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This journal is for YOU! *Order today for more FREE book options Perfect for students or anyone on the go! The Independent Review is available on mobile devices or tablets: iOS devices, Amazon Kindle Fire, or Android through Magzter. INDEPENDENT INSTITUTE, 100 SWAN WAY, OAKLAND, CA 94621 • 800-927-8733 • [email protected] PROMO CODE IRA1703 GRAPHIC DETAIL Dimensions of the Shadow Economy —————— ✦ —————— FRIEDRICH SCHNEIDER hadow economic activities—employment, production, and exchange unre- ported to government authorities—constitute a large and growing part of all S economic activity throughout the world. Although these activities, by their very nature, cannot be measured with precision, attempts have been made to estimate their magnitudes and to relate those magnitudes to tax rates and other determinants. This article summarizes the findings of some recent quantitative studies. As table 1 shows, the shadow economy in seventeen member countries of the Organization for Economic Cooperation and Development (OECD) was large and growing between 1994 and 1998. In 1998, the year with the latest figures for these countries, Greece had the largest shadow economy, equivalent to 29 percent of its of- ficial gross domestic product (GDP), followed by Italy with 27.8 percent, Spain with 23.4 percent, and Belgium with 22.6 percent. In the middle range were Ireland with 16.3 percent, Canada with 15 percent, France with 14.9 percent, and Germany with 14.7 percent. At the lower end appeared Austria with 9.1 percent, the United States with 8.9 percent, and Switzerland with 8 percent. Between 1994 and 1998, the shadow economy increased by at least 1.6 percentage points in Greece, Italy, Sweden, Norway, Germany, and Austria and by smaller amounts in all but two of the other OECD countries listed in table 1. The figures in table 1 were calculated using the currency demand approach, which assumes that shadow (or hidden) transactions are undertaken in the form of Friedrich Schneider is a professor of economics at the University of Linz, Austria. The Independent Review, v.V, n.1, Summer 2000, ISSN 1086-1653, Copyright © 2000, pp. 81–91 81 82 ✦ F RIEDRICH SCHNEIDER cash payments, so as to leave no observable traces for the tax (or other) authorities. An increase in the size of the shadow economy will therefore increase the demand for currency. To isolate the resulting “excess” demand for currency to be used in the shadow economy, a currency demand equation is econometrically estimated over time, controlling for all conventional factors such as the growth of income, changes of payment habits, and so forth. In addition, variables such as the direct and indirect tax burden, government regulation, and the social security burden, which are assumed to be the major factors causing people to operate in the shadow economy, are included in the estimation equation. The “excess” increase in currency, which is the amount unexplained by the conventional factors, is then attributed to the rising tax and social security burdens and other factors inducing people to work in the shadow economy. From the excess increase in currency, the size of the shadow economy over time can be calculated by assuming that the expenditure velocity of money is equal in the shadow economy and the official economy.1 To facilitate consideration of a preliminary explanation of the differing sizes of the shadow economies in the OECD countries, table 2 presents data on the size of the shadow economy and the various tax burdens in those countries in 1996. With the exception of Spain (shadow economy 22.9 percent, tax and social security bur- den 67.2 percent), the countries that had the largest shadow economy in 1996— Greece, Italy, Belgium, and Sweden (28.5, 27, 21.9, and 19.2 percent, respectively)—also had the highest tax and social security burden (72.3, 72.9, 76, and 78.6 percent, respectively), whereas the countries with the lowest overall tax and social security burden—Switzerland and the United States (39.7 and 41.4 per- cent, respectively)—also had the smallest shadow economies, 7.5 and 8.8 percent, respectively. Of course, the pattern was not perfect. The United Kingdom and Aus- tria each had a fairly high overall tax and social security burden (54.9 and 70.4 per- cent, respectively) and a relatively small shadow economy (13.1 and 8.3 percent, respectively). But overall, the pattern fits the data well: the higher the social security and tax burden, the larger the shadow economy. Table 3 presents estimates of the relative size of the labor force in the shadow economy in some OECD countries during the period from 1974 to 1998. For ex- ample, the results for Denmark indicate that the population engaged in the shadow economy ranged from 8.3 percent of the total labor force in 1980 to 15.4 percent in 1994. In Germany this figure rose from 8–12 percent in 1974–82 to 22 percent in 1997–98. In other countries as well, the shadow economy labor force is quite large: in Italy, between 30 and 48 percent (1997), in Sweden, 19.8 percent (1997), in France, 6–12 percent (1997–98). In the European Union in the late 1990s, at least 20 million people were engaged in shadow economic activities, and in all OECD countries about 35 million worked off 1. For a detailed description and critique of this approach, see Schneider 1986, 1997. THE INDEPENDENT REVIEW D IMENSIONS OF THE SHADOW ECONOMY ✦ 83 the official records. These figures demonstrate that the shadow-economy labor market is substantial and may help to explain why several OECD countries, such as Germany, have recently had high and persistent unemployment in the official labor market. Tables 4, 5, and 6 present estimates of the size of the shadow economy for a number of developing, transitional, and OECD countries—seventy-six countries in all—between 1989 and 1993. The estimates have been made by using the physical- input (electricity) method, the currency demand approach, and the model (MIMIC) approach, as indicated in the tables. The physical-input (electricity consumption) method assumes that a part of the electricity supply is used for shadow-economy activities and that it is possible to isolate that part and, with the help of another method, to calculate value-added figures for the shadow economy. The MIMIC approach considers multiple causes leading to the existence and growth, as well as multiple effects, of the shadow economy over time. This method is based on the statistical theory of unobserved variables. For the estima- tion, a factor-analytic approach is used to measure the shadow economy as an unob- served variable.2 Table 4 presents the findings for eight African countries. Of those, Nigeria and Egypt had the largest shadow economies, with 76 percent and 68 percent of GDP, respectively, off the official record in 1989–90. At 20 percent, Mauritius’s shadow economy was the smallest in the group. Use of the currency demand approach indi- cates that Tanzania had a shadow economy equivalent to 31 percent of GDP, and South Africa, a Western-type industrial country, had a shadow economy of 9 percent during the same years. For a group of Latin American countries, table 4 presents two estimates, one based on the physical-input method (Lackó 1996) and one based on the MIMIC ap- proach (Loyaza 1996). For some countries, such as Venezuela, Brazil, and Guatemala, the estimates of the size of the shadow economy are similar. For others, such as Panama, Peru, and Mexico, there are large differences. Using the MIMIC approach to rank the Latin American countries, the biggest shadow economies appear to have been those in Bolivia, where off-the-record output was equivalent to 65.6 percent of GDP, Panama (62.1 percent), Peru (57.4 percent), and Guatemala (50.4 percent). The smallest shadow economies appear to have been those in Costa Rica (23.2 per- cent), Argentina (21.8 percent), and Chile (18.2 percent). All the foregoing Latin American estimates are for the period 1990–93.3 2. For detailed descriptions of the physical-input (electricity) method and the MIMIC approach, see Schneider and Enste 2000. 3. For Mexico, the results of all three methods are shown. Although the MIMIC approach and the currency demand method produce estimates in a similar range (27.1 percent for MIMIC and 35.1 per- cent for the currency demand method), the physical-input method produces an estimate of 49 percent, far above the other two. VOLUME V, NUMBER 1, SUMMER 2000 84 ✦ F RIEDRICH SCHNEIDER For a group of eleven Asian countries, table 4 shows that Thailand ranked num- ber one, at 71 percent, followed by the Philippines with 50 percent and Sri Lanka with 40 percent of GDP in the shadow economy.