Risks of Partnerships of across-border smugglers

Why across border smuggle partnerships are formed

People respond to incentives. Poor and desperate people respond to incentives in a more urgent manner. Survival behavioral patterns differ much from behavior of middle class people in a stable society in terms of abiding by law, following moral principle and enhancing informal human institutions. Generally, transitional economies are relatively poor. Their governments try to copy the basic European pattern of welfare state hence they overregulate, overtax and overspend. Bureaucrats use various sophisticated econometric modes to boast their omniscience and ability to define the «optimal distribution pattern» and determine «strategic sectors» and «national champions of economic growth». They increase the risk of making investment mistakes and hence the danger of structural imbalances.

While the government of a transitional country is busy changing labels and learning new European policy language people try to minimize the impact of the state on their lives and on their survival patterns. They view the law as unjust and in many cases immoral. No wonder they form informal domestic and across border partnerships to ease the burden of the state. In fact the prices that come out of this informal exchange put much competitive pressure on the formal market monopolized by the state.

Grey economy in the highly interventionist economy performs two more important functions. Firstly, it adjusts merchandize markets to purchasing power of the population. Secondly, it cushions the process of adjustment of domestic prices to world prices in the time of unstable and inflated income. Hence, household propensity to smuggle goods and to get involved into grey economy is quite high. It can be reduced in a few ways: a) by forming respect to law i. e. creation of informal institutions. It takes much time and resources; b) by raising penalties and fines for smuggling. It means investing in control and force structures that are supposed to executive various forms of punishment; c) by erecting «Iron curtain» on the border i. e. investing into border infrastructure, imposing visa restrictions and other impediments for across border cooperation; d) easing tax and regulatory burden and the differential of this burden on the smuggled goods between the countries that are involved in this form of exchange; e) raising the income of the population of the neighboring countries. It is also a long process that takes not just adequate domestic policy but an intense international cooperation.

Designing anti-smuggling policy it is worth keeping in mind factors that drive the propensity to smuggle much higher. They are a) raising taxes; b) introducing more cumbersome regulations that require disciplines administrators; c) increasing the tax differential between the countries and d) increasing the income differential of households. After Lithuania joined EU it will have to raise taxes on a few smugglable goods to comply with EU legislation. More regulations are expected to be introduced. As a result the difference in prices of cigarettes, alcohol and gasoline is likely to increase and drive the propensity to smuggle much higher. It is not only about Belarus’ keeping prices for these goods low but it is also a matter of income distribution in Lithuania. Active creation of jobs in the border region of Lithuania will ease the pressure of smuggling of course but in the mid run it will create structural imbalances and hence additional burden on the budget. So it is up to policymakers to decide on the shape of the tradeoff to be reached on this particular issue. But in any case European excise policy on cigarettes, alcohol and gasoline is lose - lose game for Lithuanian consumers (not to count those few beneficiaries who will use EU funds to fight contraband and to create jobs).

The gap is widening

Lithuania joined EU and paved the way to sustainable development in the European customs union. Its national income is growing. Lithuania has gone through restructuring and diversified its trade and production. It built the social security network that is much more advanced that the old Soviet one. It is on the way to become an integral part of the European system of division of labor.

Joining the European Union was a relatively easy task. It took much time and efforts but it is by far much more difficult to eliminate causes of gray economy in the country. Competence of government employees does not increase automatically. People did not wake up on May 2 to start trusting official institutions more. Government employees do not become competent and corruption free overnight either. They keep enforcing faulty laws and regulations to benefit some groups and to harm others. EU regulations will require more, not less government regulation and higher taxes.

Belarus in its turn is still in many aspects a centrally planned economy. It heavily relies on Russia (58% of merchandize trade turnover), redistributes over 50% of GDP through the budget and numerous off-budget funds. Belarus is a textbook case of an administratively managed economy that channels money to projects that the government believes to reap the highest benefits. This policy benefits about 100’000 150’000 households that are directly involved in various redistribution schemes and are licensed to produce and to trade. They are quite well-off. They act in the environment of restricted competition (through licenses and other administrative tools) and easy access to cheap credit and numerous tax breaks. i. e. loose monetary and fiscal policy prevails. These households amount to a bit more than 1% of all families in the country. They do not mind buying more expensive goods in Belarusian shops. At the same time they are driving forces behind various schemes that make cigarettes, alcohol and gasoline prices lower due to tax breaks, favorable import regime or just tax evasion.

Formally Belarusian economy is booming. GDP growth in the first 5 months of the year exceeded 10%. Industry grew by 13% and fixed capital investment (largely sate one) grew by almost 25% compared to the same quarter of 2003. Export grew by 24% and import - by 14.4$. Inflation in the first quarter amounted to 5%. The average salary was almost $135 and the average pension - $62. The reasons for this kind of boom are a) high demand from Russia, b) favorable price situation (metals, chemicals, oil), c) Russia’s protectionist policy against non-CIS food products; 4) peculiarities of Belarusian accounting and statistics as directors, controllers and the government have a very strong incentive to fudge statistics and to achieve the target indicators of economic performance; 5) loose monetary and fiscal policy and channeling funds in favor of «national industrial champions».

The formal success of Belarusian economy has a negligent impact on the level of income of the population and stability of the labor market. In order to estimate the income level of Belarusian households let’s address the results of the recent household opinion poll. In 2003 the monetary income of the average Belarusian family was $103.5 (the average family is 2.56 persons). The average pension in 2003 was $36.8. According to the Ministry of statistics the average salary in 2003 was $123.5 and the average pension was $50.3. This kind of income places more than 70% of households below the minimal consumption budget and 37% of the population below the poverty line (estimated by Human Development Report for Belarus 2003).

How do Belarusian households make ends meet? Firstly, they work hard at their dachas and land lots. The unique feature of Belarusian households is that 93.6% of them get income from this kind of economic activities. On average the family receives the equivalent of $20.4 from this income source. Secondly, households spend their savings (37.8% of households consume monthly $19.2 of their savings). Thirdly, 45% of households receive financial assistance from their relatives.

Finally people smuggle goods in order to earn more money for household daily expenditures. According to the household opinion poll results (conducted by the Ministry of Statistics) the households in Grodno region are the poorest in Belarus (the monthly household salary is $80.4 or just 47% of the city of Minsk level). The wage income in Brest region is $89.5 per household, in Vitebsk region - $92.6. If you take into account the growing prices for housing and utility services, public transportation, health and education it becomes obvious that the household propensity to smuggle in border regions in Belarus is increasing. Experts estimate that 40 - 45% of all households in the city of Grodno generate income from so called «ant trade» (alcohol, cigarettes, gasoline to Lithuania and Poland, food, constructions materials, household appliances - to Belarus). Sealing the border for this kind of trade will likely to increase social tension in Grodno region as there are very few opportunities for official employment. In fact statistically significant economic growth does not create jobs, which feeds doubts about is nature and sustainability.

No matter how much money the Lithuanian government and EU pumps into the border infrastructure it will not likely to sever ties among peoples of the two countries. These ties are the informal institution that will generate not only friendship but smuggling. There will be a sort of conspiracy against high taxes and burdening regulation that will benefit both Lithuanian and Belarusian households. The customs and border people as well as local nomenclature and their companies will not give up their income opportunities either. They will start exploring new ways to smuggle goods as the growing difference in prices is likely to lower the risk threshold for them. As Belarusian authorities are highly unlikely to raise prices for cigarettes, alcohol and gasoline the price gap on these products will grow.

Factors not to be ignored

There are a few other important issues that should be taken into account while estimating the consequences of Lithuania’s adopting EU excise and tax legislation. It is common in Belarus to give tax breaks and create favorable production and import regime for various companies. It means that no matter how high the common tax and regulatory burden in Belarus is (even if the rates are close to those of Lithuania) there will always be cheaper cigarettes and alcohol in the domestic market. Such loopholes in legislation and in the market will create further incentives for people to smuggle.

In order to boost domestic production Belarusian cigarette and alcohol plants (for example Grodno tobacco plant) are often given numerous benefits and perks (cheap credits, tax breaks, cheap energy resources, individual depreciation policy etc.). Hence, Belarusian market will continue to be the source of relatively cheap goods. As these goods are politically and socially sensitive the government is unlikely to raise taxes on them. Even if the change of government happens in Belarus the new reformers’ cabinet of Ministers is not likely to do it on the first stage of reforms. Moreover the reformers’ government will have to significantly lower the tax and regulatory burden and create even higher price differential between Belarus and Lithuania. It means that neither «exit» nor «voice» options for Belarus will generate higher prices for excise goods in Belarus. So it is rather for EU and Lithuanian government to see to the consequences of growing gap in prices in the two neighboring country.

In spite of Belarusian police’s numerous efforts to fight illegal production of alcohol it flourishes alongside with household domestic production of moonshine. In 2002 - 2003 a number of Belarusian companies bought ethyl spirits allegedly for production of drugs (for this purpose the company does not have to pay 1.8 euro of excise tax per liter). For the last 2 years manufactures of drugs bought about 1 mln. decaliters. The control bodies of Belarus audited the enterprises of this sector and just this year 10 criminal cases were launched. Hence Belarus faces a big problem of effective law enforcement. Low salaries of policemen, poor technical equipment, low quality of human capital and lack of independence make force structures of the country vulnerable to political pressure. Besides lack of transparency, public and parliamentary control over force structures creates a strong incentive for people in uniform to take smuggling and illegal production under their own control.

Another factor that should be taken into account is the Belarusian duty free system of shops. Experts say that excise goods in these shops are one of the cheapest in the region. As Belarus does not have to comply with EU regulations on these shops there will be more incentives for their operators to sell cheap alcohol and cigarettes to the domestic market and to export them to Lithuania.

Finally, Belarusian - Russian border is not equipped with any meaningful effective means to prevent inflow of cigarettes and alcohol from Russia and Belarus. One-day companies fudge documents, excise marks, certificates of quality and even licenses to carry out illegal activities. Experts estimate that only one out of twenty bottles or packs of cigarettes is stopped by police. Lithuanian - Belarusian border is different of course but we can hardly say that it is sealed up.

Thus the price differential in cigarettes, alcohol, fuel between Lithuania and Belarus will persist. Moreover it is likely to increase as Lithuania will have to comply with EU norms and requirements in excise tax policy. The difference in prices of different goods will vary from 100 to 400% and remain a powerful magnet for household and commercial scale smuggling.

How to proceed

Lithuanian government is expected to invest much money in modernization of its border. It will also take numerous measures to improve the quality of state control bodies (including border control and customs) personnel. It may artificially create jobs in the border region to ease the social tension (the unemployed and low income families will be offered alternative sources of income). Simultaneously the government will spend resources on educating and informing people on immorality of smuggling and cheating on the state. All these measures mean redistribution of resources and wealth from one group of citizens to another. This redistribution scheme is not market driven hence it will destroy jobs and income in some parts of the country to create them in other areas. If Lithuania becomes a net recipient of EU transfers then it will be better off (though it could have used these resources more efficiently in case of lower price differential between the countries). However freedom of maneuver of the Lithuanian government is reduced by EU excise tax policy framework.

Belarusian government faces difficult challenges ahead. Sooner or later it will have to go through the painful period of restructuring and systemic reforms. Being self-isolated from European processes Belarusian government will not likely to adjust its excise and VAT tax policy to that of the European Union because it does not have to. Even if it had to it would have much time and resources to make Belarusian households and businesses comply with high excise and VAT policy. Besides in order to catch up it will create more competitive regulatory and tax environment.

As relative poverty in Belarus will persist and the respect to the state institutions will remain quite low most of such administrative policies will be futile. Failure of government institutions to enforce existing laws will remain the major problem both for the budget and small companies. Propensity to smuggle will remain high as risks of smuggling will be perceived much lower than possible benefits. It will be easy for Belarusian households to find Lithuanian partners to arrange such deals.

Taking account various factors that will have an impact on the structure and intensity of smuggling we recommend the following:

To urge EU bodies to adjust its tax and regulatory policy to existing conditions of new markets and their peculiarities (weakness of administration and control bodies, low purchasing power, high unemployment in the near border area, low respect to law and strength of informal institutions and connections);

To make excise tax policy the national issue having in mind tax competition rather than tax harmonization. Concentrating efforts on fighting smuggling that will occur as a result of adoption extremely high EU tax policies instead of environmental issues, education or infrastructure is counterproductive;

To support a few across border Lithuanian - Belarusian projects (EU supported) to create jobs for the local population. It is much more fruitful than investing in building a new «Iron Curtain»;

To take measures to make state bodies transparent and reportable i. e. to work out the strategy of rising respect to law and enforcement structures.

To launch wide scale anti-tobacco and anti-alcohol campaign to support healthy life. In the end of the day it is up to a consumer to decide to buy or not to buy;

To support the strategy of bringing Belarus on board of EU in the future.

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Risks of Partnerships of across-border smugglers