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Shadow Economies and Data Quality: Consequences for Economic Planning and Management

by Mark D. Wenner and Dillon Clarke

The terms “shadow,” “underground,” or “parallel” economies are interchangeable terms used to describe economic activities, legal and illegal, that are not registered in official estimates of gross domestic product (Smith, 1994, p. 18). See table below for what constitute shadow economic activities.

Taxonomy of Underground  Economic Activities

Monetary Activities Nonmonetary Activities
  Trade in Stolen or Prohibited Goods and Services Barter of Prohibited Goods and Services
Illegal Activities Drug manufacture and trafficking

Prostitution

Gambling

Fraud

Smuggling

Produce of drugs for own use

Theft for own use

Exchange of one illegal good for another (drugs for stolen items)
Legal Activities Legal economic activity but citizen/company purposefully engages in tax evasion Legal economic activity but citizen/company purposefully engages in tax avoidance Activity is legal but it has an unwitting tax evasion effect in official statistics Activity is legal but it has an unwitting tax avoidance effect in official statistics
Underreported income from self-employment High levels of employee discounts and fringe benefits in lieu of  taxable income Barter of legal goods and services Do-it-yourself work

 

Underreported wages, salary income, and sale of assets related to legal goods and services

Source: Mirius and Smith 1997.

 

Causes and Size

Shadow economies exist in all types of economies (high income, middle income, low income, transition) and in all regions. Caused primarily by citizens’ reactions to government taxation and regulation, shadow economies involve four factors:

  1. High tax burdens that prompt people to avoid and evade taxes;
  2. Rigid labor market regulations (e.g., minimum wages, dismissal protections, time and work place rules, foreign worker rules as well as high social security contribution burdens) that increase the cost of creating formal sector jobs significantly;
  3. A marked incapacity of the government to enforce rules and regulations that reduces the probability of persons and companies being caught and penalized for noncompliance; and
  4. Governments that are perceived to deliver inadequate services, resulting in an attitude of tax morality (the idea of “why pay taxes for public services if they are not provided?”) that forces governments to raise taxes more, which, in turn, leads to more tax evasion and informality.

The phenomenon is larger in developing states with lower institutional capacity than in more developed ones. According to the Schneider and Ernst (2000) based on 1990–93 data, the size of underground economies in northern Europe was 12 to 23 percent of official gross domestic product, while southern Europe was 24 to 30 percent and Africa was in the range of 39 to 76 percent. In a more recent study based on 1999 to 2007 data, Schneider and colleagues (2010), found that the countries with the smallest shadow economies (unweighted)[1] were China, Singapore, and Vietnam (13.6 percent average) while the countries with the largest shadow economies were Bolivia (66.9 percent), Panama (63.9 percent) and Peru (59 percent).  The three Caribbean states included in the study, ranked in the middle, Dominican Republic (31.9 percent) Jamaica (35 percent), and Trinidad and Tobago (36 percent).

Consequences

The larger the underground economy, the more marked the consequences are for economic planning and policy making.  A large underground economy simply makes for unreliable economic statistics, which, in turn, affects the efficacy of policy measures adopted.  The main variables that politicians and policymakers pay attention to—such as unemployment, labor force participation, consumption, and income—will all be erroneous. With a large underground or shadow economy, underemployment/unemployment could be confused (many are working but may want to work more hours and/or earn better pay/benefits or are employed informally but willfully misrepresent), consumption will be higher than officially estimated, and official household income statistics will be understated. Fiscal and monetary policy that is based on erroneous indicators may be ineffective or counterproductive.  For example, if official statistics are used the inflationary effect of a fiscal stimulus to spur growth may be overestimated and an expansionary monetary policy may be totally impotent, because many persons are already holding large amounts of cash and the velocity of money may be very difficult to estimate if the scale of illegal and legal activities is unclear.

Although the effects on the shadow economy on growth will be ambiguous, depending on the underlying structure and linkages between the formal and informal economies in question, the most visible and indisputable effect of a large shadow economy is that tax revenues and social security payments will be much less than expected, which will negatively affect the quantity and quality of public goods and services provided and will undermine the viability of social welfare and pension systems.

 

What Does This Mean for the Caribbean?

The availability and quality of official statistics in the Caribbean is generally poor. The World Bank calculates the statistical capacity index of Latin America and the Caribbean as region as 77.3 on a scale of 100.  With the exception of the Dominican Republic (78.9) and Jamaica (77.8), all the other reporting Caribbean states (Belize, Dominica, Grenada, Guyana, Haiti, St. Lucia, St. Kitts and Nevis, St. Vincent and the Grenadines, Suriname, and Trinidad and Tobago) are below this average. The average for the three reporting IDB Caribbean members, excluding Jamaica, is 60.7. Thus, policy makers interested in fiscal adjustment and growth-spurring reforms, need to take in account the size of their informal economies. The shadow economy simply compounds the weaknesses and incompleteness of official statistics. Consequently, greater efforts may be needed to improve the quality of official statistics sine non qua, to model the size of the shadow economy, to take into account how it affects the official economy, and to think how to reduce the size of the shadow economy and informality.

References

Mirius, Rolf, and R. Smith. 1997. “Canada’s Underground Economy: Measurement and Implications.” In The Underground Economy: Global Evidence of its Size and Impact, edited by Owen Lippert and Michael Walker.  Vancouver: Fraser Institute.

Schneider, Friedrich, and Dominik Enste.  2000. “Shadow Economics: Size, Causes, and Consequences”.. Journal of Economic Literature 28: 77–114.

Schneider, Friedrich, Andreas Buehn, and Claudio E. Montenegro. 2010. “Shadow Economies All Over the World: New Estimates for 162 Countries from 1999–2007.” World Bank Policy Research Working Paper Series, No. 5356. http://ssrn.com/abstract=1645726

Smith, P. (1994), Assessing the Size of the Underground Economy: The Canadian Statistical Perspectives, Canadian Economic Observer, Catalogue No. 11-010, pp 16-33.

World Bank. “Statistical Capacity Indicator.” http://datatopics.worldbank.org/statisticalcapacity/SCIdashboard.aspx

[1]  When weighted, Switzerland, the United States, Luxembourg, and Austria emerge as top ranking with an average of 9.1 percent of official gross domestic product.

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