Lecture 4 (Shadow Economy)
Theoretically, corruption and the shadow economy can be either complements or substitutes. Choi and Thum (2004)
present a model where the option of entrepreneurs to go underground constrains a corrupt official’s ability to ask for
bribes.
Dreher, Kotsogiannis and McCorriston (2005) Their model shows that corruption and shadow economy are substitutes
in the sense that the existence of the shadow economy reduces the propensity of officials to demand grafts.
Johnson et al. (1998), to the contrary, model corruption and the shadow economy as complements.
In their full-employment model, labor can be either employed in the official sector or in the underground economy.
Consequently, an increase in the shadow economy always decreases the size of the official market. In their model,
corruption increases the shadow economy, as corruption can be viewed as one particular form of taxation and regulation
Hindriks et al. (1999) also show that the shadow economy is a complement to corruption. This is because, in this case,
the tax payer colludes with the inspector so the inspector underreports the tax liability of the tax payer in exchange for a
bribe.
Agenda
1. The Shadow Economy: Definition
2. The Shadow Economy: Measurements
3. The Shadow Economy and Development
4. The Shadow Economy: Main Causes
5. The Shadow Economy: MENA vs. R.O.W
Definition of the Shadow Economy
“Narrow” Definition of the Shadow Economy (Schneider, 2005)
•the shadow economy defined as
• “all market-based legal production of goods and services that are deliberately concealed from public authorities for
the following reasons:
(1) to avoid payment of income, value added or other taxes,
(2) to avoid payment of social security contributions,
(3) to avoid having to meet certain legal labor market standards, such as minimum wages, maximum working hours, and
safety standards,
“Narrow” Definition of the Shadow Economy (Schneider, 2005) •the shadow economy defined as
• “all market-based legal production of goods and services that are deliberately concealed from public authorities for
the following reasons:
(4) to avoid complying with certain administrative procedures, such as completing statistical questionnaires or other
administrative forms.”
“Narrow” Definition of the Shadow Economy (Schneider, 2005)
• Which items are not included in the Schneider definition of the Shadow Economy?
• Typical economic activities that are illegal and fit the characteristics of classical crimes: crimes like burglary, robbery,
drug dealing, etc.
• Informal household economy, which consists of all household services and production
Numerous terms exist to describe this concept:
• Shadow economy, • Informal economy, • Hidden economy, • Irregular economy, • Black economy, • Unofficial
economy, • Parallel economy, • Underground economy, • Marginal economy, • Unregistered economy, • Dual economy,
and so on
Shadow economy measurements
• Estimating the size of the informal economy is a challenge as the purpose of operating in it is often to avoid detection
and countries may lack the capacity to monitor underground activity.
• While there are no direct measures of the size and composition of the underground economy, a number of indirect
methods have been proposed, although each of these has drawbacks.
Shadow economy measurements 1- Currency demand approach:
• Since most transactions in the underground economy are conducted in cash, this approach estimates the size of the
underground economy from the excess demand for cash
2- Electricity demand approach:
• Assumes that electricity usage is a good physical indicator of economic activity, and estimates the growth of the
underground economy based on the difference between growth rate of electricity consumption and the official GDP
growth.
• If the growth of electricity consumption is significantly higher than formal economy growth rate, then that can be an
indicator for the shadow economy activities.
3- Labor force approach:
• A decline in labour-force participation in the official economy can be seen as an indication of increased activity in the
shadow economy.
If total labour-force participation is assumed to be constant, a decreasing official rate of participation, ceteris paribus,
can be seen as an indicator of an increase in illicit activities.
The participation rate is a measure of the active portion of an economy's labor force. It refers to the number of people
who are either employed or are actively looking for work.
People not included in the participation rate include those who do not want to work or cannot work.
4- Multiple indicators multiple causes model (MIMIC model):
• Estimates the size of the shadow economy based on multiple observed variables that are presumed to cause it,
including
– Tax burden – Regulatory burden – Quality of institutions – Inflation and unemployment – Level and growth of
economic development – Government spending – Black market premium, …. Etc
4- Multiple indicators multiple causes model (MIMIC model):
• Previous Table presents various measures of the size of the informal sector, with 185 countries grouped by the
quartile of per capita income. Fortunately, the very different measures of informality all paint a consistent picture.
• Depending on the indicator, the informal sector accounts for 30–40 percent of total economic activity in the poorest
countries, and a higher share of employment. This falls to something closer to 15 or 20 percent in the richest quartile
countries.
• The last column of Table offers another perspective: the poorest countries average about three registered firms per
1,000 people; in the richest quartile countries, this number rises to 42 per 1,000 people. Especially in the poor countries,
the informal sector is huge, accounting for a giant share of output and employment
On previous Figure:
• In La Porta and Shleifer (2008), authors conduct an extensive analysis of size and productivity of formal and informal
firms using data from poor countries where the World Bank surveyed both formal and informal businesses. Several
findings stand out.
• First, informal firms—even the real businesses surveyed by the World Bank—are much smaller than formal firms. An
average formal firm employs 126 people, while an average informal firm employs only 4. Informal firms are also much less
productive, with productivity calculated as value added (sales net of expenditures on raw materials and energy) per
employee.
• As previous Figure shows, in the median sample country, informal firms add only 15 percent of the value per
employee of formal firms. The ratio of value added by informal firms to that by formal firms ranges from 1 percent in
Congo to 70 percent in Cape Verde.
• In La Porta and Shleifer (2008), the authors present some evidence indicating that these productivity differences
reflect reality, not just underreporting of sales to interviewers by informal firms
On Figure 2:
There are two other ways to see the extreme inefficiency of the informal sector.
• First, although productivity increases with size within the formal sector (as Hsieh and Olken discuss in their paper in
this issue), Figure 2 shows a sharp productivity difference between informal firms and formal firms of the same size (in
the median sample country, informal firms add 21 percent of the value per employee of formal firms).
• Inefficiency of the informal sector is not just a matter of small size.
• Second, in La Porta and Shleifer (2008), authors also find that, averaging across countries, wages in informal firms are
roughly one-half of those in small formal firms and less than one-third of those in large formal firms, another indication of
low productivity.
• Many informal entrepreneurs would gladly close their businesses to work as employees in the formal sector if offered
the chance, even if wages in the formal sector are taxed while income in the informal sector is not. Few of them have this
opportunity
In La Porta and Shleifer (2008), authors explore the sources of productivity differences between formal and informal
firms. One interesting finding is that differences in the human capital of workers are small, at least as measured by
education. The data on formal and informal firms contains no direct measures of capital, although formal firms are much
more likely to have their own electricity generators. One of the most striking differences between formal and informal
firms is in the human capital of their managers. Figure 3 presents World Bank survey data on the fraction of informal and
formal firms run by college-educated managers.
Consistent with the dual view, only 7 percent of the managers of informal firms have a college degree, while this
number is 76 percent for the formal firms. In production function estimates, managerial human capital emerges as a
quantitatively large and statistically significant determinant of productivity.
In Gennaioli, La Porta, Lopez-de-Silanes, and Shleifer (2013), authors report closely related findings for formal firms
around the world. They document enormous productivity gaps between firms run by educated versus uneducated
managers and entrepreneurs. Production function estimates imply nearly 30 percent returns per extra year of education
of managers, even though estimated returns to an additional year of worker education are in the standard range of 6–7
percent.
The message that emerges consistently from this work is that informal firms are hugely unproductive, and a principal
reason is the low level of human capital of the people who run them.
Why study of the shadow economy is important?
Large underground economies pose problems for policy making
• Vicious cycle can be set off, as governments with large informal or underground economies may raise tax rates to
make up revenues, encouraging further enlargement of the underground economy
• The informal sector in an economy may be a source of unfair competition to formal firms. Why?
• Moreover, large informal economies render official statistics unreliable and incomplete, complicating the formulation
of informed policies.
Example of such data problems in the presence of shadow economy?
Main Causes of the Shadow Economy
1. Tax and social security contribution burdens
• Studies point to tax and social security burdens as one of the main causes of the existence of the shadow economy.
• Since taxes affect labor–leisure choices, and also increase labor supply in the shadow economy, the distortion of the
overall tax burden is a major concern.
• The greater the difference between the total cost of labor in the official economy and after-tax earnings from work,
the greater is the incentive to work in the shadow economy.
• Empirical studies of the influence of the tax burden on the shadow economy by Schneider (1994, 2000) and Johnson et
al. (1998) show statistically significant evidence for the influence of taxation on the shadow economy.
But, there is a vicious circle in Shadow Economy – Tax Burden nexus
• The higher the tax burden, the larger the shadow economy – and the larger the shadow economy, the smaller the tax
base.
• Hence, to finance a given supply of public goods, the tax rate needs to increase, which in turn leads to more incentives
to work illicitly.
• Direction of causality is not much clear.
• More theoretical arguments for effect of tax burden on the shadow economy.
2. Density of regulation
• a high level of regulation can impose rigidities and distort incentives for: – factor reallocation, – capital accumulation,
– competition, and – innovation in the official economy
• In the absence of perfect monitoring and compliance, firms and individuals will find it optimal (or necessary) to evade
regulations and work outside the strict legal regime (Loayza, Oviedo, and Servén (2006: 121–2)).
The informal sector is only the second-best response to regulation, because…?
Because firms lose the advantages of legality, such as:
• police and • judicial protection or • access to formal credits
• The intensity of regulations in these models is measured by:
• the number of laws and regulations, such as licence requirements, labour market regulations, trade barriers,
and labour restrictions for immigrants (e.g., Johnson,
Kaufmann, and Zoido-Lobato´n (1998a); Loayza and Rigolini (2006)).
• Loayza, Oviedo, and Servén state:
• countries with better institutions tend to create regulatory environments genuinely aimed to improve business
conditions rather than privilege a few interest groups.
• They are also more likely to enforce regulation in a transparent and even-handed manner, limiting the regulator’s
margin for arbitrariness and corruption.
De Soto (1989) has famously argued that informal firms would like to become formal, but are held back by corruption
and government regulation.
• World Bank Enterprise Surveys of informal entrepreneurs allow a direct assessment of this view.
• Next table compares perceived obstacles to doing business reported by informal and formal entrepreneurs.
• By far the greatest perceived obstacle by both types of firms is lack of access to finance, although informal firms
perceive this as a much greater problem.
Why don’t informal firms become formal?
• Next to perceived financing problems, government regulations are distant concerns.
• Fewer than 10 percent of either formal or informal firms worry about each of the following categories: corruption;
business licensing and permits; or the legal system.
• Lack of access to land is a bigger problem for informal firms.
3. An empirical example (effect of tax system complexity on shadow economy):
• A sample of more than 100 countries.
• Dependent Variable: Self-employed, total (% of total employed) (a proxy for informal economy). Average 2006-2015
• Independent Variable: Time to prepare and pay taxes (hours) (a proxy for regulation (tax) density). Average 2000-2005
• Q: what is the effect of higher tax burden on informality of economic agents?
Main Causes Of The Shadow Economy
Time to prepare and pay taxes is the time, in hours per year, it takes to prepare, file, and pay (or withhold) three major
types of taxes: the corporate income tax, the value added or sales tax, and labor taxes, including payroll taxes and social
security contributions.
Self-employed workers are those workers who, working on their own account or with one or a few partners or in
cooperative, hold the type of jobs defined as a "selfemployment jobs." i.e. jobs where the remuneration is directly
dependent upon the profits derived from the goods and services produced. Self-employed workers include four
subcategories of employers, own-account workers, members of producers' cooperatives, and contributing family workers
3. quality of institutions and shadow economies
If the state guarantees property rights and provides a well-developed infrastructure and public goods according to the
preferences of the people, paying taxes and fees is accepted.
Back to our example: We control now corruption index of WGI data (re-scaled by *-1: higher scores mean now higher
corruption).
4. Unemployment:
• The relation between shadow economy and unemployment rate is ambiguous (Tanzi (1999) and Giles and Tedds
(2002)).
• However, the greater the number of unemployed, the more individuals will be willing to find a job in the shadow
economy.
• Nevertheless, it is also possible that job opportunities in the shadow economy are limited when unemployment levels
are excessively high.
• The unemployment rate is one of the many indicators of the state of the economy, and when it increases, business
sector offer fewer jobs of all types, whether official or clandestine.
• Thus, the expected sign for this indicator is also ambiguous.
5. Disposable income per capita:
• If individuals have low disposable income, it is to be expected that they are more willing to do various jobs, some of
them in the shadow economy.
• But lower income per capita, may also means lower demand for all goods and services in both formal and informal
markets.
