The Growth of the Shadow Economy in the OECD: Some Preliminary Explanations(1).

• Author: SCHNEIDER, FRIEDRICH

"... growing concerns have led many economists to the difficult task of measuring the size and development of the shadow economy [in OECD countries], tracing its main causes and analyzing the interactions between official and unofficial economies."

Over the last two decades, officials, politicians and social scientists have become increasingly concerned with the phenomenon of the shadow economy In many countries of the world, including the most developed, there are several important reasons why informed observers should be concerned about the size and growth of the shadow economy

First, an increase in the size of the shadow economy is usually a result of a rise in the overall tax and social security payments burden. This increased burden creates incentives for individuals to undertake commercial activity in the informal sector to avoid additional payments to the government. As a result, the rise in the shadow economy may lead to erosion of the tax and social security bases and a decrease in tax receipts. In turn, this may lead to a further increase in the budget deficit or to further increases in direct as well as indirect taxation. This may eventually create a vicious circle of increasing tax rates and ever-growing shadow economy.

Second, the very nature of the shadow economy makes it difficult to accurately measure official economic indicators, such as unemployment, income and consumption. Thus, economic policy, which is based on interpretation of these indicators, can be inefficient or even harmful. Where there is a prospering shadow economy, politicians must base policy on unreliable official indicators. The very direction of intended policy measures may therefore be questionable.

Third, a growing shadow economy creates strong incentives for workers--domestic and foreign--to work more in the shadow economy and less, or less efficiently, in the official economy

These growing concerns have led many economists to the difficult task of measuring the size and development of the shadow economy, tracing its main causes and analyzing the interactions between the official and unofficial economies. This paper provides an overview of this research. The first section lays out the latest results of the size of the shadow economies for 18 Organization for Economic Cooperation and Development (OECD) countries. The second section examines the development of the shadow economy over time, using Austria as a case study The third section looks at the influence of a changing tax structure on the shadow economy The final section summarizes my conclusion and gives some prospects for future research.

EMPIRICAL FINDINGS ON THE SIZE OF THE SHADOW ECONOMY FOR OECD COUNTRIES

As literature on the topic indicates, the currency demand approach is most often used to estimate the size of the shadow economy.(2) This approach estimates the size of the shadow economy by calculating the difference between the size of the economy (based on actual levels of cash) compared to the expected level of cash demand (given its GDP and its velocity of money).(3) It has been applied to estimate the size of the informal economies in most OECD countries. The results are shown in Table 1. Note that Greece has the largest informal economy, which comprises 29 percent of its GDP, while Switzerland has the smallest, with 8 percent. The US is also on the low end of the spectrum, with 8.9 percent.

Table 1 The Development of the Size of the Shadow Economy in Selected OECD Countries Over Time Applying the Currency Demand Approach

Size of the Shadow Economy (in percent of official GDP) Using the Currency Demand Approach in the Year 1960 1970 1980 Australia -- -- -- Austria 0.4 1.8 3.0 Belgium -- 10.4 16.4 Canada -- -- 10.1-11.2 Denmark 3.8-4.8 5.3-7.4 6.9-10.2 France -- 3.9 69.0 Germany 2.0-2.1 2.7-3.0 10.3-11.2 Greece -- -- -- Ireland -- 4.3 8.0 Italy -- 10.7 16.7 Netherlands -- 4.8 9.1 New Zealand(*) -- 6.9 9.2 Norway 1.3-1.7 6.2-6.9 10.2-10.9 Spain -- 10.3 17.2 Sweden 1.5-1.8 6.8-7.8 11.9-12.4 Switzerland 1.2 4.1 6.5 United Kingdom -- 2.0 8.4 USA 2.1-4.1 2.6-4.6 3.9-6.1 Size of the Shadow Economy (in percent of official GDP) Using the Currency Demand Approach in the Year 1994 1995 1996 Australia 13.0 13.2 14.0 Austria 6.7 7.3 8.3 Belgium 21.4 21.6 21.9 Canada 14.6 15.0 15.1 Denmark 17.6 18.1 18.3 France 14.3 14.8 14.9 Germany 13.1 13.9 14.5 Greece 26.0 26.6 28.5 Ireland 15.3 15.6 15.9 Italy 25.8 26.2 27.0 Netherlands 13.6 14.1 14.0 New Zealand(*) 11.3 -- -- Norway 17.9 18.5 18.9 Spain 22.3 22.6 22.9 Sweden 18.3 18.9 19.2 Switzerland 6.6 6.9 7.5 United Kingdom 12.4 12.6 13.1 USA 9.4 9.0 8.8 Size of the Shadow Economy (in percent of official GDP) Using the Currency Demand Approach in the Year 1997 1998 Australia 13.9 14.1 Austria 8.9 9.1 Belgium 22.4 22.6 Canada 14.8 15.0 Denmark 18.1 18.4 France 14.7 14.9 Germany 15.0 14.7 Greece 28.7 29.0 Ireland 16.1 16.3 Italy 27.3 27.8 Netherlands 13.5 13.5 New Zealand(*) -- -- Norway 19.4 19.7 Spain 23.1 23.4 Sweden 19.8 20.0 Switzerland 8.1 8.0 United Kingdom 13.0 13.0 USA 8.8 8.9 Source: E Schneider, "The Shadow Economies of Western Europe," Journal of The Institute of Economic Affairs, 17, no. 3, pp. 42-48; F. Schneider, "Ist Schwarzarbeit ein Volkssport geworden? Ein internationaler Vergleich des AusmaBes der Schwarzarbeit von 1970-97" in S. Lamnek and J. Luedtke, eds., Der Sozialstaat avischen Markt und Hedeonismus, Obladen (West Germany: Luedtke and Budrich publishing company,, 1999) pp.293-318.

(*) Source: D. Giles, "Modelling the hidden economy in the tax cape in New Zealand," Working paper (Department of Economics, University of Victoria, Canada, 1999).

Table 1 clearly shows that the increase of the shadow economy in all of these countries is quite remarkable and evident in all investigated countries. Whereas in 1960, the size of the shadow economy was below 5 percent of GDP, the shadow economy increased dramatically by 1998. By this time, in many OECD countries, the informal sector constituted over 13 percent of GDP; elsewhere, it was closer to 10 percent. In Belgium, the size of the shadow economy was 10.4 percent of GDP in 1970; by 1998, it had more than doubled to 22.6 percent. In Italy, the size of the shadow economy was 10.7 percent in 1970 and 27.8 percent in 1998--an increase of more than 160 percent in only 20 years.

Yet even in countries where the shadow economy is considerably smaller, the increase has been remarkable. In the United States, the shadow economy constituted between only 3.6 and 4.6 percent in 1970. By 1998, it had increased to 8.9 percent, a growth of 168 percent. The shadow economy of the Netherlands increased from 4.8 percent in 1970 to 13.5 percent in 1998, an increase of more than 181 percent. These findings demonstrate convincingly that in the OECD countries--the most affluent and stable economic systems of the world--there was a strong and steady increase in the size of the shadow economy over the last three decades.

Table 2 presents one possible explanation of the different sizes of the shadow economies in the OECD countries by comparing their overall tax and social security contributions with the size of their shadow economies for 1996.

Table 2 Size of the Shadow Economy and the Burden of Taxes and Social Security Contributions in OECD Countries

Size of the shadow economy Value added Average direct (in % tax rate tax rate of GDP) (in %)(*) (in %)(**) 1996 1996 1996 (1) (2) (3) Greece 28.5 18.0 11.0 Italy 27.0 19.0 12.0 Spain 22.9 16.0 13.0 Belgium 21.9 21.0 19.0 Sweden 19.2 25.0 20.0 Norway 18.9 23.0 19.0 Denmark 18.3 25.0 36.0 Ireland 15.9 21.0 20.0 Canada 14.6 7.0 21.0 Germany 14.5 15.0 18.0 France 14.3 20.6 6.0 Netherlands 14.0 17.5 10.0 U.K. 13.1 17.5 16.0 USA 8.8 3.0 17.0 Austria 8.3 20.0 8.0 Switzerland 7.5 6.5 10.0 Social Social Total social security security security contributions contributions contributions by employees by employers rate (in %) rate(***) rate(***) sum of (in %) (in %) (4)+(5) 1996 1996 1996 (4) (5) (6) Greece 15.8 27.5 43.3 Italy 9.9 32.0 41.9 Spain 6.6 31.6 38.2 Belgium 10.0 26.0 36.0 Sweden 4.0 29.6 33.6 Norway 7.0 12.8 19.8 Denmark 9.0 0.0 9.0 Ireland 7.2 12.3 19.5 Canada 7.0 8.0 15.0 Germany 16.1 16.1 32.2 France 13.0 31.0 44.0 Netherlands 31.0 8.8 39.8 U.K. 10.7 10.2 21.4 USA 7.6 13.8 21.4 Austria 18.2 24.2 42.4 Switzerland 11.6 11.6 23.2 Total social security Total tax and contributions + social security direct tax burden: burden: sum sum (4)+(5)+(3) (2)+(3)+ (in %) (4)+(5) 1996 1996 (7) (8) Greece 54.3 72.3 Italy 53.9 72.9 Spain 51.2 67.2 Belgium 55.0 76.0 Sweden 53.6 78.6 Norway 38.8 61.8 Denmark 45.0 70.0 Ireland 39.5 60.5 Canada 36.0 43.0 Germany 50.2 65.2 France 50.0 70.6 Netherlands 49.8 67.3 U.K. 37.4 54.9 USA 38.4 41.4 Austria 50.4 70.4 Switzerland 33.2 39.7 (*) Rates of the year 1996; USA: Average sales tax

(**) Average direct tax rate is calculated as the stun of all income taxes (+ payroll and manpower taxes) paid on wages and...