Emerging from the dark- The Shadow Economy

By Devika Mathur, Edited by Vaibhav Agarwal


The shadow economy refers to all work, activity, and business transactions that occur ‘below the radar’ – economic activity that is undeclared and for which taxes that should be paid, are not. On hearing the term ‘shadow economy ', one mostly thinks of illegal activities, a gang dealing in drugs, some people smuggling goods, or perhaps just a trade of stolen items. While the shadow economy is all of that, its scope extends way beyond. All the goods that one buys at the traffic lights, a vegetable seller selling their produce on the cart, or a roadside cart selling snacks, and everyone who doesn't disclose or pay associated levies for their income contribute to the shadow economy. While some of these activities could be with the purpose of tax evasion, others could be attributed to tax avoidance.


There are several reasons that people engage in the shadow economy. As per Friedrich Schneider and his colleagues, excluding the criminal and informal activities, one of them is to avoid payment of income, value-added, or other taxes. In a bid to evade tax implications imposed on their incomes which lower their disposable income, some people become a part of the shadow economy. The next reason could be to avoid payment of social security contributions. In some nations, people beyond an income level are obliged to contribute a certain proportion of it towards social security. To dodge such obligations, people might have some unreported income, thus contributing to the shadow economy. Another possible reason could be to avoid having to meet certain legal labor market standards like maximum working hours, minimum wages, and safety standards. In addition to this, avoiding compliance with certain administrative procedures, such as the completion of statistical questionnaires or other administrative forms could be yet another reason.


Considering the fact that most people contributing to the shadow economy try very hard to avoid detection, estimating its accurate size can be a fairly uphill task. However, policymakers and governments do seek information regarding the same to make better and well-informed decisions on resource allocation. In 2011, in his book titled ‘The Global Rise of the Informal Economy', Robert Neuwirth estimated that the shadow economy was worth US$10 trillion and employed 1.8bn people worldwide. In fact, he stated that, if the shadow economy were a state, it would be the second-largest economy in the world. As per a report by ACCA Global, the estimated value of India's shadow economy was estimated at ₹ 26,158.01 billion in 2016. As per the overall prediction, the size of the shadow economy is anticipated to decline globally from 23% of global GDP in 2011 to an estimated 21% in 2025. But the rate of decline is not the same in all countries. For instance, India’s prediction for 2025 stands at 13.6%, compared to 9.9% for China, 33.89% for Pakistan, and 6.94% for the US. As per the report, the top three factors that determine the size of India's shadow economy are employment growth, GDP growth, and unemployment.


Source: https://link.springer.com/10.1007/978-1-4614-7753-2_574


The shadow economy has several adverse economic impacts. One of them is that, as more and more people work in the informal economy, the official economy tends to witness falling participation rates. Similarly, as people work additional hours in the hidden sector, a fall in the hours worked in the official economy may be witnessed. As the shadow economy grows, production inputs, especially labor, move at least partly out of the official economy. This displacement can potentially depress the official growth rate of the economy. As the shadow economy grows, the government's revenue tends to decrease, and thus the expenditure on public goods and welfare also falls. Some people believe that shrinking the shadow economy would increase tax revenues, stimulating a rise in public spending, especially on infrastructure and services, which would in turn support production expansion. This would lead to an overall rise in the economic growth rate.


Surprisingly, there are some positive impacts as well. One of them is the rise in the demand for money. Most of the transactions in the shadow economy tend to be in cash. Thus, a rising shadow economy can imply an increasing demand for money. Certain empirical studies have shown that at least two-thirds of the income earned in the shadow economy is quickly spent in the official economy. Thus, an increase in the shadow economy can stimulate overall economic growth.


While there is ambiguity about the conclusive effects and numbers pertaining to the shadow economy, the need for a better and stricter intervention has never been higher. To look into the same, a key element is tax administration. Tax implications and the size of the shadow economy are co-related. A study of 76 countries showed that with every 1% increase in the index of regulatory intensity, the shadow economy grows by 10%. The shadow economy has been seen growing when there is an ineffective and discretionary application of rules. Cross-country statistics have suggested that entrepreneurs choose to go underground to reduce the burden of politics, bureaucracy and corruption. High marginal tax rates, intense regulations, an extremely complex tax system, and high tax resistance have incentivized a flight to the shadow economy.


For better tax administration, one key way is to have higher tax education and simpler compliance methods, implying a system that is easily understandable and accessible to all. Increasing detection and reducing the opportunities of evasion is another way through which a better tax administration can be achieved. For that purpose, proper and efficient use of behavioral, transactional, operational, and open data can help administrators keep a close check on unreported/ underreported income and associated frauds. Technology can play a crucial role in the same. Another useful measure could be establishing strong behavioral norms by widely spreading messages regarding the perks of compliance and the risks associated with non-compliance. A social influence should be created to cater to that.


To sum it up, the shadow economy is a large and very significant part of the contemporary world, and with its ambiguous overall effect on the economy, there is a severe need to have a stringent watch on the activities that contribute to it along with having a highly effective and efficient administrative system.


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