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Shadow Economy – Causes, Size and Dynamic Effects
Open Republic: April/ May/ June 2006

Robert Klinglmair and Friedrich Schneider, Department of Economics, Johannes Kepler University Linz, Austria

Summary: This article gives a short but comprehensive overview about the shadow economy and its causes. Additionally results about the estimation of the size of the shadow economy in 110 countries and the dynamic effects of the shadow economy on the official economy are presented.

	In this issue
			Shadow Economy – causes, size and dynamic effects Robert Klinglmair and Friedrich Schneider, Department of Economics, Johannes Kepler University Linz, Austria Rethinking the gains from immigration: theory and evidence from the US Gianmarco Ottaviano, Università di Bologna and CEPR, Giovanni Peri, University of California, Davis Demographic alternatives for aging: increased fertility rate, labour force participation, or immigration Robert Holzmann, World Bank and IZA Bonn. The trouble with Chomsky George Jochnowitz Chomsky and the West's new Fifth Column Kevin Myers New strategy needed in developing world Paul MacDonnell, director of the Open Republic Institute (ORI)

JEL-Classification: D78, H2, H11, H26, O5, O17

1  INTRODUCTION

As shadow economic activities are a fact of life around the world, most societies attempt to control these activities through various measures like punishment, prosecution, economic growth or education. Gathering statistics about who is engaged in shadow economic activities, the frequencies with which these activities are occurring and the magnitude of them is crucial for making effective and efficient decisions regarding the allocations of a country’s resources in this area. Unfortunately it is very difficult to get accurate information about these shadow economic activities on the goods and labor markets because all individuals engaged in these activities wish not to be identified. Hence, the estimation of shadow economy activities can be considered as a scientific passion for knowing the unknown.

Although quite a large literature on single aspects of the hidden economy exists and a comprehensive survey has been written by Schneider and Enste in 2000, the subject is still quite controversial as there are many disagreements about the definition of shadow economic activities, the estimation procedures and the use of these estimates in economic analysis and policy aspects (Dixon 1999). Most authors trying to measure the shadow economy face the difficulty of how to define it. One of the broadest definitions of it includes…“those economic activities and the income derived from them that circumvent government regulation, taxation or observation” (Del’Anno 2003).

2  MAIN CAUSES OF THE SHADOW ECONOMY

In almost all studies it has been found out that tax and social security contribution burdens are one of the main causes for the existence of the shadow economy. As taxes affect labor-leisure choices and also stimulate labor supply in the shadow economy, the distortion of the overall tax burden is a major concern of economists. The bigger the difference between the total cost of labor in the official economy and the after-tax earnings (from work), the greater is the incentive to avoid this difference and to work in the shadow economy. Since this difference broadly depends on social security contributions and the overall tax burden, they are key features of the existence and the increase of the shadow economy. But even major tax reforms with major tax rate deductions will not lead to a substantial decrease of the shadow economy [2] what makes it even more difficult for politicians to carry out such reforms because they may not gain a lot from them.

The increase of the intensity of regulations (often measured in the numbers of laws and regulations) is another important factor which reduces the freedom (of choice) for individuals engaged in the official economy (Pelzmann 1988). Regulations, one can think of labor market regulations, trade barriers or labor restrictions for foreigners lead to a substantial increase in labor costs in the official economy but since most of these costs can be shifted to employees, these costs provide another incentive to work in the shadow economy where they can be avoided. Empirical studies find an overall significant evidence for the influence of these regulations on the shadow economy and predict that countries with more general regulation of their economies tend to have a higher unofficial economy (Johnson et al. 1998b). These findings demonstrate that governments should put more emphasis on improving enforcement of laws and regulations rather than increasing their number. Some governments, however, prefer the policy option of more regulations and laws when trying to reduce the shadow economy, mostly because it leads to an increase in power of bureaucrats and to a higher rate of employment in the public sector.

Further can increases of the shadow economy lead to reduced state revenues which in turn reduce the quality and quantity of public sector services. Ultimately this can lead to an increase in the tax rates for firms and individuals in the official sector, quite often combined with a deterioration of the quality of public goods (such as public infrastructure) with the final consequence of even stronger incentives to participate in the shadow economy. Johnson et al. (1998a) and Johnson et al. (1998b) present a simple model of this relationship and their overall conclusion is that wealthier countries of the OECD as well as some in Eastern Europe and Asia find themselves in a good equilibrium of a relatively low tax and regulatory burden, sizeable revenue mobilization, a good rule of law and corruption control and thus a (relatively) small unofficial economy. By contrast, a number of countries in Latin American and the Former Soviet Union exhibit characteristics consistent with a bad equilibrium where the tax and regulatory burden on the firm is high, the rule of law is weak and there is a high incidence of bribery and thus a (relatively) high share of activities in the unofficial economy.

Footnotes