Nama: Herawan Caraka

NIM :299164

Shadow Economies and Corruption All Over the World: Revised Estimates
for 120 Countries
Friedrich Schneider and Andreas Buehn
University of Linz, Austria; Technische Universität Dresden, Germany

Definition of Shadow Economies

Most authors trying to measure the shadow economy face the difficulty of how to
define it. One commonly used working definition is all currently unregistered economic
activities that contribute to the officially calculated (or observed) Gross National Product5.
Smith (1994, p. 18) defines it as “market-based production of goods and services, whether
legal or illegal, that escapes detection in the official estimates of GDP.” Or to put it in another
way, one of the broadest definitions of it includes…“those economic activities and the
income derived from them that circumvent or otherwise avoid government regulation,
taxation or observation”.6
In this paper the following more narrow definition of the shadow economy is used7: The
shadow economy includes 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 labour market standards, such as minimum
wages, maximum working hours, safety standards, etc., and
(4) to avoid complying with certain administrative procedures, such as completing
statistical questionnaires or other administrative forms.
Hence, in this paper, we will not deal with typical underground, economic (classical
crime) activities, which are all illegal actions that fit the characteristics of classical crimes
like burglary, robbery, drug dealing, etc. We also exclude the informal household economy
which consists of all household services and production

The Main Causes of the Shadow Economy

1. Tax and Social Security Contribution Burdens
In almost all studies9 it has been ascertained that the overall tax and social security
contribution burdens are among the main causes for the existence of the shadow economy.
Since taxes affect labour-leisure choices, and also stimulate labour supply in the shadow
economy, the distortion of the overall tax burden is a major concern for economists. The
bigger the difference between the total cost of labour 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 depends broadly on the social security
burden/payments and the overall tax burden, they latter are key features of the existence and
the increase of the shadow economy
2 Intensity of Regulations
Increased intensity of regulations is another important factor which reduces the
freedom (of choice) for individuals engaged in the official economy. One can think of labour
market regulations, trade barriers, and labour restrictions for foreigners every available
measure of regulation is significantly correlated with the share of the unofficial economy and
the estimated sign of the relationship is unambiguous: more regulation is correlated with a
larger shadow economy.
3. Public Sector Services
An increase of the shadow economy can lead to reduced state revenues which in turn
reduce the quality and quantity of publicly provided goods and 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 in the quality of the public goods (such as the public
infrastructure) and of the administration, with the consequence of even stronger incentives to
participate in the shadow economy

Econometric Results
In Tables, the econometric estimations using the MIMIC approach (latent estimation
approach) are presented for the 76 developing countries, and the 25 high income OECD-
countries of our sample. This grouping was necessary because the available data is different
for these countries. For the developing countries, two estimations with and without the
unemployment rate as causal variable are presented; without unemployment rate the number
of developing countries increase from 57 to 76. For the high income OECD countries again
two estimations are shown with and without the causal variable tax morale. For the 76
developing countries the estimation was done for six different points of time
For the developing countries we use as cause variables the following seven: share of
direct taxation (direct taxes in percent of overall taxation), size of government (general
government final consumption expenditure, in percent of GDP) as proxy for indirect taxation
and fiscal freedom (an index consisting of top individual income tax rate, top individual
corporal tax rate, and total tax revenues as percent of GDP) as three tax burden variables in a
wide sense; the business freedom index (which has the elements: time to open a business,
financial costs to start a business, minimum capital stock to start a business, and costs for
obtaining a licence) for state regulation, the state of economy with the two variables: the
unemployment rate and GDP per capita and finally an index of economic freedom. As
indicator variables we use growth rate of GDP per capita, the employment quota (people over
15 economically active in % of total population), and the annual rate of local currency per
capita.
Finally, in Tables 3.3.1, the estimation results for the 25 high income OECD countries
are shown. Table 3.3.1 shows the estimation without the tax morale variable for 25 countries
over a data set from 1996 up to 2006. If we consider first Table 3.3.1, the results without the
tax morale variable, the two variables capturing government burden (total tax burden and
fiscal freedom) are highly statistically significant and have the expected sign. The
unemployment rate has the expected sign and is at 90 percent confidence level statistically
significant. Turning to the indicator variables, the labour force participation rate and currency
as ratio of M2 are both highly statistically significant. Also, the test statistics for this equation
is quite satisfactory.
Summarizing the econometric (MIMIC) results, we can demonstrate that for all three
groups of countries, the theoretical consideration of the causes of the shadow economy in
Section 2 can be confirmed. Tax burden variables (direct and/or indirectand/or overall tax
burden or other indices) as well as indices measuring the fiscal freedom in a country are
driving forces for the growth of the shadow economy in all three types of countries. Followed
by the measures of regulation (measured in the business freedom variable and regulatory
intensity) and by measures of the official economy, the unemployment rate, and for the
developing countries, GDP per capita have a highly statistically significant influence and/or
overall tax burden or other indices) as well as indices measuring the fiscal freedom in a
country are driving forces for the growth of the shadow economy in all types of countries.
Followed by the measures of regulation (measured in the business freedom variable and
regulatory intensity) and by measures of the official economy, the unemployment rate, and
for the developing countries, GDP per capita have a highly statistically significant influence.
Corruption and the Shadow Economy: Substitutes or Complements?
Quite often shadow economy and corruption20 are seen as “twins”, who need each
other or fight against each other. This means for a social scientist that, theoretically,
corruption and the shadow economy can be either complements or substitutes. Choi and
Thum (2005) 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 (2005a
and2005b) extend the model to the explicit specification of institutional quality. The 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 graft.
In summary, we thus formulate the following two hypotheses:
Hypothesis 1: In low income countries, shadow economy activities and corruption are
complements.
Hypothesis 2: In high income countries, shadow economy activities and corruption are
substitutes.
The estimated coefficients for the paths between corruption and the shadow economy
and vice versa measure the influence of the latent variables (i.e. corruption and the shadow
economy) on each other. Although the mutual relationship between corruption and the
shadow economy is positive across all estimated specification (not shown here), the
coefficients for the two paths differ substantially in magnitude. That is, the causal effect of
the shadow economy on corruption is stronger than the effect of corruption on the shadow
economy. One possible explanation for this is that corruption functions as an additional tax in
the official economy—which, in turn, increases the size of the shadow economy. Likewise,
the shadow economy induces higher corruption as bureaucrats exploit their positions of
power and as firms or individuals willingly pay bribes and hide their underground activities.
In addition, the shadow economy can also be seen as an indication of overall deterioration of
social and cultural norms, which results in even more widespread corruption
Summary and Conclusions
There have been many obstacles to overcome to measure the size of the shadow
economy, to analyze its consequences on the official economy and the interaction between
corruption and the shadow economy, but as this paper shows some progress has been made.
We provided estimates of the size of the shadow economies for 120 countries for five periods
of time using the MIMIC procedure for the econometric estimation, and the currency demand
approach for calibrating the estimated values of the size of the shadow economy into absolute
ones. Coming back to the headline of this paper, some new knowledge/insights are gained
with respect to the size and development of the shadow economy of 120 countries,24 and to
the relationship between the shadow economy and corruption leading to four conclusions:
The first conclusion from these results is that for all countries investigated the shadow
economy has reached a remarkably large size of an average value of 32.3% of official GDP
over 120 countries over 1999/00 to 2005/06. However, the average size of the shadow
economies of all three groups of countries (76 developing countries, , and 25 high income
OECD countries) increased only modestly from 31.8% of official GDP in 1999/00 to 32.7%
of official GDP in 2005/06.
The second conclusion is that shadow economies are a complex phenomenon present
to an important extent in all type of economies (developing, transition and highly developed).
People engage in shadow economic activity for a variety of reasons, among the most
important of which we can count are government actions, most notably, taxation and
regulation.
Considering a public choice perspective a third conclusion for highly developed
countries is that a government may not have a great interest to reduce the shadow economy
due to the fact that:
(i) tax losses my be moderate, as at least 2/3 of the income earned in the shadow economy is
immediately spent in the official economy,
(ii) income earned in the shadow economy increases the standard of living of at least 1/3 of
the working population,
(iii) between 40 and 50% of the shadow economy activities have a complementary character,
which means that additional value added his created, which increases the official (overall)
GDP, and
(iv) people who work in the shadow economy have less time for other things like going to
demonstrations, etc.