Poverty and the shadow economy: The role of governmental institutions

• Published date: 01 April 2020
• Author: Friedrich Schneider,James W. Saunoris,Aziz N. Berdiev
• DOI: http://doi.org/10.1111/twec.12917
• Date: 01 April 2020

World Econ. 2020;43:921–947. wileyonlinelibrary.com/journal/twec

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921

© 2020 John Wiley & Sons Ltd

Received: 24 July 2019

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Revised: 21 October 2019

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Accepted: 7 January 2020

DOI: 10.1111/twec.12917

ORIGINAL ARTICLE

Poverty and the shadow economy: The role of

governmental institutions

Aziz N.Berdiev1

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James W.Saunoris2

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FriedrichSchneider3

1Department of Economics, Bryant University, Smithfield, RI, USA

2Department of Economics, Eastern Michigan University, Ypsilanti, MI, USA

3Research Institute of Finance and Banking, Johannes Kepler University, Linz, Austria

KEYWORDS

cross-country data, poverty, shadow economy

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INTRODUCTION

According to the most recent estimates from the World Bank, the global poverty rate stands at 10.9%

(28.6%), amounting to approximately 783 million (2.044 billion) people living onless than $1.90

($3.20) per day (Atamanov et al. 2018). However, this number masks the remarkable variance in pov-

erty rates across regions. That is, among lower income regions such as sub-Saharan Africa, the $1.90

($3.20) poverty headcount ratio is 42.3% (67.5%), whereas among severalhigh income countries, the

poverty rate isless than 1% (Atamanov et al. 2018).

Interestingly, countries that tend to have the highest poverty rate also tend to have a larger shadow

economy.1 For instance, countries in sub-Saharan Africa tend to have the largest shadow economy

estimated to be between 39% and 76% of GDP, while among high incomecountries, the shadow econ-

omy tends to be between 8% and 30% of GDP (Schneider & Enste, 2000). It is perhaps the case that

the poverty rate overestimates the extent of poverty as individuals earn unreported income

underground.

The positive relationship between poverty and the shadow economy cursorily observed motivates

the question: doespoverty increase the size of the shadow economy? The answer to this question has

been explored for quite some time by various scholars (see, e.g., Amuedo-Dorantes, 2004; Canelas,

2015; Devicienti,Groisman, & Poggi, 2010; Kim, 2005; Nazier & Ramadan, 2015). These studies,

while insightful, are limited to single-country studies, and thus, the findings from these studies are

country-specific. For instance, Amuedo-Dorantes (2004) finds that poverty is positively associated with

shadow sector work using data for Chile, whereas Nazier and Ramadan (2015) show that poverty has a

statistically insignificant influence on employment in the underground economy using data for Egypt.

1 Notice that although the terms shadow, informal and underground are employed interchangeably here, they all denote

economic activity that is unregistered in the formal economy.

We thank the editor, anonymous referees and participants at the 2019 Western Economic Association International

Conference (San Francisco) and 2019 International Institute of Public Finance Congress (Glasgow) for valuable suggestions.

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BERDIEV Et al.

Nonetheless, why would one expect a greater prevalence of poverty to increase the size of the

shadow economy? Conceivably, low incomehouseholds might drive the shadow economy through

stronger demand for goods and services. To the extent that shadow sector goods and services are

cheaper (Schneider & Enste, 2013), individuals living in poverty might purchase goods and services

at lower prices in underground, thereby promoting the spread of shadow production.

Furthermore, the prevalence of poverty might lead low incomeindividuals to turn to the un-

derground for employment opportunities (Amuedo-Dorantes, 2004). In other words, the informal

economy offers an escape for people living in poverty to earn income. Indeed, individuals receiving

government provided aid might prefer informal employment to avoid the high implicit tax associated

with losing welfare benefits as a result of taking a formal sector job. In this case, poverty is propelling

individuals to supply their labour in the shadow economy.

Another possibility is that the prevalence of poverty might drive low incomeindividuals to supply

their entrepreneurial talents to produce goods and services in the shadow economy. For instance,

because of the high barriers (e.g. taxes and regulations) to enter in the formal sector, lower income

individuals are more likely to start their informal entrepreneurial ventures in the underground.

Yet, besides economic factors such as the prevalence of poverty that might drive the shadow

economy, the extant literature has identified government institutions among the determinants of

the shadow economy (see, e.g., Berdiev & Saunoris, 2018; Berdiev, Saunoris, & Schneider, 2018a;

Dreher, Kotsogiannis, & McCorriston, 2009; Friedman, Johnson, Kaufmann, & Zoido-Lobaton,

2000; Johnson, Kaufmann, Shleifer, Goldman, & Weitzman, 1997;Saunoris & Sajny, 2017;

Schneider, 2010, 2011; Teobaldelli & Schneider, 2013; Torgler & Schneider, 2009). In general,

research has shown that high qualitygovernment institutions increase the benefits of participat-

ing in the formal economy or increase the opportunity cost of moving to the informal economy.

Consequently, government institutions impact the cost–benefit calculation of individuals in pov-

erty in the decision to participate underground.

Thus, what is the role of institutions and the government in conditioning the effects of poverty on

the size of the underground sector? Perhaps, the quality and size of government institutions might

influence the relationship between poverty and the shadow economy. For instance, low qualitygov-

ernments may enable corrupt bureaucrats to demand bribes, thereby forcing especially low incomein-

dividuals to transition to the shadow sector to avoid dealing with corrupt public officials. In other

words, low incomeindividuals may be targets of bribe demands that force these individuals to migrate

underground.

Moreover, growth in government bureaucracy as a result of poverty reduction programmes might

raise taxes and increase government reach into the market economy that promotes the development of

the underground economy. However, larger governments might offer more public goods and services

to low incomeindividuals that then increases the opportunity cost of par ticipating in the informal

sector. All of these considerations suggest that the degree of governmental institutions might amplify

or mitigate poverty's effect on underground participation/production.

In testing the above arguments, we contribute to the literature in two important ways. First, we

analyse the influence of the prevalence of poverty on the shadow economy using cross-country panel

data for over 100 nations covering the period from 1991 to 2015. Second, we study the interaction

effects between poverty and governmental institutions on the shadow economy, namely, we analyse

whether the impact of poverty on the size of the shadow economy is dependent on government institu-

tions. To account for the influence of governmental institutions in the effect of poverty on the shadow

economy, we consider two dimensions: (a) the quantity, or size, of government and (b) the quality of

government.