World Bank Report Finds Underground Economies More Affected by Economic Conditions Than Policy Measures

August 6th, 2010

A new working paper from the World Bank finds that the shadow economy is on the rise, constituting roughly 1/3 of GDP around the globe.  Transparency would dramatically curtail this underground activity.

World Bank headquarters | Photo by Shiny Things

Economic factors do a better job than regulations of reigning in the size of underground economies.  So claims a recent study by Shneider, Buehn, and Montenegro, Shadow Economies All over the World. This World Bank policy research working paper analyzes the sizes and causes of the shadow economies of 162 countries in various stages of development across the globe.  The report, released last month, finds that economic conditions generally influence the size of shadow economies more than policy measures.  The report’s findings are important in the field of understanding illicit financial flows (IFFs) because of the illicit, unrecorded nature of the underground economy.  Money in the shadow economy and illicit financial flows hurt countries in a similar way: it is all off the books and therefore never taxed.

The report uses a narrow definition of the “shadow economy” that does not include typical underground activities such as drug trafficking and robbery.  Nor does it include tax evasion.  What it does include is the sale of legally-produced goods and services that goes unreported to public authorities in order to avoid paying taxes and social security contributions, meeting legal labor standards, and complying with administrative procedures.

The average size of the shadow economy throughout the 162 countries in the study was 34.5% of official GDP, or a little over a third the size of what they produce overall.  Yet, the shadow economy’s average rate of growth over the period was rather modest: it grew from 33.7% of GDP in 1999 to 35.5% of GDP in 2007.  The authors identify four main driving forces of the shadow economy: (1)overall tax, both direct and indirect, and social security contribution burdens, (2) intensity of regulations, (3) public sector services, and (4) the state of the “official” economy.

The paper divides causal variables of the shadow economy into two categories: economic variables and policy variables.  Economic variables describe a country’s level of development and the state of its economy and include things such as GDP per capita and the unemployment rate.  Policy variables include regulations and various measures of the tax burden.  When examining the results, the authors find that economic variables generally influence the size of shadow economies more than policy ones.

This makes sense: people respond to incentives, and money is very persuasive.  If you are unemployed and unable to find work in the official economy, do you pass up a job in the unofficial economy even if it pays below minimum wage or does not fully comply with labor standards?  If you run a business that stands to greatly increase profits by paying workers under the table and not paying social security contributions, do you shift that business into the shadow economy and more profit into your pockets?  These temptations abound in countries with booming underground economies.

The paper concludes that if governments can implement incentive-oriented policy measures that make work in the shadow economy less attractive, this may lead to a stabilization, or even reduction, in the size of the shadow economy.  While governments cannot change economic conditions such as GDP per capita by will, they can implement economy-oriented policies that will induce, or increase the incentive for, certain behaviors, such as keeping one’s money in the official economy.  The paper prescribes that the best policy measure governments can take to reduce the size of the shadow economy is to reduce the tax burden.  With lower taxes, there is less of an economic incentive to skirt those taxes and do business in the shadow economy or abroad.  The next best option for reducing the underground economy’s size would be lessening fiscal and business regulations, a policy with direct economic benefits for businesses that choose to operate in the official economy.

So we see that increased regulations alone will not solve the problem of the growing shadow economy.  Regulations, in fact, are shown to spur its growth.  This is not to say that all regulations are bad; on the contrary many are necessary.  But excessive regulations and restrictions will only push more and more people into the shadow economy, thereby depriving the government of more and more tax revenue and infringing on the rights of those who must seek employment in the shadow economy, where working conditions may be dismal and minimum wage just a myth.

Increased financial transparency will help reduce the size of the shadow economy.  It becomes more difficult to conduct illegal financial activities when the transfer, banking and reporting processes are more transparent and globally accessible.  If people cannot hide their money, then they cannot use it in unrecorded exchanges without arousing suspicion.  If all income is recorded, then none of it can skirt income taxes.  Underground economies can no longer remain in the shadows when the financial activities that drive them are brought into the light and rendered transparent.

Written by Caroline Davidson

Follow @FinTrCo