The size of the shadow economies

IZA DP No. 1431
The Size of the Shadow Economies
of 145 Countries all over the World:
APER SERIES
First Results over the Period 1999 to 2003
Friedrich Schneider
DISCUSSION P
December 2004
Forschungsinstitut
zur Zukunft der Arbeit
Institute for the Study
of Labor

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The Size of the Shadow Economies
of 145 Countries all over the World:
First Results over the Period 1999 to 2003






Friedrich Schneider
University of Linz
and IZA Bonn






Discussion Paper No. 1431
December 2004






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IZA Discussion Paper No. 1431
December 2004


















ABSTRACT

The Size of the Shadow Economies of 145 Countries all
over the World: First Results over the Period 1999 to 2003

Using the DYMIMIC approach, estimates of the shadow economy in 145 developing,
transition, developed OECD countries, South Pacific islands and still communist countries
are presented. The average size of the shadow economy (in percent of official GDP) over
2002/2003 in developing countries is 39.1%, in transition countries 40.1%, in OECD countries
16.3%, South Pacific islands 33.4% and 4 remaining Communist countries 21.8%. An
increasing burden of taxation, high unemployment and low official GDP growth are the driving
forces of the shadow economy.



JEL Classification:
O17, O5, D78, H2, H11, H26

Keywords:
shadow economy, tax burden, government regulation, DYMIMIC method



Friedrich Schneider
Department of Economics
University of Linz
4040 Linz-Auhof
Austria
Email: friedrich.schneider@jku.at

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Contents

1 Introduction .......................................................................................................................3
2 Some Theoretical Considerations about the Shadow Economy....................................4
2.1
Defining the Shadow Economy .................................................................................................4
2.2
The Main Causes of Determining the Shadow Economy..........................................................6
2.2.1
Tax and Social Security Contribution Burdens ............................................................................... 6
2.2.2
Intensity of Regulations .................................................................................................................. 7
2.2.3
Public Sector Services..................................................................................................................... 8
3 The Size of the Shadow Economies all over the World –Findings for 145 Countries.9
3.1
Introductionary Remarks ..........................................................................................................9
3.2
The Size of the Shadow Economies for 145 Countries for 1999/2000, 2001/2002 and
2002/2003 .................................................................................................................................9
3.2.1
Developing Countries ................................................................................................................... 10
3.2.2
Transition Countries...................................................................................................................... 23
3.2.3
Highly developed OECD-Countries.............................................................................................. 28
3.2.4
South West Pacific Islands............................................................................................................ 32
3.2.5
Communist Countries.................................................................................................................... 36
4 Summary and Conclusions .............................................................................................40
5 Appendix: Methods to Estimate the Size of the Shadow Economy ............................42
5.1
Direct Approaches .................................................................................................................. 42
5.2
Indirect Approaches................................................................................................................ 43
5.2.1
The Discrepancy between National Expenditure and Income Statistics ....................................... 43
5.2.2
The Discrepancy between the Official and Actual Labor Force ................................................... 44
5.2.3
The Transactions Approach .......................................................................................................... 44
5.2.4
The Currency Demand Approach.................................................................................................. 45
5.2.5
The Physical Input (Electricity Consumption) Method................................................................. 48
5.3
The model approach ............................................................................................................... 50
5.4
The Size and Development of the Shadow Economies of 145 Countries over 1999/2000 to
2002/2003 ...............................................................................................................................54
6 References.........................................................................................................................58

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1 Introduction

As shadow economic activities are a fact of life around the world, most societies attempt to
control these activities through various measures like punishment, prosecution, economic
growth or education. Gathering statistics about who is engaged in shadow economy activities,
the frequencies with which these activities are occurring and the magnitude of them, is crucial
for making effective and efficient decisions regarding the allocations of a country’s resources
in this area. Unfortunately, it is very difficult to get accurate information about these shadow
economy activities on the goods and labor market, because all individuals engaged in these
activities wish not to be identified. Hence, the estimation of the shadow economy activities
can be considered as a scientific passion for knowing the unknown.

Although quite a large literature1) on single aspects of the hidden or shadow economy exists
and a comprehensive survey has been written by Schneider (the author of this paper) and
Enste (2000), the subject is still quite controversial2) as there are disagreements about the
definition of shadow economy activities, the estimation procedures and the use of their
estimates in economic analysis and policy aspects.3) Nevertheless around the world, there are
some indications for an increase of the shadow economy but little is known about the
development and the size of the shadow economies in transition, development and developed
countries over the latest period 1999/2000 to 2002/2003.

Hence, the goal of this paper is twofold: to undertake the challenging task to estimate the
shadow economy for 145 countries all over the world and to provide some insights about the
main causes of the shadow economy. In section 2 an attempt is made to define the shadow
economy and some theoretical considerations about the reasons why the shadow is increasing
are undertaken. Section 3 presents the empirical results of the size of the shadow economy
over 145 countries all over the world. In section 4 a summary is given and some policy

1) The literature about the „shadow“, „underground“, „informal“, „second“, “cash-“ or „parallel“, economy is
increasing. Various topics, on how to measure it, its causes, its effect on the official economy are analyzed. See
for example, survey type publications by Frey and Pommerehne (1984); Thomas (1992); Loayza (1996); Pozo
(1996); Lippert and Walker (1997); Schneider (1994a, 1994b, 1997, 1998a); Johnson, Kaufmann, and Shleifer
(1997), Johnson, Kaufmann and Zoido-Lobatón (1998a, 1998b); Belev (2003); Gerxhani (2003) and Pedersen
(2003). For an overall survey of the global evidence of the size of the shadow economy see Schneider and Enste
(2000, 2002), Schneider (2003, 2005) and Alm, Martinez and Schneider (2004).
2) Compare e.g. in the Economic Journal, vol. 109, no. 456, June 1999 the feature “controversy: on the hidden
economy”.
3) Compare the different opinions of Tanzi (1999), Thomas (1999), Giles (1999a,b) and Pedersen (2003).
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conclusions are drawn. Finally in the appendix (chapter 5) the various methods to estimate the
shadow economy are presented and critically evaluated.


2 Some Theoretical Considerations about the Shadow Economy

2.1 Defining the Shadow Economy

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 Product.4) 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 other wise government regulation, taxation or observation”.5) As
these definitions still leave open a lot of questions, table 2.1 is helpful for developing a better
feeling for what could be a reasonable consensus definition of the underground (or shadow)
economy.

From table 2.1, it becomes clear that a broad definition of the shadow economy includes
unreported income from the production of legal goods and services, either from monetary or
barter transactions – and so includes all economic activities that would generally be taxable
were they reported to the state (tax) authorities. In this paper the following more narrow
definition of the shadow economy is used:6) 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,

4) This definition is used for example, by Feige (1989, 1994), Schneider (1994a, 2003, 2005) and Frey and
Pommerehne (1984). Do-it-yourself activities are not included. For estimates of the shadow economy and the do-
it-yourself activities for Germany see Karmann (1986, 1990).
5) This definition is taken from Del’Anno (2003), Del’Anno and Schneider (2004) and Feige (1989); see also
Thomas (1999), Fleming, Roman and Farrell (2000).
6) Compare also the excellent discussion of the definition of the shadow economy in Pedersen (2003, pp.13-19),
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(3) to avoid having to meet certain legal labor 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, I will not deal with typical underground, economic (classical crime)
activities, which are all illegal actions that fits the characteristics of classical crimes like
burglary, robbery, drug dealing, etc. I also include not the informal household economy
which consists of all household services and production. Also this paper does not focus on
tax evasion or tax compliance, because it would get to long, and moreover tax evasion is a
different subject, where already a lot of research has been underway.7)

Table 2.1: A Taxonomy of Types of Underground Economic Activities1)
Type of Activity
Monetary Transactions
Non Monetary Transactions



Illegal
Trade with stolen goods; drug dealing Barter of drugs, stolen goods,
Activities
and manufacturing; prostitution;
smuggling etc. Produce or growing
gambling; smuggling; fraud; etc.
drugs for own use. Theft for own
use.






Tax Evasion
Tax
Tax Evasion
Tax Avoidance
Avoidance

Unreported income
Employee
Barter of legal
All do-it-yourself
Legal
from self-
discounts,
services and
work and
Activities
employment; Wages,
fringe benefits
goods
neighbor help
salaries and assets
from unreported work
related to legal
services and goods
1) Structure of the table is taken from Lippert and Walker (1997, p. 5) with additional remarks.


who uses a similar one.
7) Compare, e.g. the survey of Andreoni, Erard and Feinstein (1998) and the paper by Kirchler, Maciejovsky and
Schneider (2002).
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2.2 The Main Causes of Determining the Shadow Economy

2.2.1 Tax and Social Security Contribution Burdens

In almost all studies8) it has been found out, that the tax and social security contribution
burdens are one of the main causes for the existence of the shadow economy. Since taxes
affect labor-leisure choices, and also stimulate labor supply in the shadow economy, the
distortion of the overall tax burden is a major concern of economists. The bigger the
difference between the total cost of labor 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 are key features of the existence and the increase of the shadow
economy.
But even major tax reforms with major tax rate deductions will not lead to a substantial
decrease of the shadow economy.9) Such reforms will only be able to stabilize the size of the
shadow economy and avoid a further increase. Social networks and personal relationships, the
high profit from irregular activities and associated investments in real and human capital are
strong ties which prevent people from transferring to the official economy. For Canada, Spiro
(1993) found similar reactions of people facing an increase in indirect taxes (VAT, GST).
This fact makes it even more difficult for politicians to carry out major reforms because they
may not gain a lot from them.
Empirical results of the influence of the tax burden on the shadow economy is provided in the
studies of Schneider (1994b, 2000, 2005) and Johnson, Kaufmann and Zoido-Lobatón (1998a,
1998b); they all found statistically significant evidence for the influence of taxation on the
shadow economy. This strong influence of indirect and direct taxation on the shadow
economy is further demonstrated by discussing empirical results in the case of Austria and the
Scandinavian countries. For Austria the driving force for the shadow economy activities is the

8) See Thomas (1992); Lippert and Walker (1997); Schneider (1994a,b, 1997, 1998a,b, 2000, 2003b, 2005);
Johnson, Kaufmann, and Zoido-Lobatón (1998a,1998b); Tanzi (1999); Giles (1999a); Mummert and Schneider
(2001); Giles and Tedds (2002) and Dell’Anno (2003), just to quote a few recent ones.
9)See Schneider (1994b, 1998b) for a similar result of the effects of a major tax reform in Austria on the shadow
economy. Schneider shows that a major reduction in the direct tax burden did not lead to a major reduction in the
shadow economy. Because legal tax avoidance was abolished and other factors, like regulations, were not
changed; hence for a considerable part of the tax payers the actual tax and regulation burden remained
unchanged.
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direct tax burden (including social security payments), it has the biggest influence, followed
by the intensity of regulation and complexity of the tax system. A similar result has been
achieved by Schneider (1986) for the Scandinavian countries (Denmark, Norway and
Sweden). In all three countries various tax variables (average direct tax rate, average total tax
rate (indirect and direct tax rate)) and marginal tax rates have the expected positive sign (on
currency demand) and are highly statistically significant. These findings are supported by
studies of Kirchgaessner (1983, 1984) for Germany and by Klovland (1984) for Norway and
Sweden, too.
In this study an attempt will be made to investigate the influence of the direct and indirect tax
burden as well as the social security payments on the shadow economy for developing,
transition and highly developed countries. Hence, for the first time this influence is
investigated for developing, transition and highly developed countries for the same time
period and using the same estimation technique.

2.2.2 Intensity of Regulations

The increase of the intensity of regulations (often measured in the numbers of laws and
regulations, like licenses requirements) is another important factor, which reduces the
freedom (of choice) for individuals engaged in the official economy.10) One can think of labor
market regulations, trade barriers, and labor restrictions for foreigners. Johnson, Kaufmann,
and Zoido-Lobatón (1998b) find an overall significant empirical evidence of the influence of
(labor) regulations on the shadow economy, the impact is clearly described and theoretically
derived in other studies, e.g. for Germany (Deregulation Commission 1990/91). Regulations
lead to a substantial increase in labor costs in the official economy. But since most of these
costs can be shifted on the employees, these costs provide another incentive to work in the
shadow economy, where they can be avoided. Empirical evidence supporting the model of
Johnson, Kaufmann, and Shleifer (1997), which predicts, inter alia, that countries with more
general regulation of their economies tend to have a higher share of the unofficial economy in
total GDP, is found in their empirical analysis. A one-point increase of the regulation index
(ranging from 1 to 5, with 5 = the most regulation in a country), ceteris paribus, is associated
with an 8.1 percentage point increase in the share of the shadow economy, when controlled
for GDP per capita (Johnson et. al. (1998b), p. 18). They conclude that it is the enforcement

10)See for a (social) psychological, theoretical foundation of this feature, Brehm (1966, 1972), and for a (first)
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of regulation, which is the key factor for the burden levied on firms and individuals, and not
the overall extent of regulation - mostly not enforced - which drive firms into the shadow
economy. Friedman, Johnson, Kaufmann and Zoido-Lobaton (1999) reach a similar result. In
their study every available measure of regulation is significantly correlated with the share of
the unofficial economy and the sign of the relationship is unambiguous: more regulation is
correlated with a larger shadow economy. A one point increase in an index of regulation
(ranging from 1-5) is associated with a 10 % increase in the shadow economy for 76
developing, transition and developed countries.
These findings demonstrate that governments should put more emphasis on improving
enforcement of laws and regulations, rather than increasing their number. Some governments,
however, prefer this policy option (more regulations and laws), when trying to reduce the
shadow economy, mostly because it leads to an increase in power of the bureaucrats and to a
higher rate of employment in the public sector. In this study the effect of government
regulation on the development of the shadow economy will be investigated for developing,
transition and highly developed countries.

2.2.3 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. Johnson, Kaufmann, and Zoido-Lobatón (1998a,b)
present a simple model of this relationship. Their findings show that smaller shadow
economies appear in countries with higher tax revenues, if achieved by lower tax rates, fewer
laws and regulations and less bribery facing enterprises. Countries with a better rule of the
law, which is financed by tax revenues, also have smaller shadow economies. Transition
countries have higher levels of regulation leading to a significantly higher incidence of
bribery, higher effective taxes on official activities and a large discretionary framework of
regulations and consequently to a higher shadow economy. Their overall conclusion is that
“wealthier countries of the OECD, as well as some in Eastern Europe find themselves in the
‘good equilibrium’ of relatively low tax and regulatory burden, sizeable revenue mobilization,

application to the shadow economy, Pelzmann (1988).
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