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Cablegate: Spain's Underground Economy

This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 03 MADRID 002418

SIPDIS

SENSITIVE

TREASURY FOR TRACI PHILLIPS

E.O. 12958: N/A
TAGS: EFIN ECON ELAB KIPR SP
SUBJECT: SPAIN'S UNDERGROUND ECONOMY

REF: A. MADRID 736

B. MADRID 604

1. (SBU) SUMMARY: Several European researchers have published
studies outlining the problem of Spain's underground economy.
The most recent study, published by Friedrich Schneider in
March 2004, claims that Spain's underground economy is
currently equivalent to 22.3% of official GDP. Spain's
continually high unemployment and illegal immigration have
accompanied the incidence of significant informal economic
activity. Unreported labor and income are more prevalent in
predominantly unskilled sectors such as agriculture,
construction, and some services. The European Commission
(EC) criticized the GOS in 2002 for its lack of coordination
in dealing with underground economic activity, observing that
the GOS tends to react to easily observable offenses instead
of proactively seeking preventative measures. Spain seems to
benefit from tolerating at least some underground economic
activity and is unlikely to combat it in the near future.
END SUMMARY

THE SIZE OF THE PROBLEM
-----------------------

2. (U) Published in March 2004, Friedrich Schneider's study
entitled "Shadow Economies around the World: What Do We
Know?" surveys the economic landscape of 110 so-called shadow
or underground economies. The underground economy is defined
as "those economic activities and the income derived from
them that circumvent or otherwise evade government
regulation, taxation or observation." In 2003, Spain's
informal sector summed to 22.3% of official GDP, making it
the third largest of OECD countries only surpassed by that of
Italy and Greece. While common perception is that
underground economic activity is undesirable, Schneider found
that an increase of 1% in the underground economy of an
industrialized country results in a 0.8% increase in the
official GDP. His analysis showed that an increasing burden
of taxation and social security contributions combined with
greater state regulatory activities are the driving forces
behind the growth and size of the shadow economy.

3. (U) A 2001 study on the Spanish underground economy
conducted by the Institute of Fiscal Studies of the Spanish
Department of Treasury in cooperation with the Universidad
Complutense de Madrid estimated Spain's underground economy
to be 20% of GDP. The report analyzes the growth of Spain's
shadow economy over a twenty-year period on a regional basis.
It shows that over the last two decades, Spain's underground
economy expanded from 15% to 20% of GDP. Tenerife, Ciudad
Real, and La Rioja were provinces with the largest
underground economies. Other, earlier studies have
calculated Spain's underground economy as ranging from 20% to
as high as 40% of official GDP.

4. (U) The EC has also looked at the underground economy in
Spain as part of a larger study on the issue in the EU. The
EC found that Spain has the second largest informal sector of
the then EU-15, surpassed only by Italy. According to this
study, the Spanish underground economy is estimated to equal
23% of GNP (7% more than the European Community average) and
accounted for 120 billion euros (USD 143 billion at 1 euro =
USD 1.19) of undeclared earnings. The EC's study urged Spain
to convert illegal employment into legal employment. The
study's authors criticized GOS policy for being ill suited to
respond to growth in the underground economy, tending to
react to the problem rather than consider ways to prevent it.
Furthermore, the EC reported that there is little
cooperation amongst GOS agencies and instead each agency has
its own priorities when it comes to reducing the underground
economy.

REASONS FOR UNDERGROUND ECONOMY
-------------------------------

5. (U) These studies indicate that rising labor costs and
high social security taxes are key factors behind underground
economies in Europe. In the case of Spain, a confluence of
two additional trends helped stimulate high levels of
informal economic activity. First, Spain historically has
maintained a high unemployment rate (24.2% at its peak in
1994, and currently 11.3%). Second, Spain is a refuge for
economic migrants from Latin America and, more recently,
Northern Africa. While not all immigrants are destined for
the underground economy, statistics of detected illegal
workers in Spain reveal that participation of immigrants in
the underground economy has increased substantially. By 2001
(the most current statistics available), immigrants
represented more than a third of detected illegal workers.

SECTORS
-------

6. (SBU) The sectors that generally have the largest number
of workers in the shadow economy are those that require
minimal educational and professional formation. This is
evidenced in cities like Tenerife, a tourism hub that is in
the midst of a construction boom, Ciudad Real province,
active in textile production, and La Rioja, an agricultural
and leather production center. The studies show that the
highest concentration of illegal workers in Spain is in the
agriculture, construction, and service sectors. Gayle
Allard, an economist at the Institute of Business (Instituto
de Empresa) in Spain, opined that undocumented labor is a
hidden subsidy for all of these affected sectors.
Underground economic activity is beneficial not only for the
private sector, but also more profitable for the GOS than
enforcing their own tax and immigration laws. The increased
amount of immigrant labor in construction is a recent
phenomenon linked to Spain's housing boom (reftel B) and the
expansion of tourism and hotel construction along the coasts
of southern Spain. Allard believes that it is beneficial for
the time being to have a subsidized construction sector to
help lift Spain out of the recent recession.

IMPACT OF UNDERGROUND ECONOMY
-----------------------------

7. (U) An underground economy of approximately 21% of Spanish
GDP is roughly equivalent to 130 billion euros (USD 155
billion). This translates into significant unrealized tax
revenue for the Spanish government. A large informal sector
also creates an atmosphere conducive to other illegal
activities such as selling drugs and the piracy of
intellectual property goods (e.g. software, CD's, DVD's,
videogames, brand name clothing), which are significant
problem in Spain (reftel A). Spain's Treasury Department has
calculated that the selling of one kilogram (2.2 lbs.) of
pirated CD's is five times more profitable than one kilogram
of hashish.

8. (SBU) The underground economy also distorts Spain's
economic statistics. For example, some studies suggest that
as much as one-third of the unemployed are involved in the
underground economy. If correct, this would mean that
Spain's high unemployment rate is at least partially
artificial. If the GOS can, as the EC report urges it to do,
transfer underground occupations to the legitimate labor
force, this inflated unemployment figure could fall
substantially and social security coffers could grow.

GOS ACTION AND REACTION
-----------------------

9. (U) The EC report characterizes Spain's policy toward the
underground economy as reactive and uncoordinated. The GOS
claims to be combating the problem by investigating illegal
employment and unclaimed income cases. For example, in
summer 2002, Spain's Department of Treasury dispatched 200
government officials along the coasts of Spain in an attempt
to detect illegal employment and tax evasion. If individuals
or businesses were suspected of tax fraud, the officials
would initiate an investigation of their tax claims. Another
inspection conducted by the Spanish Department of Labor had
more tangible results, by recuperating 435.5 million euros
(USD 520.5 million) in unpaid social security contributions.
From January to June of 2002, the Department of Labor found
33,215 underground workers, of which 4,137 were foreigners
without work permits. As a result of the inspections, GOS
fined businesses 7.3 million euros (USD 8.7 million) and
illegal immigrants 25 million euros (USD 29.9 million) for
illegal employment.

10. (SBU) While current action has allowed GOS to recover
some lost tax revenue and punish employers for illegal labor
practices, the current policy is not effective in shrinking
the underground economy. Instead of acting in advance to
deter unreported employment or employment of illegal
immigrants, its policies focus on reaction by giving
disproportionate fines to employees instead of employers in
the shadow economy. While any action represents a
commendable step, the EC suggests that preventative action
through coordinated policies would prove to be more
successful at reducing the submerged economy. As the EC
report found, the policies of the various government agencies
are not coordinated. That lack of harmonized policies leaves
the government with misaligned goals, resulting in a
governmental principal-agent dilemma. Pilar L'Hotellerie,
head of analysis of the Spanish economy for the Bank of
Spain, said that although the new socialist government is
paying slightly more attention to tax evasion and fraud than
the former Popular Party (PP) government, she does not expect
to see any form of legislation intended to deter underground
economic activity in the foreseeable future.

11.(SBU) COMMENT: The GOS usually turns a blind eye to
underground economic activity in traditionally important
sectors such as agriculture and construction. Untaxed
factors of production act as a hidden subsidy, increasing the
country's general economic welfare in sectors where official
subsidies are impossible to enact because of GOS-EU trade
obligations. In many of these markets Spain is in direct
competition with low labor-cost producers, and without these
hidden subsidies domestic firms would exit. There is no
question that the underground economy has contributed to
Spain's remarkable economic growth since joining the EU.
Absent budgetary pressures or stronger EC urging to curb such
activity, we see no change in the role or size of Spain's
underground economy in the near future. END COMMENT
ARGYROS

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