Shadow Economy – Causes, Size and Dynamic
Effects
Open Republic: April/ May/ June 2006
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. 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).
Following this definition it is obvious that the shadow economy includes unreported income from the production of legal goods and services - either from monetary or barter transactions – and thus includes all economic activities that would generally be taxable were they reported to the state (tax) authorities. As such a broad definition still leaves open a lot of questions it seems necessary to develop a better feeling for what could be a reasonable consensus definition of the hidden economy and we at least try to give such a more precise definition: The shadow economy includes all legal production of goods and services that are deliberately concealed from public authorities for the reason of avoiding payment of income, value added or other taxes, avoiding payment of social security contributions, avoiding having to meet certain legal labor market standards such as minimum wages, maximum working hours, safety standards and avoiding complying with certain administrative procedures such as completing statistical questionnaires or other administrative forms [1].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.
3 THE SIZE OF THE SHADOW ECONOMY AROUND THE WORLD
As already mentioned above estimating the size of a shadow economy is a difficult and challenging task not only because there are disagreements about the estimation methods. Nevertheless almost everyone would agree that there are some indications for an increase of the shadow economy worldwide but little is known about the exact size of the shadow economies in transition, developing and developed countries over the period from 1990 to 2000. Therefore we estimated the size of the shadow economy using a combination of the DYMIMIC and the currency demand approach [3] for a sample of 110 countries that is grouped into developing countries, transition countries and highly developed OECD countries.
The group of 66 developing countries has been further divided into Africa, Asia and Central/South America.| 1990/91 |
1994/95 |
1999/2000 |
|
| Developing Countries (66) |
|||
| Africa (24) |
33.9 % |
37.4 % |
41.2 % |
| Central/South America (17) |
34.2 % |
37.7 % |
41.4 % |
| Asia (25) |
20.9 % |
23.4 % |
26.3 % |
| Transition Countries (23) |
31.5 % |
34.6 % |
37.9 % |
| OECD countries (21) |
13.2 % |
15.7 % |
16. 8% |
Source: Own calculation by authors
The results show that the shadow economy in percent of official GDP has on average increased remarkably in all country groupings during the 1990s but also empirical evidence for the hypothesis that highly developed OECD countries and Asian countries typically have lower shadow economies while transition and developing countries have higher shares can be found. A detailed list of the size of the shadow economy for each country over time can be found in Schneider et al. (2004) and Schneider (2005).
4 DYNAMIC EFFECTS OF THE SHADOW ECONOMYGenerally the view prevails that the informal sector influences the tax system and its structure, the efficiency of resource allocation between sectors and the official economy as a whole in a dynamic sense. In order to study the effects of the shadow economy on the official sector, several studies integrate underground economies into theoretical and/or empirical macroeconomic models where ambiguous results have been found so far (Adam et al. 1985, Loayza 1996 or Neck et al. 1989).
Further, in the neoclassical view the hidden economy is optimal in the sense that it responds to the economic environment's demand for urban services and small-scale manufacturing. From this point of view the informal sector provides the economy with a dynamic and entrepreneurial spirit that can lead to more competition, higher efficiency and stronger boundaries for government activities. Put it differently, the informal sector may help to create markets, increase financial resources, enhance entrepreneurship and transform the legal, social and economic institutions necessary for accumulation (Asea 1996). It may be such that in highly developed countries people and entrepreneurs are overburdened by taxes and regulation so that a rising shadow economy stimulates the official growth as additional value added is created and additional income earned in the shadow economy is spent in the observed official sector. On the other hand in developing countries a rising shadow economy leads to a considerable erosion of the tax base with the consequence of a lower provision of public infrastructure and basic public services with the final consequence of lower official growth [4]
In order to empirically test the relationship between economic growth, the shadow economy and other possible factors in developing, transition und developed countries a panel data set containing variables[5] that growth theory suggests to be relevant for economic growth (Barro et al. 1995) for 104 countries [6] for the time period from 1990 to 2000 is used. A basic equation with the average annual growth rate of GDP per capita as the dependent variable is estimated and we found a highly interesting and statistically significant influence of the shadow economy on (official) economic growth for the entire sample. In industrialized countries this influence is positive while in developing countries the opposite holds. In particular this means:
All other variables (except the inflation rate in other countries) have plausible signs and are statistically significant on a 5 percent confidence level (for details see Table 1 in the Appendix).
Further two separate sub-samples of 21 OECD countries and 83 developing/transition countries were estimated because such a splitting up is an additional test of robustness for the findings from the total sample. When one focuses now more narrowly on 21 highly developed OECD countries similar results appear. The trend variable clearly has a negative and statistically significant influence on the official growth rate in OECD countries – a result which is not unusual for 1990s as it reflects the overall poor economic performance of most OECD countries during this period. Again the shadow economy has a positive and statistically significant influence on the official growth rate of GDP per capita in industrialized countries and an increase in the shadow economy by 1 percentage point of official GDP is associated with an increase in the annual GDP growth rate of 7.8 percent. In addition all other variables are statistically significant on a 5 percent confidence level and have plausible signs as theory would suggest (details see Table 2 in the Appendix).
The estimation of a sub-sample consisting of 83 transition and developing countries only also supports the findings from the total sample. Once again an increase of 1 percentage point in the relative size of the shadow economy increases official growth in transition countries by 9.9 percent and decreases growth in developing countries by 4.5 percent. As for other variables the inflation rate in other countries, the capital accumulation rate and foreign direct investment lagged for one period have no statistical significant influence, all other variables have plausible signs and a statistically significant influence (details see Table 3 in the Appendix).
5 SUMMARY AND CONCLUSIONS
There have been many obstacles to overcome to measure the size of the shadow economy and to analyze its consequences on the official economy but as this article shows some progress has been made and some insights into the size and development of the shadow economy of developing, transition and highly developed OECD countries can be given.
The first conclusion from these results is that for all countries investigated the shadow economy has reached a remarkably large size and the empirical results convincingly demonstrate that an increasing burden of taxation and social security payments combined with rising state regulatory activities are the major driving forces for the size and growth of the shadow economy.
Moreover it can be demonstrated that there is an empirically strong interaction of the shadow economy with government policies and with the official economy. The shadow economy has a statistically significant and quantitatively important influence on the growth of the official economy. For industrialized and/or transition countries this impact is positive while for developing countries it is negative and these results (at least partly) confirm the theoretical considerations about the dynamic effects of the shadow economy on the official sector. Finally to conclude: shadow economies are a complex phenomenon and are present in all type of economies to an important extent. People engage in shadow economic activities for a variety of reasons and among many we can count government actions, taxation and regulation as the most important ones. With these two insights goes a third, no less important one: a government aiming to decrease shadow economic activity has first and foremost to analyze the complex relationships between the official economy and the shadow economy – and even more important – the consequences of its own policy decisions.6 APPENDIX
Table 1: Panel Regression for the entire sample
| Dependent Variable |
Annual GDP per capita Growth Rate |
| Explanatory Variables: | Estimated Coefficients: |
| Shadow Economy Industrialized Countries [7] |
0.077** |
| (2.63) |
|
| Shadow Economy Developing Countries |
-0.052** |
| (2.37) |
|
| Openness |
0.012** |
| (2.14) |
|
| Inflation Rate Other Countries |
0.023 |
| (1.32) |
|
| Inflation Rate Transition Countries |
-0.021** |
| (4.10) |
|
| Government Consumption |
-0.181** |
| (3.23) |
|
| Lagged Annual GDP per capita Growth Rate |
0.154** |
| (3.06) |
|
| Total Population |
0.000036** |
| (2.07) |
|
| Capital Accumulation Rate |
0.019* |
| (1.88) |
|
| Constant |
0.062** |
| (4.13) |
|
| Number of countries |
104 |
| Overall R-Squared |
0.347 |
| Within R-Squared |
0.266 |
| Between R-Squared |
0.417 |
| Wald-CHI² |
94.63 |
| (0.000) |
|
| Absolute value of z-statistics in parentheses * significant at 10 % ** significant at 5 % Random effects GLS-regressions, 104 countries, period 1990-2000, annual data | |
Source: Own Calculation by authors
Table 2: Panel Regression for 21 highly developed OECD countries
| Dependent Variable |
Annual GDP per capita Growth Rate |
| Explanatory Variables: | Estimated Coefficients: |
| Trend Variable |
-0.003** |
| (3.36) |
|
| Shadow Economy |
0.078** |
| (2.05) |
|
| Openness |
0.016** |
| (2.47) |
|
| Capital Accumulation Rate |
0.127** |
| (3.47) |
|
| Annual FDI Growth Rate |
0.004** |
| (2.49) |
|
| Annual Labor Force Growth Rate |
0.951** |
| (2.44) |
|
| Constant |
6.206** |
| (3.36) |
|
| Number of countries |
21
|
| Overall R-Squared |
0.370
|
| Within R-Squared |
0.213
|
| Between R-Squared |
0.716
|
| Wald-CHI² |
51.10
|
| (0.000)
|
|
| Absolute value of z-statistics in parentheses * significant at 10 % ** significant at 5 % Random effects GLS-regressions, 21 countries, period 1990-2000, annual data | |
| Dependent Variable |
Annual GDP per capita Growth Rate |
| Explanatory Variables: | Estimated Coefficients: |
| Shadow Economy Transition Countries |
0.099** |
| (3.80) |
|
| Shadow Economy Developing Countries |
-0.045** |
| (-2.36) |
|
| FDI lagged |
0.00049 |
| (0.05) |
|
| Inflation Rate Other Countries |
0.0263 |
| (1.28) |
|
| Inflation Rate Transition Countries |
-0.021** |
| (-3.69) |
|
| Government Consumption |
-0.184** |
| (3.25) |
|
| Lagged Annual GDP per capita Growth Rate |
0.154** |
| (3.06) |
|
| Total Population |
0.000036* |
| (1.80) |
|
| Capital Accumulation Rate |
0.015 |
| (1.42) |
|
| Constant |
0.067** |
| (5.00) |
|
| Number of countries |
83
|
| Overall R-Squared |
0.321
|
| Within R-Squared |
0.263
|
| Between R-Squared |
0.443
|
| Wald-CHI² |
73.89
|
| (0.000)
|
|
| Absolute value of z-statistics in parentheses* significant at 10 % ** significant at 5 % Random effects GLS-regressions, 83 countries, period 1990-2000, annual data | |
Source: Own Calculation by authors
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