Explainer: Salaries, Taxes and Migration
December 13th, 2023
Disclaimer / Author’s Note: This article will is part of a series of economics and reform focused pieces that we’ll be running over the next 2 months. In this series we’re going to take a look at various aspects of the Moldovan economy to better understand why things are as they are and what important reforms are needed. I’m writing these articles based on experience from my day job as a small business owner in Moldova and from my work as President of the Moldova Small Enterprise Alliance AIM. In particular, topics will track elements of AIM’s 2024 Legislative Agenda which you can read online.
These articles are meant to help readers better understand the problems and opportunities within the Moldovan economy. As such, they are a blend of analysis and opinion. Please feel free to leave comments and let me know what you think.
Moldova’s Biggest Economic and Social Challenge - Migration
Over the course of the last 2 years Moldova saw record decreases in population with a 2.35% decrease in 2021 and a 2.4% decrease in 2022. Outbound migration is nothing new in Moldova as the nation’s population has dropped by around 25% since the country declared independence. The decrease in population is driven by a lot of complex factors but the largest driver is people leaving the country for economic opportunity abroad. As we discussed in a recent article about the role of small businesses in fighting corruption, companies main challenges have been very stable over the last decade. Most companies cite corruption, access to finance and access to information as their main challenges (in no particular order). Last year that shifted and every company I talk to has one dominant challenge - workforce and hiring.
What we’re seeing is a long term challenge begin to reach an acute phase. Companies are scrambling for workers at all levels: stilled, unskilled, management, highly educated, pretty much everyone. This is driving up salaries somewhat (not faster than inflation) but even with higher salaries there are clearly shortages of workers.
Migration is essentially *the* main economic, social and demographic challenge facing the country. It has complex causes and no easy solutions. In a very real sense all economic reform plans are plans to slow and eventually reverse migration. That said, there are some policies that are more related to migration than others. When co-authoring AIM’s 2024 Legislative Agenda I identified Human Capital as the number 1 concern that the business association will be focused on this year. In this we identified 3 areas of reform that can help target the underlying issues in the workforce:
Reform and investment in higher education and trade schools
Attracting and integrating immigrants
Competitive salaries
In the future I hope to come back to this topic and write dedicated articles about the higher education system and inbound immigration. But today I want to write about salaries because this topic opens up a lot of interesting structural issues within the Moldovan economy.
Low Salaries and “Salaries in Envelopes”
When asked why they are going abroad the vast majority of Moldovans cite low salaries as the main reason. A well educated young person can go to Italy or Ireland and make more money working construction in a few months than they might make as a bank teller in Moldova in a year. Moldova’s path towards EU integration has resulted in it being very easy to travel to countries in the EU and work there (not always legally). At face value “low salaries” just seems like a proxy indicator of a problem economy. Fix the economy and salaries go up! Not that “fixing the economy” is easy, but even if we accepted it was, the staggering income inequality found in many developed countries highlights how the actual salary rate is the product of more complex choices than that. So let’s dive into this topic and explore some of the factors influencing salaries in Moldova. First, some definitions:
Salary - In Moldova, like most of Europe, “salary” is discussed as the monthly sum a person receives after taxes. Jobs hiring will post the “Net” salary which will be the amount the employee expects to take home monthly. Pay periods in Moldova are also almost always monthly. For the purposes of this article we will use the word “salary” in the way that employees understand it - the amount of money they take home each month.
Payroll Taxes - Moldova has a flat payroll / income tax of around 40%. There is a minuscule standard deduction but other than that everyone is expected to send around 40% of their monthly paycheck to the government. Now, I can already hear 50 Moldovan accountants pick up the phone to tell me all about “Brutto” salaries, employer and employee contributions, the difference between income tax and pension withholding, etc. Moldovan accountants have a hundred ways of making this topic complicated, and the Moldovan government uses these complications to say things like “Moldova has a really low income tax regionally!” (semantically correct but very misleading). For the purposes of this article payroll and income taxes will be used in the way that business owners use it - the total amount of money the company needs to pay to the government monthly for a given employee to work.
Salaries in Envelopes - Salaries in envelopes is Moldova’s way of saying “paid under the table.” Many employees are paid fully in-envelopes meaning that there is no official record of their work at all. Many more are paid partially in-envelopes. This means that the company officially hires a person for say, minimum wage, and then pays them the rest in cash. This allows a company to pass an inspection without a state representative asking “who is this person?” but also to evade as much in taxes as possible.
Salaries in envelopes are a major problem in the Moldovan economy. Estimates vary but normally fall around 60/40, meaning that 40% of all workers in Moldova are paid in envelopes.
Note: This number is an estimate by it’s very nature. The UNDP estimates the shadow economy at 40% of GDP and unofficial employment at around 30% of the workforce. Other studies show the informal workforce as slow as 25%. Other studies from 2014 estimate that of the people formally employed, on average 40% of their salaries are paid in envelopes. It’s impossible to find an exact number so for the case of this argument we will take 40% as a combined estimate of the UNDP’s 30% who are fully informal and around another 10% working formally that receive some compensation in envelopes. Obviously, this estimate could be low based on the 2014 numbers.
Why Pay Salaries in Envelopes?
The reasons for Moldova’s burgeoning black economy are complex and go beyond simple tax-evasion. For example, there are a lot of workers that simply don’t exist in Moldovan legislation. The labor code is an inheritance of the Soviet period and a whole lot of assumptions about how an economy works come from that. Essentially, Moldovan law assumes a fairly Soviet employment situation. People are hired at companies and work there their entire career. Companies are large and most functions are in-house. If your factory sometimes needs a carpenter then you probably have a small carpentry department on payroll. Innovations like hiring a contractor for a day job, or frankly the existence of small business, is the norm in the economy, but often not recognized in the legal structure.
This means that there’s basically no functioning concept of “self employment.” Nor is there an idea of seasonal worker (since the collective farm hires everyone and keeps them on payroll all year). This has a few major implications:
You can’t hire a plumber for a day job. Or painter, or handyman, or whatever. Legally you can *hire* a plumber, but this process involves 2 weeks of paperwork and state registrations ahead of 2 hours of work and then another 2 weeks of laying someone off (if you can - it’s not easy to legally fire someone without cause). Practically speaking, when a business needs a plumber because a pipe burst they need to pay cash in an “envelope.”
You can’t hire farm workers seasonally. Same idea but on a bigger scale. Need 200 people for the harvest? That mostly needs to be cash.
Micro businesses for services don’t exist. What about the other side? Let’s say I’m a handyman, plumber, or for that matter an individual consultant. There’s no legal way to get paid in this process without starting an SRL (LLC) which involves a huge amount of overhead as well as the requirement to pay taxes. This is simply too much for most people working alone or with 1-2 other people.
So clearly there’s more going on than simple tax-evasion. But let’s not confuse the point - there is *a lot* of tax evasion going on too. In industries where it is the norm to pay salaries in envelopes (e.g. restaurants) any company who is paying full salaries is at a massive competitive disadvantage. To put some numbers to it, salaries account for 30 - 35% of revenue for most restaurants. 40% (taxes) of 30% of income = 12% of income being paid to the government above what a non-compliant restaurant would pay. This gets even starker when you ask “where does the cash for salaries come from?” Usually it’s from evading VAT taxes on some percentage of sales. Couple this with inspectors who are either inept or buyable (corrupt) and you have a major issue with collecting taxes on salaries.
The Impact of Salaries in Envelopes
A system where around 40% of the workforce aren’t paying taxes has a whole lot of issues. Here’s a few:
Market distortions / disloyal competition - Companies that are paying official salaries find themselves at a competitive disadvantage. The effect of this varies by industry with some industries operating much more legally than others, but at the core it creates substantial market distortions between companies and in the workforce.
People are underbanked / credit market problems - People being paid in cash tend to do their shopping in cash. This means a substantial part of the workforce is unbanked or underbanked. In Moldova the percentage of people over 14 with bank accounts is 64.25% compared with 69.12% in Romania, 99%+ in Germany and Estonia and 83.56% in Ukraine. People without bank accounts tend to save money in less productive ways (e.g. buying lots of building materials well in advance of renovations) and have little to no access to personal loans.
Culture of lawbreaking - The payment of salaries in envelopes is not secret. In highly impacted industries (e.g. restaurants) employees often prefer to be paid in envelopes because they understand the tax rates and know they can get more money in pocket now if paid that way. Few people worry about pensions that they have little faith in anyway. If breaking the law becomes the norm in doing business, it is impossible to establish ethical norms which support legal compliance.
Massive strain on the budget (especially pensions) - Any system with such widespread tax evasion obviously puts strains on the government’s budget. Worse, current pensioners worked during the Soviet period where work was much better recorded, meaning that the ratio of people who previously worked officially compared to those who do now creates more strains.
There’s another problem - the salaries that are legally paid
Up until now we’ve focused on the practice of paying “salaries in envelopes” and the effects of tax evasion on the economy. This conversation almost totally focuses on blue-collar workers, people who are self-employed, agricultural workers and workers in industries with low levels of tax-compliance. The problem is widely discussed in Moldovan politics and the government is working on some potential solutions (more on that below). What isn’t talked about enough is what the data on salaries tells us about who *is* getting paid legally.
According to National Bureau of Statistics data gathered in September 2022 the average salary in the economy was 10353 lei / month. The study doesn’t specify what they mean by “salary” but most likely it is Brutto meaning that number includes some employee taxes and the net salary is probably around 9000 lei. In any case, the study looks at salaries that are trending upward across most industries. Though, it doesn’t take inflation into account and with 34.5% inflation in 2022 any nominal gains were real terms losses.
Important note: In many countries this data would be the result of government statistical estimates based on polls of companies. In Moldova this is hard data representing every company or public institution with more than 4 employees. Every company reports full employee details (salary, days worked, days off, etc) to the government on a monthly basis. If this sounds like a lot of paperwork… it is.
What is most interesting about the salary distribution is the question they do not ask of the data - namely, how are the wealthiest doing? The top income bracket in Moldova is measured as people making more than 20,000 lei / month which is 7.3% of the population. They don’t provide average earnings of this income bracket, but doing a little napkin math we can get an estimate of 35,000 lei / month average salary within this top 7.3% of the population. That’s around $1,980.82 / month and the number likely includes some taxes. In Moldova, that can be a great salary. But anyone who lives in Chisinau will see a red flag here. That salary range does not account for the price of new apartments, luxury houses, fancy cars or frankly much of the life that can be observed on Chisinau streets. This implies that there is “leakage” from the tax system on the top end of income earners as well as on the lower end. And why not? Anyone in the United States expects that the people who best know how to “optimize” their taxes both legally and illegally are those making the most money. The difference in Moldova is that “the most money” is a lot less.
Oh, and it’s worth noting that almost all of the 21,000 IT Parks employees fall into this top tax bracket. And they pay zero income taxes as part of the Park’s 7% flat tax on revenue.
A Regressive Tax System
As we can see from the information above, Moldova’s supposedly “flat” payroll tax of 40% is actually not so flat at all. Tax evasion by seasonal workers and blue collar professionals chips away at the lower end of the system. At the higher end taxes payed on income taper off quickly at a level representing a basic middle class salary in Chisinau. This implies that many of wealthier citizens are getting their income, legally or not, through avenues other than official employment. Further, the fastest growing cohort of middle class professionals, IT workers, pay essentially nothing in taxes.
This sets up a system where a very heavy tax burden falls on the 60% who pay taxes, who are overwhelmingly working class.
Surely the wealthy pay taxes some other way?
Naturally there are other taxes that people pay. Landlords pay taxes on rent of 10% per month. Of course, very few rental contracts are officially registered with the state. Property taxes also exist… but they are miniscule. For my former restaurant, 290 sq meters in the center of Chisinau, the commercial property tax was around $10 / year. Road taxes for cars are based on engine size, meaning that older cars with less efficient engines often pay more than expensive new ones.
So there are other taxes that people pay, but it is very hard to compare them to losing 40% of your salary every month.
Note: It is worth pausing on the commercial property tax rate. Chisinau has long had a problem of fallow property and high rents. It is not uncommon for buildings to spend years on the rental market only to be rented at too high a price and see the renting business fail in under a year. With essentially no property taxes there is little to no incentive to adjust prices based on the market and many landlords simply wait until someone will meet their overpriced ask.
What about Trickle Down?
Before I get accused of being quite the economic lefty let’s take a look at the arch libertarian argument here. Low taxes on the wealthiest surely results in capital that can be invested back into the economy? right?
Wrong. It is true that you can start a company, capitalize it and then build something in Moldova. What is not true is that there is any real investment market. The Moldovan stock market is totally non-functional - something we’ve written on in-depth at Moldova Matters. There is no private bond market, no venture capital firms, no securities or financial market at all. Until parliament passed a reform to the country’s SRL / LLC law this summer (which we also wrote a lot about) it was extremely challenging even to come into a company as an investor after its original founding. This all means that people who have liquid assets that they want to invest turn to investment opportunities outside of Moldova.
So topics of taxation on salaries here isn’t a left wing vs right wing politics question. It’s about a system of misaligned incentives and market failures.
Impacts on Migration
We started with migration and we’re finally getting back to it. As we’ve seen through this long discussion of income taxes, Moldova has a very high “flat” tax rate that isn’t really flat at all. Most countries in Europe have some form of a progressive income tax. In Germany for example, a person would not pay 40% in taxes until making 104,000 euros / year net (approximately - less if they pay the Church tax). That compares to Moldovan’s paying 40% in income taxes when they make around 3000 euros / year net.
Since not everyone pays these taxes, and many people who are self employed are left without any legal structure at all, this creates quite a lot of pressure on salaried workers in Moldova who are responsible for a disproportionate percent of the country’s tax revenue.
What’s the government doing about this?
Over the course of this article we’ve outlined a complex set of policy failures and market failures that result in a bit of a mess. None of this is new and the current state of play has resulted in compounding problems rooted in Soviet era legislation. The current government is very focused on trying to address the problem of salaries in envelopes and is pushing the following 2 policies right now:
Reform of the Labor Inspectorate - The Ministry of Labor and Social Protection has been working for over a year to overhaul the notoriously corrupt labor inspectorate. The goal is to have a new cadre of honest, effective inspectors who will use statistics and risk-based criteria to target industries and companies for inspections. This process would also substantially expand the powers of the inspectors to conduct unplanned checks - something which worries companies because this inspectorate has been notoriously corrupt in the past (something I can personally attest to).
Limits on Cash - The government is considering limiting transactions over a certain amount for cars, apartments and other property to payments by bank transfer. The goal is to limit the use of large amounts of cash and therefore incentivize people to find a way to get the money into banks - a process which requires proving the source of funds.
There is clearly some logic in both of these policies. If the labor inspectorate is successfully reformed, and *if* it does not relapse into corruption, then the algebra of deterrence might push companies into greater compliance. At the same time it’s worth asking what would happen if this was a run away success? What if they could eliminate illegal work all together? Well, firstly, since there is no legal form for self employment or seasonal work, whole sectors of the economy would get into trouble really fast. But even ignoring that point, what would happen if 40% of the country lost 40% of their paychecks? Nothing good. Lots of anger, more migration, more poverty.
What can be done?
There are no silver bullets to solve these various problems. But we can see a nexus at the center of them. Moldova has an income tax system that is not fit for purpose. The rates are too high for people making the least and companies feel industry wide incentives to evade taxes. Self employed persons are outside the system. IT Professionals and the wealthiest have subsidized rates or are themselves outside the income system. Workers are often happy to work at a place that pays unofficially because their main concern, and what is driving people abroad, is salaries that are too low. Finally, the government has a budgetary crisis with income tax receipts not covering 40% of the workforce and a pension and healthcare system that is chronically underfunded.
In AIM’s legislative agenda the association advocates for the government to consider 2 fixes:
A progressive / marginal income tax - Moldova could institute a progressive, marginal income tax that would lessen the tax burden on the least off workers. A marginal tax rate would create new incentives for companies to bring their employees into the tax system and also create a structure for capturing other types of income favored by wealthier citizens into a common structure. Finally, it would allow an eventual phase-out of the IT Parks tax. Right now, a special rate for IT workers is hugely supportive for the Moldovan economy and budding tech sector. Long term, having cooks and dishwashers pay 40% taxes while well paid tech workers pay 7% is not sustainable.
A new self - employment system - Moldova could adopt a legal structure for self employment. This would allow plumbers, painters, consultants and day laborers to have some mechanism to report their incomes and pay a fair tax rate. Many people will still work for cash - like anywhere in the world. But companies looking to hire a plumber will take advantage of a mechanism to legally expense these costs. This means that a good portion of self employment income will be brought into the tax system.
There are no silver bullets to the problem of low salaries and outbound migration. At the same time there are a lot of levers that are not being manipulated right now. In the long term Moldova needs to grow its economy in order to deliver broadly felt economic security. But that won’t ever happen without a serious conversation about the role that taxes play in the market and an effort to create a tax system that aligns market incentives with legal compliance and economic growth.
The time of finding “quick wins” in reforming law or regulation is fading fast. Soon the government will have to look hard at the big issues - and starting with the fact that only 60% of workers pay any taxes is a pretty good place.