Shadow economies

Within most economies, there are large portions that work outside the law called shadow economies. Participants in the shadow economy neither pay taxes nor obey regulations. A recent study finds that taxes and burdensome regulations push people into the shadow economy.

The authors use data from 21 countries in the Organisation of Economic Co-operation and Development (OECD) and 22 countries that are transitioning to capitalism. The sizes of the shadow economies are quite substantial:

Over 2001 to 2002, the average size of an OECD shadow economy was 16.7 percent of "official" gross domestic product (GDP).

Over the same timeframe, the average transition country shadow economy is 38.0 percent of "official" GDP.

Using other economic data, the article finds that taxes and regulations push portions of the economy away from the law. For example:

A one point increase in regulation (on a 5 point scale) results in the shadow economy increasing by 10 percent.

A one percent increase in the marginal U.S. federal personal income tax results in the shadow economy increasing by 1.4 percent.

o Higher corporation taxes have a similar effect.

This is especially prevalent in the OECD countries. Greece, Belgium, Italy, and Sweden all have tax burdens larger than 70 percent of GDP and have shadow economies larger than 20 percent of their official GDP. In contrast, the United States and Switzerland have extremely low tax burdens and extremely low shadow economies (8.8 and 7.5 respectively).

The author argues that shadow economies have a vicious cycle. As people enter the shadow economy, tax revenues fall, leading the government to raise taxes. This pushes more people into the shadow economy, starting the process all over again.

Source: Friedrich Schneider, The Size and Development of the Shadow Economies of 22 Transition and 21 OECD Countries, IZA Discussion Paper No. 514, June 2002, Institute for the Study of Labour.

For text:
http://papers.ssrn.com/sol3/delivery.cfm/SSRN_ID320083_code020729590.pdf?abstractid=320083
For more on Taxes and Growth http://www.ncpa.org/iss/int

FMF Policy Bulletin \7 November 2002