Measuring the shadow economy

Last week, I wrote a post on the influence of mafia firms in Italy. But criminal activities are peanuts in comparison to the size of the shadow economy, i.e. the economic activities in a country that are not reported to tax authorities or other government agencies. These are the plumbers who work on a cash-only basis and never report the revenue to the tax authorities, the consultants who report some project income but not others and the many small businesses who run two sets of books. In other words, these are legal economic activities that are performed under the radar screen of the government. 

And it includes facilitation payments (aka bribes) to individuals for better service, etc. Ironically, the difference between bribery and regular business can be quite small in some cases. For example, in many poorer countries of this world, you need to pay a doctor an incentive payment to get better medical treatment. That is called bribery. In many developed countries, on the other hand, you can buy private health insurance from a company that will give you access to better treatment options. That is called capitalism. 

As you might guess, it isn’t easy to measure the size of this shadow economy, but there have been several approaches. First, researchers have tried to elicit the size of the shadow economy with the help of surveys or analysis of tax audits. But the problem with this approach is that tax audits are typically only performed on higher-income persons and not the many small fish while surveys depend on the honesty of the respondents. But why would respondents be honest about an activity that, if discovered, could get them into legal trouble? 

Another approach, that is more promising is to look at differences in different macroeconomic indicators. For instance, one can look at the difference between reported employment figures and actual employment, or the GDP as calculated by the income method vs. the expense method. You can underreport income, but it is hard to cover up consumption and other expenses. Or one can estimate true GDP with the help of satellite imaging of night-time activities which gives an independent measure of the size of the economy and compare this with the official figure.

If you combine these different macroeconomic approaches into one large regression analysis, you can get an estimate of the size of the shadow economy around the globe. And the size of it is astonishing (at least to me). On average it was about 30.9% of GDP between 1991 and 2017 according to a recent study by Leandro Medina and Friedrich Schneider. It was lowest in Switzerland (6.4%), the United States (7.6%) and Austria (7.9%) and highest in Bolivia (62.9%), Georgia (61.7%) and Nigeria (56.8%). Not surprisingly, those countries with a large shadow economy also rank low on the list of countries by the perception of corruption, meaning that corruption seems omnipresent in these countries. Out of 180 countries, Nigeria ranks number 144 and Bolivia number 132. Georgia, on the other and is a surprising number 41 in the perception of corruption index.

In general, however, the map below shows that developed countries have a relatively small shadow economy. The OECD average of the shadow economy is about 15% of GDP. It is highest in Latin America (34% on average) and Sub-Saharan Africa (34.4%). In these regions a lot of government tax income is lost to the shadow economy and the fight against corruption and the shadow economy is an important way to enhance economic growth and prosperity.

Estimated size of the shadow economy

Source: Medina and Schneider (2019). Note: % of GDP, darker colors imply a larger shadow economy.