How Parental Benefit Systems Encourage Wage Formalisation in Eastern Europe

A World Bank study found that workers and employers in Hungary and Latvia often temporarily increase officially reported wages during pregnancy to qualify for higher parental benefits, especially in small firms where underreporting is common. The research warns that while contribution-linked benefits can encourage short-term formalization, they may also create fiscal costs and fail to improve long-term tax compliance.

A new World Bank study has uncovered how parental benefit systems in Hungary and Latvia may be encouraging workers and employers to temporarily "clean up" hidden wages during pregnancy. The research, conducted by economists from the ELTE Centre for Economic and Regional Studies, Corvinus University of Budapest, UNU-WIDER, the World Bank, Amazon, and the Consumer Financial Protection Bureau, examined how social welfare rules can shape tax reporting behavior in countries where undeclared cash payments remain common.

The study focuses on "envelope wages," a practice in which employees officially report only part of their salary while receiving the rest informally in cash to avoid taxes. According to the researchers, pregnancy changes the equation because parental benefits depend heavily on officially declared income before childbirth. Suddenly, reporting higher wages becomes financially rewarding.

Why Pregnancy Changes Wage Reporting

In both Hungary and Latvia, maternity and parental benefits are linked to earnings reported during a specific period before childbirth. The more income workers officially declare, the larger the benefits they receive after giving birth.

Researchers found that women employed in small private firms often experienced sharp increases in officially reported wages once they became pregnant. These jumps happened exactly during the months used to calculate benefit eligibility. In contrast, women working in large firms, foreign-owned companies, or the public sector showed little or no similar increase.

The study argues that these changes were not genuine salary raises. Instead, employers and workers appeared to temporarily formalize wages that had previously been hidden from tax authorities.

The timing strongly supported this explanation. Wage increases began during pregnancy and, in many cases, disappeared after the benefit qualification period ended.

Small Firms at the Center of the Pattern

The strongest reporting changes were concentrated in smaller firms and among lower-paid workers. Many women who had been officially earning the minimum wage suddenly reported much higher salaries during pregnancy.

In Hungary, where parental benefits were capped, many workers appeared to increase their declared wages to exactly twice the minimum wage, the level that maximized benefits. Researchers described this as clear evidence of strategic reporting rather than normal wage growth.

Latvia showed even larger wage increases because its benefit cap was much higher and less restrictive. Women in small firms there displayed especially strong reporting responses after a major parental benefit reform in 2005.

The research also found that working hours barely changed during pregnancy, even though reported wages often rose sharply. This suggested that employees were not actually working more, but simply declaring more of their income officially.

Reforms Made the Response Even Stronger

Policy reforms in both countries played a major role in intensifying the behavior.

Hungary changed its rules in 2015 by shortening the earnings period used to calculate benefits. This meant workers only needed to report higher wages for a shorter time to receive larger benefits. Latvia introduced a new wage-linked parental benefit in 2005, making official earnings even more valuable.

After these reforms, the reporting response became much stronger, especially among workers in small firms. According to the study, this showed that employers and employees were highly sensitive to the incentives built into the welfare system.

Researchers also examined women who changed employers between pregnancies. Women moving into small firms showed strong wage-reporting increases during pregnancy regardless of where they had worked before. Those moving into large firms or the public sector stopped showing the same behavior. This suggested that firms themselves played a key role in organizing temporary wage formalization.

A Warning for Policymakers

The findings carry important lessons for governments designing social welfare systems.

On the positive side, linking benefits to reported earnings can encourage some workers and firms to formalize wages and employment relationships. But the study warns that these effects may only be temporary.

In many cases, the extra parental benefits received by workers were larger than the additional taxes collected by governments during pregnancy. This meant employers and employees could benefit financially from strategic reporting while continuing longer-term underreporting practices afterward.

The researchers conclude that welfare systems do more than provide social support, they also shape tax behavior. In countries with large informal economies, poorly designed contribution-based benefits may unintentionally encourage temporary compliance rather than lasting improvements in tax collection.