To shrink or not to shrink? Shadow economy reversals around the world

Abstract

The relationship between shadow economy (SE) and development has been extensively researched. However, there is a lack of consensus on the factors that drive reversals. This paper examines the effect of SE reversals when government collections are affected to changes in productivity, business regulations and financial depth. To this end, drawing on González et.al. (2005; 2017) Panel Smooth Transition Regression (PSTR), we examine the rationale of exclusion and escape theories in Advanced (AE) and Emerging and Developing Economies (EMD). Results show that at a macroeconomic level, both perspectives coexist simultaneously. In EMD, the optimal threshold for revenues hovers around 13.6% of GDP while in AE it equals 24%. The explanation for this is that institutional tensions lead to SE reversals when financial pressure is binding (e.g., more robust banking systems) facilitating the transactions in the formal channels and reducing the incentives for joining the SE. Conversely, when economies are above the critical tax level of revenues, financial pressure is binding and workers may voluntarily take part-time positions or jobs in units with lower required skills which explains the expansion of the SE. Evidently, the institutional has a direct effect over worker’s productivity with mixed effects over tax collection.