Does globalisation affect the shadow economy?

• Published date: 01 January 2018
• DOI: http://doi.org/10.1111/twec.12549
• Author: James W. Saunoris,Aziz N. Berdiev
• Date: 01 January 2018

ORIGINAL ARTICLE

Does globalisation affect the shadow economy?

Aziz N. Berdiev

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James W. Saunoris

2

1

Department of Economics, Bryant University, Smithfield, RI, USA

2

Department of Economics, Eastern Michigan University, Ypsilanti, MI, USA

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INTRODUCTION

The presence of the shadow economy exists in all countries to varying degrees (Loayza, 2016;

Schneider, 2005; Schneider & Enste, 2000).

1

For instance, among developed countries, it is esti-

mated that around 16% of total production takes place in the shadow whereas for developing coun-

tries approximately 38% of their production is underground, while in some cases (Bolivia; 66%) a

majority of their economy is underground (Schneider, 2005). Interest in the shadow economy is

partly in response to the potentially large costs they impose on the official sector. For example, the

shadow economy weakens the government’s ability to collect taxes, undermines established institu-

tions, distorts relative prices and allocations of resources to the extent the less productive under-

ground economy competes with the official sector, and misrepresents official statistics in which

many policies are based (see G€

erxhani, 2004; Schneider & Enste, 2000).

Alternatively, it is possible that the shadow economy provides benefits to the formal sector. For

example, Dell’Anno and Solomon (2008) find that the shadow economy employs unemployed

individuals from the formal sector, thereby lessening the negative consequences of unemployment

on the formal sector. Moreover, the shadow economy contributes to economic growth and develop-

ment by “the creation of markets, increase financial resources, enhance entrepreneurship, and trans-

form the legal, social, and economic institutions necessary for accumulation”(Asea, 1996, p. 166,

cited in Schneider & Enste, 2000). The widespread prevalence of the shadow economy and the

costs and benefits it imposes has thus prompted researchers and policymakers to better under the

factors driving the size of the shadow economy in an attempt to curtail its spread or encourage

shadow activities to transition to the formal sector (G€

erxhani, 2004).

In addition to the growing concern over the consequences of the shadow economy worldwide,

there has been an increasing acceptance towards opening borders and becoming more global ly

integrated (economically, politically and socially) to exploit the benefits of globalisation. Globalisa-

tion as defined by Keohane and Nye (2000, p. 2) is “a state of the world involving networks of

interdependence at multi-continental distances.”Globalisation contributes to, among other things,

the sharing of ideas, reducing trade barriers, increasing capital flows and lowering costs of

1

Although we use the terms informal and shadow economy interchangeably, we are referring to firms and workers that oper-

ate outside the legal and regulatory framework (see Loayza, 2016); that is, shadow economy production includes activity

that, had it been recorded, would be included in official GNP estimates; therefore, it excludes the criminal sector of the

economy (e.g. drug production).

DOI: 10.1111/twec.12549

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©2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/twec World Econ. 2018;41:222–241.

transportation (World Bank, 2002). Likewise, the benefits of globalisation show up in increasing,

for example, economic growth (see Dreher, 2006). Whereas the effects of globalisation on

economic growth have been well documented in the literature, the effects on the shadow economy

are less forthcoming.

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To fill this void, in this paper we study the impact of globalisation on the shadow economy.

Since the process of globalisation is comprised of numerous dimensions (Dreher, 2006; Potrafke,

2010), we also investigate the effect of economic, political and social globalisation on the shadow

economy; however, it is important to recognise that the disaggregated measures of globalisation

are not mutually exclusive and instead are intricately related. We use globalisation variables devel-

oped by Dreher (2006) and further summarised in Dreher, Gaston, and Martens (2008). Moreover,

we employ the measures of the shadow economy calculated by Elgin and

€

Oztunali (2012) and

Schneider, Buehn, and Montenegro (2010). Using panel data for 119 countries, we find that glob-

alisation matters in mitigating shadow development. In particular, after controlling for important

factors that affect the shadow economy, our evidence suggests that it is the political (rather than

economic or social) element of globalisation that is primarily responsible for impeding shadow

development. These findings are robust after accounting for an alternative measure of the shadow

economy, outliers, endogeneity, and alternative model specifications.

The rest of the paper is organised as follows: Section 2 describes the relationship between glob-

alisation and the shadow economy; Section 3 describes the data and the model; Section 4 presents

the empirical results, while Section 5 offers a number of robustness tests. We summarise our major

findings in the final section.

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GLOBALISATION AND THE SHADOW ECONOMY

Understanding the effects of globalisation and the shadow economy can be best understood using a

standard two-sector growth model—that is, formal and informal sectors—where labour, entrepre-

neurs and managers have the ability to escape the formal sector (including a government) and

migrate to the informal sector (see, e.g. Loayza, 1996, 2016; Rauch, 1991).

3

As defined above, the

informal sector comprises firms and workers that operate outside the legal and regulatory framework.

The attractiveness of the informal sector is determined by the cost-benefit differential between the

two sectors. For example, the development of the informal economy is determined by the trade-off

between informal firms benefiting from avoiding high labour costs (e.g. minim um wage laws, hiring

and firing regulations) at the cost of higher capital costs and lower productivity (see, e.g. Loayza,

1996, 2016; Rauch, 1991).

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Therefore, the taxes and regulatory burdens imposed in the formal sector

encourage economic actors to evade these by employing their resources in the informal economy

(see, e.g. G€

erxhani, 2004; Johnson et al., 1997; Loayza, 1996; Loayza et al., 2009; Schneider, 2011;

Schneider & Enste, 2000; Tanzi, 1982).

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Additionally, the quality of formal institutions distorts the

2

For a relevant exception, see, for example, Fugazza and Fiess (2010) and more recently Pham (2017).

3

Related to this literature is the economics of tax evasion by Allingham and Sandmo (1972), according to which, rational

individuals weigh the benefits from evading taxes against the probability of detection.

4

Loayza (1996) and Loayza, Serv

en, and Sugawara (2009) provide an excellent discussion on the costs of formality and

informality. Kaufmann (1997) also notes that companies examine the costs and benefits of participating in the official versus

the shadow economy.

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Related to these causal factors includes the citizen’s perception of the state referred to as tax morality, which has been

shown to significantly influence shadow development (see Torgler & Schneider, 2007).

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