The make-up of the shadow economy

I have written about new estimates for the size of the shadow economy around the world in another post. That post triggered several reactions from readers who – rightfully – mentioned that the shadow economy isn’t necessarily bad. Some of it is simply a reflection of the way we measure GDP. The professional nurse, who cares for an elderly person and receives a salary is added to GDP, while the person who stays at home and cares for his or her elderly parent does not. GDP only accounts for monetary benefits if they are actually charged.

Also, the shadow economy might look very different in different countries. As one reader pointed out, in countries suffering from civil wars and terrorist insurgencies the shadow economy mostly consists of illegal and criminal activities.

The spread of the internet and social media has made it easier for organised crime to establish links with local insurgents and revolutionaries in the developing world. And since laws are typically not enforced and borders relatively easy to cross in a war-torn country, it has become increasingly easy for organised crime to create global value chains by cooperating with local insurgents. Usually, these global value chains focus on the production and export of natural resources and agricultural products. There is a reason why Afghanistan dominates the global production of opium and heroin and Colombia is the world’s biggest hub for coca production. And in Afghanistan, the opium trade is controlled by the Taliban, while the FARC rebels in Colombia dominated the coca trade in the past.

The cooperation between local insurgents as producers and international crime syndicates as distributors is beneficial for both parties. Organised crime doesn’t have to establish local dominance to control the production of natural resources, while insurgent groups can finance their struggle with the export of these products. In recent years, some insurgents even have become logistics operators themselves. For example, cocaine is increasingly smuggled from Latin America to Europe via West Africa where local insurgencies such as Boko Haram finance their operations with trafficking drugs destined for Europe.

In industrialised countries, on the other hand, criminal activities and corruption typically only account for a small part of the shadow economy. A 2013 survey in the European Union tried to identify the main reasons why people engaged in the local shadow economy.

Trying to avoid high income taxes and social security contributions accounted for c. 40% to 50% of the size of the shadow economy. However, as our chart below shows, the tax rate is not necessarily a determining factor of the total size of the shadow economy. The average size of the shadow economy in industrialised countries is about the same whether you look at low tax countries like Switzerland or Singapore or at countries with famously high taxes, such as the Scandinavian countries or Australia. Other important factors that motivate people to participate in the shadow economy are bureaucracy and labour market regulations that make it hard to engage in legal work or the fear to lose social security payments. In other words, the shadow economy in industrialised countries consists mostly of people who are employed illegally to circumvent social security obligations or continue to claim benefits despite being gainfully employed.

Armed with these insights, researchers conclude that to reduce the size of the shadow economy it isn’t enough to simply reduce taxes. In fact, cutting taxes and social security benefits will likely do nothing to prevent people from participating in the shadow economy. Instead, what is effective is the reduction of red tape and entry barriers to legal work. This can come in the form of reduced qualification requirements for certain jobs or partial payment of social benefits for people who come out of unemployment.

And as always, the best way to reduce the size of the shadow economy is the hardest to implement in practice. It has become increasingly clear that people who experience the value of paying taxes first hand are least likely to avoid them. Countries like Sweden may have high tax rates, but citizens experience the value for money of their taxes every day in the form of free health care, education and other services. If the perceived value for money of taxes declines and citizens lose trust in the government and the democratic process, they are more likely to drop out of the legal economy as well.

Estimated size of the shadow economy in selected countries

Source: Medina and Schneider (2019).

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