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Kotzinos, A.; Canellidis, V.; Psychoyios, D. ICT Diffusion Impact on the Shadow Economy. Encyclopedia. Available online: https://encyclopedia.pub/entry/45024 (accessed on 05 July 2024).
Kotzinos A, Canellidis V, Psychoyios D. ICT Diffusion Impact on the Shadow Economy. Encyclopedia. Available at: https://encyclopedia.pub/entry/45024. Accessed July 05, 2024.
Kotzinos, Apostolos, Vasilios Canellidis, Dimitrios Psychoyios. "ICT Diffusion Impact on the Shadow Economy" Encyclopedia, https://encyclopedia.pub/entry/45024 (accessed July 05, 2024).
Kotzinos, A., Canellidis, V., & Psychoyios, D. (2023, May 30). ICT Diffusion Impact on the Shadow Economy. In Encyclopedia. https://encyclopedia.pub/entry/45024
Kotzinos, Apostolos, et al. "ICT Diffusion Impact on the Shadow Economy." Encyclopedia. Web. 30 May, 2023.
ICT Diffusion Impact on the Shadow Economy
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This entry is adapted from the peer-reviewed paper 10.3390/computation11050090

The primary factors that influence sovereign bond yields are typically domestic macroeconomic and financial fundamentals, as well as global factors such as international risk appetite and global liquidity, as indicated by a substantial body of literature. Credit ratings are widely regarded as a standard means of measuring a country’s financial risk and play a critical role in assessing its overall risk profile. Furthermore, international investors seeking to realize higher returns inevitably face higher risk and volatility and scarce relevant information when focusing on emerging markets. As a result, they turn to credit ratings as valuable indicators of a country’s capacity or willingness to meet its financial obligations. Hence, credit ratings can also be seen, as Cantor and Packer (1996) suggest, as a reflection or proxy of domestic macroeconomic and financial indicators. 

credit ratings sovereign debt shadow economy

1. Shadow Economy: Definition, Causes, and Effects

The traditional view of the shadow economy as a parasitic phenomenon [1] plagued with meager wages and poor working conditions [2] undoubtedly remains dominant among scholars and policymakers. A considerable amount of literature extensively discusses the negative impacts of the informal economy. One of the apparent consequences of this type of economy is the reduction of a government’s capability to generate revenue through taxation. Since the primary focus of the informal sector is to avoid paying taxes, a large informal sector severely limits government revenues [3]. The impact of the shadow economy extends beyond just reduced public revenues; it also distorts important economic indicators, which can hamper the effectiveness of macroeconomic policies, as stated in previous literature [4]. Additionally, informal firms face limitations in accessing funding due to their hidden nature and avoidance of accumulating physical capital to avoid detection by tax authorities, which reduces their ability to operate on a larger scale and adopt technological innovations [5]. Therefore, because shadow activities tend to be concentrated in sectors of the economy that involve small-scale labor-intensive production with short cycles, the employment of low-skilled and less-experienced workers becomes unavoidable. Such sectors are usually agriculture, trade, construction, and low-added-value services. Therefore, it should be expected that in countries with large shadow economies, the above segments would become rather inflated, composing a large part of national output.
Additionally, there is a body of literature that challenges the conventional notion that the shadow economy has only negative impacts on economic growth. Instead, some studies suggest that, under certain circumstances, the shadow economy can have positive effects. One significant effect of the shadow economy is its potential to create employment opportunities [6] and ‘protect’ household incomes. According to Gutierrez-Romero [7], there is also evidence to suggest that in developing countries, there is a negative relationship between the informal economy and income inequality. Moreover, a large part of shadow activity earnings is eventually spent in the official sector [4][8], providing a significant positive stimulus effect on the formal economy and tax revenues [6]. It has also been proposed [9][10] that the informal sector may act as a buffer over business cycles since total employment, formal and informal, as a sum, is less volatile than each of them separately. Interestingly, while informal output seems to behave pro-cyclically and in tandem with official output, informal employment seems, in broad terms, to behave acyclically, meaning that it probably adjusts to economic cycles through changes in the level of wages and working hours and not in the number of employed [5]. From a neoclassical perspective [2], the informal economy is considered the optimal solution for fulfilling the demand for small-scale goods and personal or household services that maximize consumers’ utility. Thus, individuals who are willing to take higher risks and offer goods and services in the shadow economy are likely to have an entrepreneurial mindset, which can boost economic growth by increasing overall competitiveness, according to Eilat and Zinnes [4]. This may also compel firms operating in the formal sector to improve their productivity or exit the market [9].

2. Diffusion of ICT and Transformations of the Economy

Although scholars do not fully agree on the causal relationship between ICT and economic growth [11], a significant body of empirical research published since the early 2000s suggests that the accumulation of ICT capital, or capital deepening, promotes economic growth by increasing productivity. This is due to the availability of more and better capital equipment for workers [12]. The substantial drop in the cost of ICT equipment has resulted in two significant changes. Firstly, it led to the replacement of labor and non-ICT capital with ICT capital in ICT-using sectors. Secondly, changes in the organization of the ICT-producing sector have led to total factor productivity (TFP) gains across the industry [13]. According to Vu et al. [14], the theoretical bases for the positive impact of ICT on economic growth are the diffusion of knowledge, constant innovation, better-informed decision-making by economic agents, reduced costs of transportation, communication, and trading, and increased efficiency in logistics. However, to fully realize the positive effects of ICT, organizational transformation is also necessary.
The benefits of ICT are not limited to advanced economies. Developing nations provide internet and telephone services primarily through inexpensive and easy-to-implement mobile networks. Rather than using a closed-off approach, they focus on learning through experience and aim to entice foreign ICT investments, including capital and expertise. It is indicative that, concerning 2021 and according to the latest ITU estimations, mobile-cellular telephone subscriptions reached a penetration rate of 105.1% (it is remarkable that, as the World Bank (World Development Report, 2016) [15] highlights, in developing countries, more households possess a cellphone than have access to electricity or clean water) for developing countries as opposed to a rate of 134.8% for developed ones, both approaching saturation, while the penetration rate of fixed-broadband subscriptions reached 13% versus a 35.7% rate, respectively. Mobile telecommunications brought radical changes to a wide range of crucial areas for economic growth, introducing mobile platforms, mobile money, microfinance or microinsurance, m-government, m-health, and boosting education and women’s entrepreneurship. The above functions affect economic development in a number of ways. Naming a few, digital ID alleviates severe weaknesses in civil registration systems that left millions of people without official registration documents, depriving them of opening bank accounts, registering property, or receiving social benefits [15]. Moreover, the implementation of a digital ID system permits the removal from the government payroll of “ghost” civil servants and strengthens electoral integrity. Mobile money, which started as an exchange of airtime credit, evolved in order to store credit on the SIM card [15] and became the most influential ICT enabler of financial inclusion [16] for millions of unbankable people. Such schemes made possible safe, low-cost transfers of small amounts of money to or from tiny or informal enterprises and women entrepreneurs with limited mobility due to cultural, religious, or practical reasons. M-health by providing disease surveillance and telemedicine; m-education by facilitating text message exchange between teacher and students or dispatching class tips to young and inexperienced teachers in rural areas; and m-platforms concerning the primary sector by providing information on prices, crop diseases, and potential buyers enable governments to provide innovative, low-cost solutions to long-standing deficiencies that undermine growth potential.
Conversely, there are worries about the negative consequences of ICT, particularly in terms of widening the digital gap between workers, which can negatively impact social unity and economic progress. Specifically, the increased use of ICT can lead to the replacement of unskilled labor with ICT capital and automation, which is likely to result in lower wages and job insecurity for low-skilled, low-paying, and less-educated workers [11]. As a result, opportunities for these individuals and their families are expected to diminish, leading to a reduction in social mobility.

3. The Impact of ICT Diffusion on the Shadow Economy and Their Possible Interactions’ Effects on Sovereign Ratings and the Cost of Debt

There is a relationship that has not been fully explored, which is the connection between the spread of ICT and the prevalence of the underground economy at a macro level [17]. This link has only recently been examined in academia, as seen in works such as in [18][19][20]. The literature is still inconclusive about how different types of ICT interact with the underground economy, how their effects vary across different regions of the world, and the direction of Granger causality between ICT and the underground economy [21] suggests that the Granger causality is bidirectional for both high- and low-income countries).
Veiga and Rohman, Garcia-Murillo and Velez-Ospina [17][20] argue that cell phones rather exacerbate the shadow economy, particularly in developing countries where broadband access is still scarce. On the contrary, high-speed internet connections seem to deter the phenomenon by enabling re-entry into formality through a greater positive productivity effect. The dual role that ICTs might play in the shadow economy also emanates from a sequence of other research papers [19] that provide mixed evidence.
Despite the potential risks associated with the underground economy, ICT presents clear opportunities for governments worldwide to combat the various factors that contribute to it (outlined in Section 1). Governments can leverage ICT to reduce regulatory hurdles, enhance tax administration by adopting a more client-focused approach toward taxpayers, identify tax evasion schemes, and streamline the process of formalizing employment [22]. There is an abundance of such successful governmental policy measures; in Georgia tax reforms accompanied by a new electronic tax filing system led to an impressive 2.5 percent of GDP a year gain on tax revenues [23]; in Costa Rica, the digitization of tax registration records and company books was followed by a considerable decrease in informal employment and estimated informal output [9]; in Brazil, Peru and Estonia initiatives to enable the electronic registration of workers and the unification of data declarations to internal revenue service and ministry of labor were accompanied by increased registrations of first time workers and improved labor tax collections. The researchers discussed how ICT can facilitate financial inclusion. As the financial sector continues to evolve and more intermediaries enter the market, the cost of credit will decrease. This, in turn, increases the opportunity cost for businesses that operate underground and are therefore excluded from official credit. Additionally, in the absence of access to formal banks, microfinance through mobile “accounts” can provide legitimate credit and security to those who have been excluded from traditional banking systems. Consequently, the financial development enabled by ICT can reduce barriers to obtaining credit and help transition informal businesses towards legitimacy [24].
Furthermore, ICT can promote transparency in government action in various ways. Firstly, internet-enabled technologies have allowed individuals to become providers of news and information, transforming the way information is consumed, created, and distributed, which enables whistleblowing and independent exposure to corruption incidents. Secondly, open government data have the potential, although not yet fully explored, to encourage collaboration between the government and stakeholders (citizens and businesses) to extract value from their use. Thirdly, technologies such as blockchain, which are tamper-evident and tamper-resistant by definition, are suitable for secure document handling and identity management, which are crucial for reliable access to government e-services. Improved transparency in public administration, enabled by technological advancements, is a key factor in enhancing overall governance quality. Evidence shows that improving governance quality may help reduce the growth of the underground economy [1][21].

4. Non-Parametric Analysis of Sovereign Credit Risk

This entry uses a series of machine learning techniques and employs model-agnostic methods in order to better understand the effects of the ICT penetration and the shadow economy on sovereign credit ratings and cost of debt, along with possible second-order effects between the two variables. The entry suggests that there is a clear, modest negative effect of ICT diffusion and usage on ratings and rates, with technological laggards paying a premium of 0.2 to 0.4 p.p. and pioneers paying a discount of about 0.2 p.p. Countries with modest ICT penetration do not enjoy any apparent direct effect; nevertheless, if they suffer from a high rate of the shadow economy, their commitment to digitization seems to be appraised by markets at a 0.25 p.p. discount.

In contrast, evidence is found of a positive relationship between the size of the informal economy and ratings as well as yields. A threshold of approximately 15–20% is found to be acceptable by both investors and agencies. Countries that manage to keep their shadow economies below this level increase their chances of obtaining a top rating by roughly 0.1. However, if this threshold is exceeded, the informal sector can have an adverse impact. Large shadow economies may be charged a premium of up to 1 percentage point by the markets. Notably, in the presence of poor ICT performance, a medium-sized shadow economy appears to be perceived by investors as a temporary economic safety valve. By presenting evidence that the informal sector of ICT laggards should not be eliminated before advancements in ICT take place, the entry indirectly supports the findings of Ndoya et al., who suggest that in some cases the underground economy presents a positive economic impact in African countries with low ICT penetration, and therefore a consolidation of ICT infrastructure in these countries could help curb the informal economy by including similar positive economic effects (absorption of unemployed workers, enhancement of entrepreneurial spirit, etc.).

The preceding discussion leads to a few policy implications. Firstly, countries can greatly benefit by keeping their shadow economies below 15–20%, which is the threshold for acceptable rates of informality set by both markets and agencies. Secondly, to take advantage of digitally transformed and interconnected economies, countries must invest heavily in ICT. Finally, if a country has a medium-sized shadow economy and low ICT penetration, it should prioritize improving its digital infrastructure before taking more aggressive measures to tackle the informal sector.

References

  1. Psychoyios, D.; Missiou, O.; Dergiades, T. Energy based estimation of the shadow economy: The role of governance quality. Q. Rev. Econ. Financ. 2021, 80, 797–808.
  2. Asea, P.K. The informal sector: Baby or bath water? A comment. Carnegie-Rochester Conf. Ser. Public Policy 1996, 45, 163–171.
  3. Elgin, C.; Birinci, S. Growth and informality: A comprehensive panel data analysis. J. Appl. Econ. 2016, 19, 271–292.
  4. Eilat, Y.; Zinnes, C. The shadow economy in transition countries: Friend or Foe? A policy perspective. World Dev. 2002, 30, 1233–1254.
  5. Elgin, C.; Ayhan Kose, M.; Ohnsorge, F.; Yu, S. Understanding Informality. In Koç University-TUSIAD Economic Research Forum Working Papers 2114; Koc University-TUSIAD Economic Research Forum: Instabul, Turkey, 2021.
  6. Dau, L.A.; Cuervo-Cazurra, A. To formalize or not to formalize: Entrepreneurship and pro-market institutions. J. Bus. Ventur. 2014, 29, 668–686.
  7. Gutiérrez-Romero, R. The Effects of Inequality on the Dynamics of the Informal Economy. In Proceedings of the IZA/WB conference, Bonn, Germany, 8–9 June 2007.
  8. Medina, L.; Schneider, F. Shedding Light on the Shadow Economy: A Global Database and the Interaction with the Official One; CESifo Working Paper, No. 7981; Center for Economic Studies and IFO Institute (CESifo): Munich, Germany, 2019.
  9. Ohnsorge, F.; Okawa, Y.; Yu, S. Lagging Behind: Informality and Development. In The Long Shadow of Informality: Challenges and Policies; Ohnsorge, F., Yu, S., Eds.; World Bank: Washington, DC, USA, 2022.
  10. Loayza, N.; Rigolini, J. Informal Employment: Safety Net or Growth Engine? World Dev. 2011, 39, 1503–1515.
  11. Caruso, L. Digital innovation and the fourth industrial revolution: Epochal social changes? AI Soc. 2018, 33, 379–392.
  12. Stiroh, K.J. Economic Impacts of Information Technology. In Encyclopedia of Information Systems; Hossein, B., Ed.; Elsevier: New York, NY, USA, 2003; pp. 1–14.
  13. Haacker, M.; Morsink, J. You Say You Want a Revolution. Information Technology and Growth, IMF Working Paper, WP/02/70, 2002. Available online: https://www.imf.org/en/Publications/WP/Issues/2016/12/30/You-Say-You-Want-A-Revolution-Information-Technology-and-Growth-15787 (accessed on 24 December 2022).
  14. Vu, K.; Hanafizadeh, P.; Bohlin, E. ICT as a driver of economic growth: A survey of the literature and directions for future research. Telecommun. Policy 2020, 44, 101922.
  15. The World Development report. Digital dividends. A World Bank Group Flagship Report. 2016. Available online: https://www.worldbank.org/en/publication/wdr2016, (accessed on 24 December 2022).
  16. Joia, L.A.; dos Santos, R.P. ICT and Financial Inclusion in the Brazilian Amazon. In Electronic Government. Lecture Notes in Computer Science; Springer: Berlin/Heidelberg, Germany, 2017; Volume 10428.
  17. Garcia-Murillo, M.; Velez-Ospina, A.J. The impact of ICTs on the informal economy. In Proceedings of the 20th ITS Biennial Conference, International Telecommunications Society, Rio de Janeiro, Brazil, 30 November–3 December 2014.
  18. Elgin, C.; Uras, B.R. Public debt, sovereign default risk and shadow economy. J. Financ. Stab. 2013, 9, 628–640.
  19. Chacaltana, J.; Leung, V.; Lee, M. New Technologies and the Transition to Formality: The Trend Towards e-Formality; Employment Working Paper No. 247; International Labor Office: Geneva, Switzerland, 2018.
  20. Veiga, L.; Rohman, I. E-Government and the Shadow Economy: Evidence from across the Globe. In Proceedings of the Electronic Government: 16th IFIP WG 8.5 International Conference, EGOV 2017, St. Petersburg, Russia, 4–7 September 2017; Springer: Berlin/Heidelberg, Germany, 2017.
  21. Elbahnasawy, N. Can e-government limit the scope of the informal economy? World Dev. 2021, 139, 105341.
  22. Vorisek, D.; Kindberg-Hanlon, G.; Koh, W.C.; Okawa, Y.; Taskin, T.; Vashakmadze, E.; Ye, L.S. Informality in Emerging Market and Developing Economies: Regional Dimensions. In The Long Shadow of Informality: Challenges and Policies (205–254); The World Bank: Washington, DC, USA, 2022.
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Subjects: Economics
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Apostolos Kotzinos
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Vasilios Canellidis
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Dimitrios Psychoyios
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Update Date: 01 Jun 2023
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