NS4053 Winter Term 2015 The Shadow Economy

Shadow Economy I IMF, Inclusive Growth, Institutions and the Underground Economy, 2012 Main points Large underground (shadow) economies pose problems for policy making A vicious circle can be set off as governments with large informal economies may raise tax rates to make up revenues Encourages further enlargement of the underground economy This may erode the institutional capacity of the government even more Fragile states are at a heightened risk of falling into this vicious circle Large informal economies render official statistics unreliable and incomplete complicating formulation of policies 2

Shadow Economy II Benefits of a formal economy: Property rights Protection Access to credit markets Not widely available in shadow economies May discourage economic growth and deny economic opportunities to many 3

Shadow Economy III Underground economy may include both illegal and illegal activities constitutes large portion of economy in many countries Definitions of underground (shadow economy vary) Market based production of goods and services whether legal or illegal that escape detection in official GDP statistics IMF uses – all market based legal production of goods and services that are deliberately concealed from public authorities Cause is usually to avoid taxes or regulations On positive, side a breeding ground of future economic growth within the formal economy 4

Shadow Economy IV What links underdevelopment and the shadow economy? De Soto links the problem of underdevelopment with key institutional weakness Much of the productive capital in poor countries is outside the system of formal property rights Unlike countries with mature property rights systems where capital can be leveraged for productivity activity It is often very difficult to establish clear rights to property Productive capacity of the economy restricted due to this fundamental institutional weakness Wider participation in the formal economy is hindered Encourages enclave like development that benefits few and leaves out the many 5

Shadow Economy V In De Soto’s view, The establishment of institutions that create (and protect) property rights is the key that can unlock the potential for growth within the informal sector Emerging economies – large size of the informal sector in these economies Suggests that even higher rates of growth are potentially available Several studies have linked the size of the shadow economy to various measures of institutional development 6

Shadow Economy VI Measuring the size of the shadow economy No direct measures of the size and composition of the underground economy A number of indirect methods have been proposed Currency demand approach Since most transactions in the underground economy are conducted in cash, this approach estimates the size of the underground economy from the excess demand for cash Electricity demand approach Assumes that electricity usage is a good physical indicator of economic activity and Estimates the growth of the underground economy based on the difference between the growth of electricity consumption and the official GDP growth 7

Shadow Economy VII Measurement of Shadow Economy Contd. Labor Force Approach: Estimates the growth of the shadow economy based on the decline in labor participation assuming a constant labor participation rate Multiple indicators multiple causes model: Estimates the size of the shadow economy based on multiple observed variables that are presumed to cause it: Share of direct taxes, The size of the government Tax rates, The regulatory burden GDP per capita 8

Shadow Economy VIII 9

Shadow Economy IX 10

Shadow Economy X 11

Shadow Economy XI 12