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Mohammed Nayel Abu Alfoul
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Alfoul, M.N.A.;  Khatatbeh, I.;  Jamaani, F. The Shadow Economy in Earlier Researches. Encyclopedia. Available online: https://encyclopedia.pub/entry/24688 (accessed on 01 July 2024).
Alfoul MNA,  Khatatbeh I,  Jamaani F. The Shadow Economy in Earlier Researches. Encyclopedia. Available at: https://encyclopedia.pub/entry/24688. Accessed July 01, 2024.
Alfoul, Mohammed Nayel Abu, Ibrahim Khatatbeh, Fouad Jamaani. "The Shadow Economy in Earlier Researches" Encyclopedia, https://encyclopedia.pub/entry/24688 (accessed July 01, 2024).
Alfoul, M.N.A.,  Khatatbeh, I., & Jamaani, F. (2022, June 30). The Shadow Economy in Earlier Researches. In Encyclopedia. https://encyclopedia.pub/entry/24688
Alfoul, Mohammed Nayel Abu, et al. "The Shadow Economy in Earlier Researches." Encyclopedia. Web. 30 June, 2022.
The Shadow Economy in Earlier Researches
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This entry is adapted from the peer-reviewed paper 10.3390/su14105761

Information and communication technology (ICT) development is vital to the shadow economy. Mainly, internet usage is robust and negatively associated with the shadow economy. Furthermore, inflation and poverty emerge as key determining factors of the shadow economy. The research findings will aid in the development of recommendations for potential strategies to minimize the international extent of the shadow economy. 

shadow economy extreme bounds analysis taxes data mining

1. Introduction

It has become evident that the shadow economy varies across countries’ economic components. The different causes that contribute to creating the shadow economy phenomenon increased questions concerning the justification of cross-country differences in the incidence of the shadow economy. One of these questions is what are the leading causes of shadow economy? The leading causes determining the shadow economy have been briefly presented in previous studies e.g., [1][2]. However, the previous literature typically centres on four or five causes at a time to estimate the shadow economy, therefore evoking the ceteris paribus condition. Several causes determine the shadow economy. Thus, it is difficult to determine all the causes that justify cross-country variations in the shadow economy. It has also become apparent that shadow economy rates do not necessarily go with some causes of the shadow economy, such as unemployment, inflation, or tax evasion.
Moreover, they certainly do not have to be determined equally by the same causes. For instance, the shadow economy is more reliant on the tax burden, unemployment rate, and inflation rate than the institutional quality or the educational level. Therefore, the current research investigated the majority of potential causes that determine the shadow economy using 36 explanatory variables over 132 countries.
In a recent study, Medina and Schneider [3] argued that knowing the leading causes behind the shadow economy is very important to measure the size of the shadow economy in the world. They state that “The link between theory and empirical estimation of the shadow economy is still unsatisfactory. In the best case, the theory provides us with derived signs of the causal and indicator variables. However, which are the core causal and core indicator variables is still a theoretically open question.” [3]. Whereas it is clear that determining the causes of the shadow economy matters for policymakers, the literature remains equivocal about the core causes of the shadow economy. Based on this consideration, further investigation of all potential causes leading to the shadow economy may be of great importance in re-evaluating the future effects of the shadow economy for policymakers.
There are many significant reasons why policymakers should be particularly worried about the underlying causes that are going to be an increase in the shadow economy. Among the most significant of these are (i) an ever-increasing shadow economy can be interpreted as the response of people who feel burdened by the country and who decide on the “exit option” instead of the “voice option” [4]. If the rise in the shadow economy has been caused by an increase in the total tax and social security burden in conjunction with the “institutional sclerosis” [5], the “consecutive flight” to the shadow economy can erode the tax burden and social security bases. The outcome can be a vicious circle of an additional rise in the budget deficit or tax rates, further growth of the shadow economy, as well as the gradual deterioration of the economic and social basis (For a more detailed analysis of the effects of the shadow economy, please see [1]. Slightly more common implications for governments have been discussed, e.g., by [6][7].); (ii) a flourishing shadow economy can cause serious problems for politicians because formal indicators—on consumption, income, labour force, unemployment—are undependable. Policy based upon inaccurate formal indicators has the potential to be ineffectual, or even worse.
Recent researches suggest that a high level of shadow economy hinders economic and sustainable development, which means that higher levels of the shadow economy are associated with low levels of economic development and sustainable development [6][7]. A robust negative effect of the size of the shadow economy on economic growth was found in [8]. Additionally, [9] argued that the shadow economy harms sustainable economic development by slowing economic growth, which in turn adversely affects sustainable development.
There is a noticeable increase in the literature that investigates the shadow economy phenomena as well as its impact on the official economy. Furthermore, economists have a growing interest in understanding the shadow economy criteria and determining the most important causes that lead to the increase in this phenomenon around the world through implementing various econometric methods. Although a majority of the literature are about the characteristics of the shadow economy, the researchers' comprehensive study is lacking. Disputes continue regarding the definitions, estimation methods, and concerning the use of estimations in economic analysis and policies. The article [10] shows the feature “Controversy: On the Hidden Economy” and documents the differing opinions, e.g., [11][12]. The causes, indicators, size, and effects of the shadow economy differ depending on the various types of countries. However, certain analogies may be useful for social scientists and politicians who may ultimately have to deal with this phenomenon.

2. Shadow Economy in Earlier Researches

Numerous studies have debated the shadow economy phenomenon, which, in turn, reflects the significance of this matter to economists. Earlier studies used both direct methods (survey methods) and indirect methods, which include the indicator approach and the model as a latent approach, which is a statistical method such as the Multiple Indicator Multiple Cause model (MIMIC) (For further details on the different benchmarking procedures, see [13][14].) to estimate the shadow economy (The researchers will not go into great detail about the various methods for measuring a shadow economy (including the MIMIC method) due to the vast amount of literature available.). The shadow economy is determined by a variety of factors. Specific causes of the shadow economy are highlighted in the earlier literature. In this section, the researchers will discuss several researches have inspected shadow economies and provide the most prevalent shadow economy reasons identified in earlier researches.
Schneider’s empirical results [13] indicated that the primary factors contributing to the growth of the shadow economy in 31 European nations and five additional OECD countries from 2003 to 2014 were tax policy and national regulation. They observed that the size of the shadow economies was 22.6 % of official GDP in 2003, but had decreased to 18.6 % in 2014. Hassan and Schneider [14] examined the development and size of 157 nations’ shadow economies from 1999 to 2013. They discovered four major factors that boosted the size of these nations’ shadow economies between 1999 and 2013 using the MIMIC approach: I increased taxation; (ii) increased regulatory burden; (iii) increased joblessness; and (iv) increasing self-employment rates. These data corroborated the conclusions of past research. [15][16][17][18].
Vo and Ly [19] evaluated the direction and size of the invisible economy in the Association of South-East Asian Nations (ASEAN) member nations, excluding Brunei and Singapore. Their research, which spanned the years 1995–2014, used the MIMIC technique. The findings demonstrated that labour flexibility, tax rates, and corporate freedom have all had a substantial impact on these Asian nations’ shadow economies. Furthermore, Macias and Cazzavillan [17] used the MIMIC approach to quantify and analyze the growth of Mexico’s shadow economy between 1970 and 2006. The r Researchers considered a variety of criteria, including the tax load, wage levels, inflation, joblessness, and heavy governmental policies, while using real GDP and real currency as proxies for the shadow economy. The findings revealed a positive association between the invisible economy and the actual GDP; and, secondly, that the primary drivers of Mexico’s invisible economy were heavy government restrictions and insufficiently high pay.
On the other hand, several researches used two distinct approaches to determine the direction and size of the shadow economy. For example, the CDA and structural equation modeling were both used by Hassan and Schneider [20] to estimate the size and trajectory of Egypt’s shadow economy. Self-employment and agriculture were employed as proxy variables to gauge the strength of democratic institutions in Egypt’s formal sector. It was shown that the invisible economy has shrunk from 50% in 1976 to a mere 32% in 2013.Utilizing a wider dataset covering 162 countries, the empirical paper of Schneider et al. [21] evaluated the influence of religion on the shadow economy in terms of the total degree of religiosity, the effect of various religions and religious competition, and the proximity of state and religion on the shadow economy using the MIMIC approach. The authors found that the degree of individual religiosity was extremely important as nations with more religious citizens had better functioning economies. This is because religion and religious standards simplify transactions through a formal alternative to the laws of the religious aspect of the provision.
Medina and Schneider [3] evaluated the size of the shadow economy in 158 nations between 1991 and 2015. They used the MIMIC technique to quantify the shadow economy and enhanced it with the CDA. Additionally, they used the predictive mean matching (PMM) methodology to avoid the problems the previous papers had with the usual calibration methods. The authors found that the PMM approach produces a reliable result that corroborates the MIMIC results. Furthermore, they found a decrease in the size of the shadow economy from 1991 to 2015, except in 2008, where, due to the world economic crisis in that year, the size of the shadow economy increased. Medina and Schneider [22] conducted another recent research in which they evaluated the extent of the shadow economy in 157 economies between 1991 and 2017. Furthermore, they examined the shadow economy’s connection with the formal economy. The researchers discovered that the influence of the shadow economy on the formal economy and vice versa is conceptually unrestricted. Additionally, the shadow economy is fairly large in certain locations. Finally, the research recommended that policymakers should be taking into account enhancing the quality of governance indicators and improving business and competitiveness indicators in their countries to reduce the size of the shadow economy.
There is another strand in the literature supporting the impact of the shadow economy on economic growth and sustainable development. The authors of [23][24][25] showed that evading regulations and taxation results in lower tax revenues, higher public expenditures, and slower growth and productivity. Shadow economy is thus seen as a destructive activity, undermining democratic governance and the rule of law and economic and sustainable development. The shadow economy has a negative impact on a country’s economic growth and sustainable development in a variety of ways [26], as it represents a variety of illegal and criminal activities such as corruption, drug trafficking, smuggling, gambling, bookmaking, and prostitution, among others. The shadow economy is characterised by a wide range of activities such as “black-market transactions, undeclared work, tax evasion, and tax avoidance” by individuals and businesses [27]. The smaller size of the shadow economy would eventually encourage sustainable development.
Several causes have been identified in the literature devoted to the shadow economy [28][29]. Many determinants include high tax rates and social security burdens because economic agents do not want to pay high taxes that may drive them out of the formal economy [11]. Some scholars have linked the shadow economy [30] to institutions that are not strong enough (due to bureaucracy, regulatory discretion, the rule of law, corruption, and a weak legal system). It is also worth noting that penalty rates and tax evasion detection/probabilities play a role in this effect. To some extent, the government has control over these aspects [1].
Among all of these empirical studies, one factor stands out as having a significant impact on the shadow economy: corruption. The study by [6] investigated the influence of corruption and shadow economy on the economic and sustainable development using a large cross-country database of 185 countries from 2005 to 2015. They concluded that corruption and the shadow economy are diseases of poverty, and they are particularly prevalent in countries with low incomes. Corruption is more associate with the shadow economy in lower levels of economic and sustainable growth. To that end, the main contribution of their work is to provide empirical evidence for the damaging effects of corruption and the shadow economy on states’ economic and long-term development. The results also uncovered instances where corrupt practices were employed in an effort to gain an unfair advantage economically, and this served to further the growth of the economy. Furthermore, they found that corruption and the shadow economy more negatively impact economic and sustainable development in high-income countries than in low-income countries.
Many other causes contribute to a shadow economy, such as a weaker institutional quality context (i.e., regulatory inefficiency, bureaucracy, a weak rule of law, and corruption), which is typically considered a potential driver for the shadow economy [30]. Many laws and regulations affect labour costs and encourage people to work illegally in the shadow economy. Economists mainly investigate this by looking at how many laws and regulations there are, such as licences, market regulations, labour restrictions for foreigners, trade barriers, and so on [1]. As a result, the shadow economy can be reduced by reducing the density and complexity of regulations or by improving the transparency of laws and regulations (see [31]).
Not only is it important to consider institutions under different and diverse aspects, but it is also important to consider them as a traditional measure of the intensity of regulation or corruption [28][32][33]. A study conducted by [34] investigated how institutional quality interacted with the shadow economy and corruption in 145 countries from 2000 to 2002. Corrupt practises and shadow economy are substitutes, meaning that the existence of the shadow market is associated with lower levels of graft. Furthermore, their findings showed that the shadow economy is reduced when more well-functioning institutions are in place. Generally speaking, corruption does not only refer to the government’s role but also affects both the quality of institutions as a whole and the shadow market in particular. In the study by [27], for 55 countries between 1990 and 1999, this negative effect of institutional quality on the shadow economy was confirmed. Many studies have been done on this topic [27][35] (using six governance indicators from Worldwide Governance Indicators), and they have also confirmed this result.
Institutions can provide some incentives for the growth of official economic activities by improving these economic aspects. A country’s institutions can be defined as the set of rules regulating human behaviours [28][29][36][37][38]. According to [39][40], better legal systems (protection of property rights and disclosure of information) and more reliable political situations directly contribute to improving transactional trust between actors, thereby encouraging official economic activities. These rules limit the shadow economy’s potential. For example, a better quality of institutions in a country reduces transaction costs [41] and risk [42][43], as well as the amount of information that is asymmetrically distributed in a country [44]. As a result, increased market efficiency and better resource allocation are both attributed to better institutional quality [45]. A lack of institutional quality, on the other hand, creates uncertainty regarding contractibility and information asymmetry, causing economic agents to temper their official entrepreneurial activities [24][32][46][47][48].
Similarly, indicators related to government effectiveness, political stability (absence of violence/terrorism), and control of corruption are expected to reduce the shadow economy. In the same vein, the regulatory quality indicator (capturing the government’s ability to formulate and implement sound policies and regulations) and the rule of law indicator (capturing the confidence in society’s rules) create a favourable context for official business activities. Indicators of freedom of expression, association, and the media may also help reduce the shadow economy.

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Mohammed Nayel Abu Alfoul
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Ibrahim Khatatbeh
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Fouad Jamaani
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