Selected Issues in Public Sector
Shadow Economy
Selected Issues in Public Sector (SIPS) Shadow economy Spring 2016 1 / 31
Content
1 Measuring shadow economy
Direct approaches
Indirect approaches
Statistical and econometric models
2 References and discussion
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Introduction
What is the underground economy?
Example: produce vendor on the street who sell the vegetables →
cash only, no taxes.
Considerable value to the economy!
Developing countries: 36% of GDP.
Developed countries: 13% of GDP.
Note: average size 2002-2003 (source Restrepo-Echavarria, 2015).
How the economists "‘measure"’ the informal sector?
What can be measured?
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Notation
Informal economy.
Shadow economy.
Underground economy.
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Measuring shadow economy
Content
1 Measuring shadow economy
Direct approaches
Indirect approaches
Statistical and econometric models
2 References and discussion
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Measuring shadow economy
Introduction
Measures × estimates.
Three approaches: direct, indirect, statistical.
Relative vs. absolute size.
What could be "‘measured"’?
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Measuring shadow economy Direct approaches
Content
1 Measuring shadow economy
Direct approaches
Indirect approaches
Statistical and econometric models
2 References and discussion
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Measuring shadow economy Direct approaches
Motivation
Methods relying on surveys, samples based on voluntary replies, tax
audits and other compliance methods.
Main problem: the results depend on the questions asked and only
few surveys are alike ⇒ difficulties with using the same parameters to
measure and compare informal economy in different countries.
Requirements to define the informal sector in a simple way (using one
parameter only).
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Measuring shadow economy Direct approaches
Example of simple definiton
Informal sector defined as those people who do not have the right to
a pension when they retire.
Simple and clear definition × exludes several important elements that
would describe the underground economy.
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Measuring shadow economy Direct approaches
Example of another definition
People are considered to work in the informal economy if they work
for a firm that has N or fewer workers.
Commonly used definition.
Problem: very small firm can comply with the law → its production
can be reported to the authorities (its value added appears in the
GDP despite the small size of the firm).
Selected Issues in Public Sector (SIPS) Shadow economy Spring 2016 10 / 31
Measuring shadow economy Direct approaches
Reporting problem
Direct questionnaire → people are not willing to admit that they are
not reporting taxes or are engaging in fraudulent activities.
Reasons: to be feeling affraid of getting caught or to be feeling
ashamed (moral issues).
Problem to estimate the extent of undeclared work.
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Measuring shadow economy Direct approaches
Direct comparison method
Direct estimate based on calculating the discrepancy between income
declared for tax purposes and that measured by selective checks.
Example: comparing the number of jobs declared by firms with the
number of employed people found through household surveys → the
number of employed people exceeding the number of jobs.
Estimating the size of informal sector: identified number of workers in
informal sector and assumption about the same net compensation as
similar to the workers in formal economy.
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Measuring shadow economy Indirect approaches
Content
1 Measuring shadow economy
Direct approaches
Indirect approaches
Statistical and econometric models
2 References and discussion
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Measuring shadow economy Indirect approaches
Motivation
Macroeconomic approaches.
Using an indicator of the informal economy as a proxy for its size or
growth.
Approaches:
1 Discrepancy between the national expenditure and income statistics;
2 Discrepancy between official and actual labor force;
3 Transaction approach;
4 Currency demand approach;
5 Physical input (electricity consumption) method.
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Measuring shadow economy Indirect approaches
Differences in national expenditure and income statistics
Theory: both measures should be equal.
Informal activities only in the expenditure measurement.
Income side measured through the value added of registered firms
(formal economy) × expenditure side through self-reporting.
Differences as an indicator of the size of informal economy.
Problems:
1 Statisticians would like to make this difference as small as possible ⇒
ideal using the initial measures rather than the published ones.
2 Other sources of differences (sampling error, statistical error).
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Measuring shadow economy Indirect approaches
Differences in official and actual labor force
Assuming constant total labor force participation rate → decrease in
labor force participation in formal economy as an indicator of an
increase in the activity in the formal economy.
Problem: other causes of the changes in participation rate (e.g.
recent recession and exit from labor force), people may work in both
sectors of the economy.
Not a reliable estimator.
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Measuring shadow economy Indirect approaches
Transaction approach
Edgar Feige (1979).
Quantitative theory of money: M · V = p · T.
M money, V velocity, p prices, T total transactions.
Main assumption: constant relationship of the volume of transactions
and official GNP over time.
Value of total transaction (pT) as an estimate of nominal GNP →
differences between nominal GNP and official GNP.
Problems: strong assumption about the time-invariant constant ratio
of transactions to official GNP, difficulties to obtain accurate
estimates of the total number of transaction.
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Measuring shadow economy Indirect approaches
Currency demand approach
Based on the correlation between currency demand and tax pressure,
assuming that informal activities operate with cash.
Tax burden increases + increase of the demand for money ⇒
indicator of an increase in the underground sector.
Calculating excess in money demand using econometric methods →
equation for money demand.
Controlling variables: development for income, payment habits,
interest rates etc.
Other variables: government regulation, direct and indirect tax
burden, complexity of the tax system.
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Measuring shadow economy Indirect approaches
Currency demand approach (example)
Currency demand function including drivers of shadow economy (tax
burden, regulation etc.).
Simulations of the amount of money that would be necessary to
generate official GDP → comparison with actual money demand →
differences as an indicator of the shadow economy.
Calculated difference multiplied by the velocity of money of the
official economy = size of the shadow economy.
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Measuring shadow economy Indirect approaches
Currency demand approach (critique)
Not all the transactions in the shadow economy are paid in cash.
Using only the tax burden factor and ignoring other tax factors such
as "‘tax morality", regulation and attitudes toward the state (× how
to obtain these data?).
Rise in currency/demand deposits due to slowdown in demand
deposits (not the rise of currency due to informal activities).
Assumptions about the same velocity of money in formal and informal
economy.
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Measuring shadow economy Indirect approaches
Physical input method
Assumptions that electricity demand is the best physical indicator of
both formal and informal economic activity.
Observation: elasticity of electricity demand to GDP close to 1.
Indicator of informal economic activity: using electricity as proxy for
the overall economic activity and then substracting the GDP from it
⇒ the differences between the growth of electricity consumption and
official GDP as an indicator of the growth of underground economy.
Problems:
1 Not all informal activities require a considerable amount of electricity
(or other energy sources may be used – oil, gas, coal etc.)
2 More efficient use of electricity in both sectors.
3 Differences in elasticities between the sectors across countries (or
changing over time).
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Measuring shadow economy Statistical and econometric models
Content
1 Measuring shadow economy
Direct approaches
Indirect approaches
Statistical and econometric models
2 References and discussion
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Measuring shadow economy Statistical and econometric models
Motivation
Methods used depends on the specific question being asked by the
researcher (policy maker).
Macroeconomic studies – indirect approaches suffice, microeconomic
studies – direct approaches more generally used.
Newer methods (more-technical, model-based estimations):
1 MIMIC model (Multiple Indicator Multiple Causes procedure).
2 Dynamic Stochastic General Equilibrium models.
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Measuring shadow economy Statistical and econometric models
MIMIC model
Assumption: shadow economy is an unobservable phenomenon (a
latent variable) → estimates using quantitatively measurable causes
of shadow economic activity as well as indicators of illicit activity.
Causes: tax burden, intensity of regulation.
Indicators: demand for currency, official national income, official
working hours.
Econometric models → some technical challenges (endogeneity): size
of tax burden → increase in the size of the underground economy ×
increase in the size of the shadow economy → raising tax rates (tax
burden) by the government.
Disadvantage: relative estimates only (e.g. currency demand
approach for calibrating relative to absolute values).
MIMIC estimation - 21 OECD countries.
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Measuring shadow economy Statistical and econometric models
DSGE approach
Structural econometrics approach, which exploits equilibrium
conditions from and economic model to provide estimates for
unobserved variables.
Note: MIMIC model as a reduced form model (factor model, purely
statistical wihout any assumption a priori regarding the relationship
between the variables).
Economy: households, firms, government.
Objective functions, probability of being inspected and forced to pay
evaded taxes and penalty surcharges.
Orsi et al. (2014).
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Measuring shadow economy Statistical and econometric models
DSGE outputs
Size and dynamics of the shadow economy of Italy.
Laffer curve (corporate taxation).
Laffer curve (income taxation).
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Measuring shadow economy Statistical and econometric models
Comparison of methods
Comparison of estimates - Germany.
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References and discussion
Content
1 Measuring shadow economy
Direct approaches
Indirect approaches
Statistical and econometric models
2 References and discussion
Selected Issues in Public Sector (SIPS) Shadow economy Spring 2016 28 / 31
References and discussion
References
A. T. Kearney (2010): The Shadow Economy in Europe, 2010 (Using
electronic payment systems to combat the shadow economy.
Enste, D. H. (2015): The shadow economy in industrial countries.
ISA World of Labor 2015:127.
Orsi, R., Raggi, D., Turino, F. (2014): Size, trend, and policy
implications of the underground economy. Review of Economic
Dynamics 17, pp. 417-436.
Restrepo-Echavaria, P. (2015): Measuring Underground Economy Can
Be Done, but It Is Difficult. The Regional Economist, January 2015.
Schneider, F., Williams, C. C. (2013): Shadow economy. The
Institute of Economics Affairs.
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References and discussion
Policy question
There is a widespread feeling that a substantial and increasing share
of activities take place outside the official economy. What should be
done to fight against the underground economy?
1 A deterrence policy (punishment).
2 Increase the motivation to stay in the official economy.
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References and discussion
Supplementary materials
Orsi et al. (2014) - policy changes.
Size of shadow economy.
Electronic payments and the size of shadow economy.
Size of the shadow economy by economic activities.
Electronic payments advantages by economic activities.
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