Why it pays some to stay in the grey economy

When Wang Xiaolu, deputy director of the National Economic Research Institute, released his findings on the mainland's hidden economy earlier this year, the response was swift.

International media jumped on the eye-catching statistics, the mainland public asked where such money could come from if not bribery and corruption, and the National Bureau of Statistics questioned the size and make up of the sample survey.

Through all this Wang stood behind his statistics: that the mainland has a hidden economy that could amount to 30 per cent of gross domestic product, and that the income gap between rich and poor is even wider than expected.

'In 2008 the grey economy surpassed 5.4 trillion yuan (HK$6.25 trillion),' he said recently. 'The overwhelming majority of this is from the high-income population group, which accounts for the top 15 to 20 per cent of the urban population.'

Using 2008 figures, Wang estimated that the average per capita income was not the 16,000 yuan officially stated but more than 32,000 yuan and that the top 10 per cent of earners in the country had incomes of around 139,000 yuan in 2008, rather than the 44,000 yuan they admitted to tax authorities.

Therein lies the main problem. The mainland's grey economy covers both illegal activities and off-payroll incomes, and with limited regulations it is hard to rein in a hidden economy that is growing every year, or even put a finger on the exact amounts being talked about.

'The economic impact is hard to work out because, by definition, it is hidden economy,' says Mao Yushi, executive director of the Beijing Unirule Institute of Economics.

While there are certainly considerable illegal gains being made by officials - Wang says corruption among officials still ranks among the biggest contributor to the grey economy - hidden income and illegal gains are prevalent across mainland society.

For every Zheng Shaodong, the former head of the Economic Criminal Investigation Bureau who was sentenced to death in August for accepting 83 million yuan in bribes between 2001 and 2007, there are thousands of businessmen and women, low-level officials and, according to some reports in the mainland media, even doctors and teachers, collecting a significant proportion of their income in the grey area of the economy, some by legal means, some illegally.

Mao says the total value of the hidden economy could be equivalent to one fifth of the formal economy, but says any estimate is largely guesswork. 'In the West they have been collecting tax for decades but in China the tax office is weak, meaning that the amounts collected are low and the statistics are not accurate,' he says.Not only does this make it hard for the mainland to regulate these businesses and earnings but it also means the country is losing significant tax revenue.

'If you compare the current individual income tax figures with Japan, Taiwan or the US, the percentage is very small,' Mao says. 'Approximately 7 per cent of the tax revenue in China comes from income tax, in Taiwan it is 50 per cent and Japan a similar number, so a lot of money is not being collected.'

Likewise, Mao says, capital gains, an important source of income for the wealthy, are badly regulated and tax office data on them is almost non-existent. 'China desperately needs to improve its tax regulations,' he says, suggesting that if all else fails it could follow the Russian model of introducing a flat 12 per cent tax rate.

While informal economies exist in every country, in developing economies the benefits of going through legal channels are limited and there is often little incentive for companies to do so. Professor Patrick Chovanec of Tsinghua University's school of economics and management says: 'Most people who work in China know that companies have three sets of books: one for the tax collector, one for their investors, and a real one. The benefits of staying in the grey economy persist much higher up the chain in China.'

Chovanec said companies often only paid attention to it when they were trying to entice foreign investors or looking to launch an initial public offering. A second report by Wang, sponsored by Credit Suisse and released in August, said hidden income on the mainland was growing considerably faster than regular income and that 'the second 10 per cent of richest households is starting to benefit significantly from hidden income'.

This is aggravating already strained economic divides. If Wang's estimates are correct the wealthiest 10 per cent of the country how have a per capita income 65 times the size of the poorest 10 per cent and rising.

'This is worrying as such income is now becoming more widespread among a wider group of the population,' the report concluded. 'The grey income is the main reason leading to the rich poor gap,' Wang said.

He is not the only one who believes that.

'The grey income will aggravate the unreasonable social distribution, which may impair social stability,' Su Hainan , director of the China Association for Labour Studies' compensation committee, told the Legal Daily last month. 'We have to try everything to get rid of it.'

Even Premier Wen Jiabao has chimed in on the issue. 'We should resolutely clamp down on illegal income, regulate the grey income, so as to gradually establish an open, transparent, fair and reasonable income distribution system,' he said in his government work report, delivered to the National People's Congress in March, that drew considerable attention for being one of the first official references to the grey economy.

This is unlikely to happen in the next few years, however.

'It can't be quickly solved,' Mao said. 'I can't see it changing in the next 10 to 15 years but after that, if the tax regulations are improved, we should see the hidden economy shrinking.'