Republic of Belarus. https://president.gov.by/en/statebodies/national-statistical-committee
- Devby.io (2020). “10,000 Days of Arrest. Portrait of a Protester from 23.34” (in Russian).
- The Village Belarus. (2020). “Which Companies Supported the Strike and Are not Working” (in Russian).
Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.
Numerous developed countries have imposed tough sanctions on Belarus, as the Belarusian regime has become part of the Russian aggression against Ukraine. At the same time, economic relations with Ukraine have been disrupted. These shocks have simultaneously disturbed the Belarusian economy and triggered a severe recession. Thanks to several positive effects from the external environment, some success from measures undertaken by the authorities to stabilize output, and some degree of resilience – all seasoned with a large portion of good luck – the situation of the Belarusian economy is however “not that bad”. Nonetheless, the Belarusian economy is experiencing its worst economic crisis since the mid-1990s, and the current path of the economy is highly unstable and associated with numerous risks and threats. In economic terms, it is likely the case that the full costs from the sanctions are yet to be paid.
Sanctions, Multiple Shocks and Their Potential Implications
As the Belarusian regime has become part of the Russian war on Ukraine many developed countries have adopted tough sanctions against Belarus. These sanctions include an embargo on a large share of Belarusian exports and imports, prohibitions and restrictions on transportation of goods of Belarusian origin, restrictions on and/or blocking actions regarding financial operations and settlements, a freeze of parts of the Belarusian international reserves, and numerous restricting and blocking actions against banks, companies and individuals. Such sanctions, combined with a new external environment, cause powerful indirect effects with foreign companies exiting the Belarusian market and refusing business with Belarusian counterparts. Additionally, some Belarusian businesses and employees have left the country. On top of this, economic relations with Ukraine, formerly Belarus’s second largest trading partner, have been virtually reduced to zero.
In economic terms, the above mentioned may be treated as a bundle of simultaneous powerful shocks to the national economy, differing in direction, mechanics, size, and persistence. These shocks may be grouped into three clusters.
The first cluster covers demand shocks, and in particular export shocks. According to our assessments, the exogenous demand shock following the sanctions may reduce Belarusian exports (in physical terms) by 40 percent, compared to previous steady-state levels. This figure should however be seen as a potential lower bound which may be realized if no measures to mitigate the impact from the sanctions are undertaken. Belarusian authorities and businesses are however doing their best trying to find new buyers for the “vanishing” exports, bypass restrictions in order to connect to “old” buyers, and establish new logistic and financial chains. The extent to which these attempts may be successful depends on the global environment, the degree of the price competitiveness of Belarusian producers, and numerous non-economic factors. Additionally, all factors affecting exports are unstable and volatile. Exports under these new conditions are therefore less sustainable and may fluctuate in an extremely wide range. Shocks to consumption and investments stemming from weakened sentiment and expectations further amplify the demand shocks.
The second cluster of shocks relates to the supply side of the economy. It includes business closures, emigration that weakens labor supply, and production bottlenecks due to the inaccessibility of imports. Supply shocks are hard to quantify, but we perceive them as persistent and cumulative. Business closures and emigration have irrevocable effects on the national economy (at least in the medium-term), and a continuation of such drop-outs will likely amplify the size of the shock.
The third cluster combines different primarily nominal shocks: price, exchange rate, financial stability and fiscal ones. Such shocks have become permanent companions to the Belarusian economy under the sanctions, and they are volatile in terms of size. As a result, the corresponding economic indicators are likely to also become highly unstable.
This bundle of adverse shocks shifts the economy down from the previous, close to steady-state, trajectory. A new trajectory is however far from predetermined. Firstly, it depends on the effectiveness of the government in curbing the shocks stemming from the sanctions, as the actual path of the economy may be considerably affected by monetary or fiscal policy and other interventions. Secondly, some positive exogenous shocks may partially offset the effects from adverse ones. Lastly, the economy, at least for a while, may resist through exploitation of accumulated buffers (such as, international reserve assets, financial reserves of State-owned enterprises that were accumulated under favorable conditions in 2021 etc.).
Considering the worst possible assumptions regarding the above mentioned issues, our model-based simulations predict a severe recession of about 20 percent (as compared to the output peak in 2021-Q2). This recession is accompanied by a sharp increase in inflation (which in turn is highly likely to be supplemented by a full-fledged financial crisis). This simulation should however be regarded as the potential rock bottom. Whether it will become reality or not critically depends on the Belarusian government’s policies.
Policy Response by the Authorities
The root cause of the problem, namely the provision of Belarusian territory for the Russian army, has never been publicly discussed by Belarusian officials. Instead, the government has focused on strategies which treat the symptoms, rather than focusing on curing the disease itself. The main coping strategies that were publicly discussed include: 1) expected increase in Russian support and exports to Russia 2) re-orientation of exports towards Asian and developing markets 3) greater mobilization of domestic resources and 4) monetary, fiscal and other stimuli.
The Russia-related initiatives are often beyond convention and include some radical proposals. These are, for instance, accelerating the establishment of sea terminals in Russian ports, promoting exports to Russia, and requesting greater financial support from Russia linked to the so-called “deep integration” package (mainly in the form of energy subsidies, import substitution investments and direct subsidies). Adherence to these proposals would mean that Belarusian authorities de facto accept serving as a Russian protectorate and correspondingly take on the role of a puppet government.
Belarusian authorities have reached some success from choosing the “Russian track” as the debt payments to Russia were postponed, new cheap gas and oil prices were granted and export to Russia increased by 15 percent in the first 8 months of 2022. The Belarusian regime’s $7 billion compensation claim for incurred economic losses due to the war has however been rejected by Russia so far.
The coping strategy of export re-orientation serves primarily as a rhetoric intervention as China and other Asian countries considered by the government cannot fully replace the European market. For many Belarusian exports, the EU was a premium, high-margin market while re-orientation means at best lower margins. The success of re-orientation depends on the degree of price competitiveness, which can change greatly over time. The only success from this strategy to date is the re-orientation of 10 percent of potash exports to China via railroad (incurring greater transportation costs).
The third strategy “greater mobilization of domestic resources” firstly assumes more interference with the business activity of State-owned enterprises (SOE). Despite severe demand shocks these are pressured by the government to maintain production and/or salaries, the latter in order to support output via sustained consumer demand. Further, a “discipline” component of the strategy is implemented through renewed catch-pay-and-release practices. In effect, businessmen are arrested based on anti-corruption or tax fraud criminal charges. They are then offered to pay certain amounts to the state and released if they choose to pay.
Since late spring, when direct financial shocks have been suppressed, the authorities have intensified stimulus measures to the economy. In the fiscal sphere, these are aimed at promoting exports and mainly provided on an individual or sectoral basis. To a large extent, these stimuli may be seen as partial compensation to SOEs for their output-supporting role. In the monetary sphere a specific environment in which the Russian ruble is appreciated vs. the US dollar, despite the worldwide strength of the latter, has allowed the authorities to implement a “magic” (but highly likely temporary) solution: The Belarusian national currency is manipulated to depreciate vs. the Russian ruble (both in nominal and real terms) but appreciate vs. the US dollar. The former leads to a great increase in price competitiveness (as Russia is today the dominant trading partner), while the latter serves as a buffer for fragile prices and provides financial stability. Moreover, the authorities have excessively softened monetary policy, trying to spur domestic credit. These measures lead to heightened inflation pressure, which is however somehow suppressed by reinvigorated direct price controls.
Current Situation and Future Implications
Until now, the Belarusian economy places far from the potential rock bottom. By the end of the second quarter in 2022, output losses (vs. the output peak in 2021-Q2) amounted to about 5.5 percent. By the end of 2022, they are however expected to increase to about 8.5 percent (vs. the 2021-Q2 output peak). The Belarusian economy is stuck in a heightened inflation environment – with the inflation being as high as 20 percent in annual terms. Although the inflation is considerably higher than in “normal times”, it is still not a disaster (considering the much higher projected level under the worst-case scenario and the background of 40-year peak in global inflation). Moreover, the current situation is still far from a full-fledged financial crisis, despite some financial turbulence.
The position of the economy as “not that bad”, is a result of existing buffers, positive effects from the external environment and some immediate efficiency from actions undertaken by the authorities to stabilize output – all seasoned with a large portion of good luck. For instance, the jump in price competitiveness accounts for a large share of curbing efforts that counter the sanctions. This is, in turn, due to a combination of high global prices, low and frozen energy prices for Belarus, and a very specific and unstable stance on monetary policy underpinned by direct price controls. Some buffer savings that Belarusian SOEs succeeded to accumulate during the period of the so-called “foreign trade miracle” in late 2020 and 2021 also play an important role. Last but not least, the Belarusian authorities seem to have succeeded in the partial curbing of the export shock. Since the beginning of summer, there are some signs of recovery in exports which most likely reflects a partial recovery of exports within the most sensitive domains: oil products and potash fertilizers (corresponding statistics have been blocked out).
However, the “not that bad” position of the economy does not mean good. According to all standard metrics, Belarus is currently experiencing a severe economic crisis. The notion that it could be even more severe is bad news, not good ones. Moreover, the current situation is extremely unstable and fragile. The economy is facing numerous distortions, contradictions and risks, all of which can still shift the scenario of the crisis from the “not that bad” situation to the worst possible.
The Belarusian regime’s involvement in the Russian aggression against Ukraine have propelled Belarus into the most severe economic crisis since the mid-1990s. Until recently, fortunate external economic circumstances, a specific policy mix and a good portion of luck have allowed for a partial mitigation of the crisis. The situation is however extremely unstable and the full effects from the sanctions are likely yet to be realized.
Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.
We examine the relationship between the experience of unemployment in the early years of the socio-economic transition in Poland and a number of wellbeing measures about two decades later. The analysis takes advantage of the rich content of data from the Survey of Health, Ageing and Retirement in Europe (SHARE) by matching retrospective information on labour market experiences with outcomes observed in the survey after year 2006. While there is a strong correlation between unemployment and general wellbeing measures such as life satisfaction, depression and subjective assessment of material conditions, the relationship cannot be interpreted as causal. On the other hand, we find that unemployment in the early years of the transition has strong, negative, long-term consequences for income and house ownership. The analysis sheds light on the implications of unemployment and on the nature of job losses in the follow-up of the Polish ‘shock-therapy’.
Next year, the countries of Central and Eastern Europe will celebrate the 30th anniversary of the political breakthrough and the beginning of a major socio-economic transformation which followed. In the Polish case, the ‘shock therapy’ approach to the reform process implemented by the Mazowiecki government, though not without faults, has generally been viewed as the origin of the country’s economic success story. Afterwards, Poland experienced nearly three decades of uninterrupted economic growth and the Polish GDP returned to its pre-reform level already in 1995.
However, discussions of negative implications of the reform package still fuel the academic discourse as well as the political debate. While the majority of the population managed to avoid significant economic difficulties, many families experienced the painful hardship of the transition period in the form of job losses, poverty and exclusion. Given the scale of the socio-economic change, surprisingly little is known about the long-term consequences of individual experiences at that time. In particular, it is unclear if the negative outcomes observed many years after the reforms started can be causally linked to individual experiences in the early 1990s.
This lack of evidence is not unique for Poland and is largely due to unavailability of good individual-level data spanning the time before and after the collapse of communism. Since the transition cannot be lived through again, we shall never know how socio-economic conditions would have looked like under numerous alternative reform scenarios. However, as we show in a recent paper (Myck & Oczkowska, 2018), much can be learnt from the combination of contemporary and retrospective information on the nature of labour market histories during the transition and their relationship to outcomes recorded many years later.
The analysis presented in Myck and Oczkowska (2018) relies on the treatment of the systemic changes in the early 1990s as a major exogenous shock and on differentiating between reasons behind individual experiences of unemployment. We demonstrate that the observed strong correlation between unemployment in the initial years of the transition and a number of subjective wellbeing measures in later life is endogenous, and may reflect unobservable individual characteristics. It seems plausible to argue that these characteristics were the reasons behind the recorded job losses once the economy was liberalised and firms could fire their least productive employees.
Work histories in the SHARE dataset
The analysis is based on individual-level data from the Polish part of the Survey of Health, Ageing and Retirement in Europe (SHARE). SHARE is a multidisciplinary biennial panel survey focusing on individuals aged 50 years and over. Since the start of the project in year 2004 seven waves of data have been collected, and the survey was conducted in Poland in waves 2, 3, 4, 6 and 7. While the standard waves of the survey focus on contemporary conditions of respondents such as health, economic conditions, labour market activity and social networks, in wave 3 (the so-called SHARE-Life), participants were asked about their life histories including their family history, mobility and labour market experiences. The detailed labour market histories recorded in SHARE-Life allow us to identify transition-related job losses, which can be matched with current information on several measures of material conditions and wellbeing for the same individuals.
In Figure 1 we present labour market profiles since 1988 of those in the sample who were working prior to the start of the reform process.
Figure 1. Labour market status 1988 – 2008 conditional on working in 1988 in Poland
Source: Myck and Oczkowska, 2018.
The figure shows that along with rapidly increasing unemployment rates, the degree of inactivity of the Polish population grew substantially in the two decades following the transition. This data confirms that in the follow-up of the ‘shock-therapy’ reforms many individuals faced unemployment, while others, especially among older groups of employees, used several other labour market exit options, such as retirement or disability.
Analysing long-term consequences of economic shocks
To examine the role of unemployment experiences in the initial years of the transition for outcomes observed a few decades later, we use data from waves 2, 3 and 4 of the SHARE study. The analysis focuses on two groups of later-life outcomes – objective measures of material conditions such as household income, real assets and house ownership, and subjective indicators of wellbeing such as life satisfaction, depression or reporting difficulties in making ends meet.
We are able to control for an extensive set of individual characteristics which are usually unobservable to the researcher, through a complex set of background variables available in SHARE. These include respondents’ childhood conditions, parental background as well as health and labour market experience prior to 1988. With regard to the experience of unemployment we differentiate the instances of unemployment between the initial (1989-1991) and later (1992-1995) period of the transition to examine the potential differential implications of the rapid pace of the reforms in the early 1990s. Most importantly though, the data allows us to distinguish between different reasons behind job losses and we can separately examine the relationship with plant/office closures and other reasons for unemployment. Following other examples in the literature (Farber, 2011; Jacobson et al., 1993), we argue that plant closures can be treated as reasons for exogenous job separations. This in turn allows us on the one hand, to give a causal interpretation to the estimated coefficients, and on the other, to interpret those on other reasons for unemployment in the light of the causal relations.
Effects of unemployment experience on later-life outcomes
We find that experiencing unemployment due to plant/office closure between 1989 and 1991 is associated with almost a 30 percent lower level of household income and a lower probability of house ownership of about 10 percentage points (pp) some two decades afterwards. There is also a strong relationship between unemployment in the early years of the transition and wellbeing measures two decades later – individuals who experienced unemployment in the first three years of the transition have a 14 pp. higher likelihood of reporting great difficulties in making ends meet, a 10 pp. lower probability of high life satisfaction and a 11 pp. higher likelihood of depression. However, since these relations do not hold for unemployment due to plant closures, they cannot be treated as causal. The results are therefore most likely driven by unobserved factors which simultaneously determine the lower level of outcomes two decades after the ‘shock-therapy’ reforms, and the likelihood of experiencing unemployment in the early 1990s.
In this policy brief we outline recent results on long-term implications of labour market developments in the early years of the economic transition in Poland. The analysis is based on a combination of contemporary and retrospective data from the SHARE survey, and focuses on the associations between the experience of unemployment in the initial years of the transition in Poland and a number of outcomes measured about two decades later. Using plant/office closures as exogenous sources of job separations during the early 1990s, we find a strong and statistically significant, negative, long-term effect on income and home ownership, which can be treated as causal.
We also find strong negative associations between unemployment for other reasons than plant / office closures and a number of subjective measures of wellbeing. This relationship however, does not hold for the exogenous reasons for job losses, which suggests an important role of unobservable factors that lead to unemployment and at the same time are responsible for the lower level of outcomes in later life. This is consistent with the labour market reality of central planning characterised by labour hoarding and maintaining employment regardless of workers’ productivity. When the economic reality changed in 1989, the least productive individuals were the first to be fired, and as our analysis shows, these are also the individuals with lower subjective levels of wellbeing two decades later. We confirm thus that those who lost their jobs in the early 1990s have lower measures of the subjective wellbeing outcomes, although the latter cannot be identified as specific consequences of unemployment in the first years of transition.
- Farber, H. (2011). “Job loss in the great recession: historical perspective from the Displaced Workers Survey, 1984-2010”, NBER Working Paper No. 17040, National Bureau of Economic Research.
- Jacobson, L., LaLonde, R. and Sullivan, D. (1993). “Earnings losses of displaced workers”, American Economic Review, 83, pp. 685–709.
- Myck, M. and Oczkowska, M. (2018). “Shocked by therapy? Unemployment in the first years of the socio-economic transition in Poland and its long-term consequences”, Economics of Transition, 26(4), pp. 695-724.
The authors gratefully acknowledge the support of the Polish National Science Centre through project no. 2015/17/B/HS4/01018. For the full list of acknowledgements see Myck and Oczkowska (2018).