## _wp1247

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### I. Introduction: scope and definitions
- The underground economy is defined as “all market-based legal production of goods and service that are deliberately concealed from public authorities to avoid the payment of income, value added or other taxes, to avoid payment of social security contributions, having to meet certain legal labor market standards, such as minimum wages, maximum working hours, and safety standards, and complying with certain administrative procedures” (Schneider, Buehn, and Montenegro, 2010).
- Large informal or underground economies:
  - limit state capacity, hinder institutional development, discourage expansion of the formal sector, and restrict the benefits of a formal economy to relatively few participants (paras. 1–2).
  - may serve as a “nursery” for future formal-sector growth in poor and emerging countries (para. 4).
- De Soto (2000) perspective: weak formal property rights systems prevent leveraging of capital and restrict productive capacity, hindering wider participation in the formal economy (paras. 5–6).
- Paper structure described: methods to estimate size; analysis of estimates; determinants with emphasis on institutions and rule of law; role of IMF (para. 7).

### II. Measuring the size of the underground economy: methods and empirical ranges
- Measurement challenge: no direct measures; rely on indirect methods with drawbacks (para. 8).
- Methods used (Schneider 2004; Schneider, Buehn, and Montenegro, 2010):
  - Currency demand approach: excess demand for cash as indicator.
  - Electricity demand approach: difference between growth rate of electricity consumption and official GDP growth.
  - Labor force approach: estimates based on changes in labor participation assuming constant participation rate.
  - MIMIC model: multiple indicators multiple causes model using observed variables (share of direct taxes, size of government, tax rates, regulatory burden, GDP per capita) (para. 8).
- Empirical size estimates for 2006 (para. 9):
  - Advanced countries: range from 14–16 percent of GDP.
  - Emerging market countries: range from 32–35 percent of GDP.
  - Latin America, Central America, and Africa: often greater than 40 percent of GDP.
  - Middle East and Developing Asia: range between 25–35 percent of GDP.

### Box 1 — IMF role and operational activities
- Institutional development priorities: rule of law, government credibility, strong legal and judicial framework; consolidate institutions to support macroeconomic stability, property rights, and free trade.
- IMF activities:
  - Surveillance advice and technical assistance (TA) to strengthen economic institutions; post-global financial crisis work on financial regulatory and supervisory framework.
  - Improving Tax Governance:
    - Substantial TA in tax policy, tax administration, and drafting of tax legislation.
    - Aim to establish tax regimes for small businesses with minimum discretion to reduce corruption and compliance burden.
    - Work on tax procedure codes, simplified registration procedures, promotion of one-stop shop registration for small businesses.
    - Coordination with IFC on tax and administrative reforms supportive of small business.
  - Combating Money Laundering and the Financing of Terrorism (AML/CFT):
    - TA on money laundering and counter terrorist finance policy and governance/institutional issues when illicit sectors are macro-critical.
    - Objectives: increase government ability to identify source of assets (including tax fraud) and reduce cash basis of the economy.
    - TA program areas: build capacity and strengthen AML/CFT law, legal framework, financial intelligence units, training for on-site bank/regulator inspections, implement risk based supervision.
    - IMF-supported AML/CFT TA examples: Bangladesh, Cambodia, Lao PDR, Mongolia, Guinea, Lesotho, The Gambia, China, Syria, Iran, Mauritania, Mauritius, Moldova, Nigeria, the Kyrgyz Republic, Turkmenistan, and the West Bank and Gaza.
    - Reference cited: IMF, AML/CFT Methodology with FATF 40 + 9 Recommendations, Interpretive Notes and Best Practices, June 2009 (Box 1, footnote).

### III. Determinants from the literature: taxes, institutions, regulation, labor, and finance
- Tax burden debate:
  - Johnson, Kaufmann, and Zoido-Lobaton: a one point worsening on a 1-to-7 perceived tax burden scale raises shadow economy by 11.7 percentage points (para. 10).
  - Friedman and others (2000): raising taxes by one point on a 1-to-5 Heritage Foundation measure leads to a 9 percent fall in the size of the underground economy (para. 10).
- Institutional drivers:
  - Bureaucracy, corruption, and weak legal environments correlate with larger unofficial economies (para. 11).
  - Regulatory burden: a one point worsening of the regulation index (Heritage Foundation) associated with a 12 percent increase in the size of the underground economy (Friedman and others, 1999) (para. 11).
- Labor market regulations:
  - Cumbersome labor market restrictions increase informal employment and underground economy by raising hiring costs (para. 12).
  - International Labour Organization: more than 70 percent of workers in developing countries are outside the official economy, despite underground economy share around 35 percent of GDP (para. 12).
  - World Bank (2004) job-creating reforms: increase length/scope of term contracts, introduce apprentice wages, allow flexible working hours, remove administrative approvals for dismissals (para. 12).
- Financial access:
  - Limited access to formal financial services traps firms in low-productivity operations; in many developing countries, less than half the population has an account with a financial institution and in some countries less than one in five households do (para. 13).
  - Policy priorities: build sound financial institutions, encourage competition, establish sound prudential regulation, strengthen creditor rights, enable securitized lending, raise interest rate ceilings to broaden access (para. 13).
  - IMF and World Bank FSAP assesses stability and development aspects including legal framework and financial infrastructure (para. 13).

### IV. Relationship between the underground economy and institutions: empirical analysis and findings
- Empirical strategy:
  - Instrumental variable regression using exogenous geographical and historical factors that influence institutional formation to address endogeneity and isolate contribution of poor institutions to large underground economies (para. 14).
- Data and methodology:
  - Sample: data on around 100 countries, includes advanced, emerging market, and developing countries.
  - Dependent variable: size of the shadow economy (Schneider, Buehn, and Montenegro (2010)).
  - Independent variables include: top marginal income tax rate (Fraser Institute); real per capita GDP (World Bank WDI); CPI inflation (IMF’s IFS).
- Measures of institutional quality:
  - Six composite WGI indicators: voice and accountability; political stability and absence of violence; government effectiveness; regulatory quality; rule of law; control of corruption.
  - Aggregate indicators are UCM-based, in units of a standard normal distribution (mean zero, standard deviation of one, approx. -2.5 to 2.5).
  - Overall institutional quality (governance indicator) is the average of the six composites.
  - Only one governance measure used at a time due to high correlation among measures; alternative: Heritage Foundation’s Index of Economic Freedom also considered.
- Empirical patterns (figures):
  - Figure 5 regression: y = -11.39x  + 34.648 ; R² = 0.4352. Depicts Size of shadow economy (% GDP) vs Overall governance - average of WGI scores.
  - Figure 6 regression: y = -10.28x  + 34.592 ; R² = 0.4727. Depicts Size of shadow economy (% GDP) vs Rule of law - WGI score.
- Main regression findings:
  - Institutional quality effects:
    - A one standard deviation improvement in overall institutional quality implies an almost 11 percentage point reduction in the size of the shadow economy.
    - A one standard deviation improvement in the rule of law score is associated with an 8 percentage point reduction in the share of the shadow economy.
    - Results are robust across different institutional measures.
  - Once institutions are controlled for, taxes, inflation, and per capita income are no longer statistically significant; interpretation: weak institutions and rule of law, not higher taxes per se, drive underground activity.
  - Corruption effect: a one standard deviation decrease in the corruption index leads to a 7 percentage point increase in the size of the shadow economy.
- Table 1 selected reported coefficients (dependent variable: size of shadow economy in percent of GDP):
  - Top marginal income tax rate 2/: -0.345* -0.300* -0.234* -0.195 -0.191 -0.24
  - Inflation 3/: 0.674** 0.828** 0.059
  - Per capita income (log): -5.919** -2.170 -2.517 -1.325
  - Rule of law 4/: -8.172*
  - Control of corruption 4/: -7.077*
  - Overall governance 5/: -10.725*
  - Constant: 45.578** 27.615** 35.708** 88.258** 59.810** 62.185* 55.639*
  - Observations (as reported): 94135919182 82 82
  - R-squared (as reported): 0.0990.1170.2590.5230.576 0.572 0.558
  - Notes: Robust t-statistics in parentheses; ** p<0.01, * p<0.05. Data sources and sample averaging described in notes.

### V. Conclusions and policy implications
- Key conclusions:
  - The underground economy is a significant share of overall output in many countries.
  - Onerous regulation, weak and inconsistent enforcement, and corruption increase incentives to hide activities.
  - The rule of law is central to curbing shadow economic activity.
- Policy implications:
  - Large reductions in tax rates or increasing the number of regulations will not shrink the shadow economy.
  - Governments should emphasize:
    - strengthening the rule of law;
    - simplifying access to the formal economy;
    - strict enforcement of the minimum necessary set of regulations rather than increasing regulatory requirements.
- IMF engagement:
  - IMF provides surveillance advice and technical advice to strengthen economic institutions and has supported financial regulatory and supervisory reform since the global recession.
  - IMF technical assistance on AML/CFT and governance has been provided where large illicit sectors are macro-critical.

*Source: IMF staff paper excerpts provided in content unit.*

### References .............................................................................................................

### _wp1247 - References .............................................................................................................

### I. INTRODUCTION
- Large informal or underground economies limit state capacity, hinder institutional development, discourage expansion of the formal sector, and restrict the benefits of a formal economy to relatively few participants (paras. 1–2).
- The underground economy is defined in this work as “all market-based legal production of goods and service that are deliberately concealed from public authorities to avoid the payment of income, value added or other taxes, to avoid payment of social security contributions, having to meet certain legal labor market standards, such as minimum wages, maximum working hours, and safety standards, and complying with certain administrative procedures” (para. 3; Schneider, Buehn, and Montenegro, 2010).
- Large informal sectors may also serve as a “nursery” for future formal-sector growth, particularly in poor and emerging countries where informal activity shares are much larger than in rich countries (para. 4).
- De Soto (2000) perspective: weak formal property rights systems in poor countries prevent leveraging of capital and restrict productive capacity, hindering wider participation in the formal economy (paras. 5–6).
- Paper structure: methods to estimate the size of the underground economy; analysis of estimates; determinants with emphasis on institutions and the rule of law; role of IMF in addressing informalization (para. 7).

### II. MEASURING THE SIZE OF THE UNDERGROUND ECONOMY
- Measurement challenge: no direct measures; indirect methods with drawbacks (para. 8).
- Methods used (Schneider 2004; Schneider, Buehn, and Montenegro, 2010):
  - Currency demand approach: estimates size from excess demand for cash because most underground transactions are in cash.
  - Electricity demand approach: uses electricity usage as a physical indicator of economic activity; estimates based on difference between growth rate of electricity consumption and official GDP growth.
  - Labor force approach: estimates growth based on decline in labor participation, assuming a constant labor participation rate.
  - Multiple indicators multiple causes model (MIMIC model): estimates size based on multiple observed variables presumed to cause it, including the share of direct taxes, the size of the government, tax rates, the regulatory burden, and GDP per capita (para. 8).
- Empirical size estimates for 2006 (para. 9; Figures 1–3):
  - Advanced countries: range from 14–16 percent of GDP.
  - Emerging market countries: range from 32–35 percent of GDP.
  - Latin America, Central America, and Africa: often greater than 40 percent of GDP.
  - Middle East and Developing Asia: range between 25–35 percent of GDP.

### Box 1 — Role of the IMF in Reducing the Size of the Underground Economy
- Institutional development priority: rule of law, government credibility, and strong legal and judicial framework; establishment and consolidation of economic institutions to support macroeconomic stability, property rights, and free trade (Box 1).
- IMF roles and activities:
  - Surveillance advice and technical assistance (TA) to strengthen economic institutions; reform of financial regulatory and supervisory frameworks post-global financial crisis (Box 1).
  - Improving Tax Governance:
    - Substantial program of TA in tax policy, tax administration, and drafting of tax legislation.
    - Aim to establish tax regimes for small businesses with minimum discretion to reduce corruption and compliance burden.
    - Work on tax procedure codes and tax administration reforms supporting simplified registration procedures; promotion of one-stop shop registration for small businesses.
    - Coordination with IFC to facilitate tax and administrative reforms supportive of small business (Box 1).
  - Combating Money Laundering and the Financing of Terrorism (AML/CFT):
    - TA to members on money laundering and counter terrorist finance policy and on governance and institutional issues when illicit sectors affect financial or economic stability.
    - Dual objectives: increase government ability to identify source of all assets (including tax fraud) and reduce cash basis of the economy where it impedes source identification.
    - TA program areas: build capacity and strengthen AML/CFT law, legal framework, financial intelligence units, training for on-site bank/regulator inspections, and implementing a risk based approach to supervision (Box 1).
    - IMF-supported AML/CFT TA has taken place in countries such as Bangladesh, Cambodia, Lao PDR, Mongolia, Guinea, Lesotho, The Gambia, China, Syria, Iran, Mauritania, Mauritius, Moldova, Nigeria, the Kyrgyz Republic, Turkmenistan, and the West Bank and Gaza (Box 1).
    - Reference: IMF, AML/CFT Methodology with FATF 40 + 9 Recommendations, Interpretive Notes and Best Practices, June 2009 (Box 1, footnote).

### III. DETERMINANTS OF THE SIZE OF THE UNDERGROUND ECONOMY: KEY RESULTS FROM THE LITERATURE
- Tax burden debate:
  - One strand: more burdensome tax regime increases underground activity; example estimate: a one point worsening on a 1-to-7 perceived tax burden scale raises shadow economy by 11.7 percentage points (Johnson, Kaufmann, and Zoido-Lobaton) (para. 10).
  - Contrasting strand (Friedman and others, 2000): higher taxes associated with a smaller underground economy; example estimate: raising taxes by one point on a 1-to-5 Heritage Foundation measure leads to a 9 percent fall in the size of the underground economy, on the premise that higher revenues improve public goods and legal environment (para. 10).
- Institutional drivers:
  - Political, economic, and social institutions are argued as main drivers; bureaucracy, corruption, and weak legal environments correlate with larger unofficial economies (para. 11).
  - Regulatory burden is a key determinant; a one point worsening of the regulation index (Heritage Foundation) is associated with a 12 percent increase in the size of the underground economy (Friedman and others, 1999). Figure 4 shows correlation between regulatory burden and size of shadow economy (para. 11).
- Labor market regulations:
  - Cumbersome labor market restrictions increase informal employment and the underground economy by raising hiring costs and discouraging formal hiring (para. 12).
  - International Labour Organization: more than 70 percent of workers in developing countries are outside the official economy, even though the share of the underground economy is much lower around 35 percent of GDP (para. 12).
  - World Bank (2004) findings: reforms that create jobs include increasing the length/scope of term contracts, introducing apprentice wages, allowing flexible working hours, and removing administrative approvals for dismissals (para. 12).
- Financial access:
  - Limited access to formal financial services traps firms in low-productivity operations and perpetuates inequality (para. 13).
  - In many developing countries, less than half the population has an account with a financial institution and in some countries less than one in five households do (para. 13).
  - Policy priorities: build sound financial institutions, encourage competition, establish sound prudential regulation, strengthen creditor rights, enable securitized lending, and raise interest rate ceilings to make lending attractive and broaden access (para. 13).
  - IMF and World Bank Financial Sector Assessment Program (FSAP): assesses financial sector stability and development aspects including legal framework and financial infrastructure (para. 13).

### IV. RELATIONSHIP BETWEEN THE UNDERGROUND ECONOMY AND INSTITUTIONS: EMPIRICAL ANALYSIS
- Empirical question: the extent to which weaknesses in institutional quality create room for underground economic activity, noting potential mutual reinforcement between large underground economies and weak institutions (para. 14).
- Methodological approach:
  - Use of an instrumental variable regression employing exogenous geographical and historical factors shown to influence institutional formation to address endogeneity and isolate the contribution of poor institutions to large underground economies (para. 14).

*Source: IMF staff paper excerpts provided in content unit.*

### 15.      The analysis uses data on around 100 countries, and includes advanced

### _wp1247 - 15.      The analysis uses data on around 100 countries, and includes advanced

### Data and methodology
- Sample: data on around 100 countries, and includes advanced countries, emerging markets, and developing countries.
- Dependent variable: the size of the shadow economy, which is estimated in Schneider, Buehn, and Montenegro (2010) based on the methodologies outlined in the previous section.
- Independent variables include:
  - top marginal income tax rate (Fraser Institute);
  - real per capita GDP (World Bank WDI database);
  - CPI inflation (IMF’s IFS database).

### Measures of institutional quality
- Institutional measures drawn from the World Bank’s Governance database (based on Kaufmann, Kraay, and Zoido-Lobaton (1999) and Kaufmann, Kraay, and Mastruzzi (2009)).
- Six composite indicators measuring perceptions of institutional quality:
  - voice and accountability,
  - political stability and the absence of violence,
  - government effectiveness,
  - regulatory quality,
  - the rule of law,
  - control of corruption.
- Note on construction: aggregate indicators are based on hundreds of individual variables from household and firm survey respondents; an Unobserved Components Model (UCM) combines individual indicators into six composite measures of governance.
- Scale: composite measures are in units of a standard normal distribution, with mean zero, standard deviation of one, and running from approximately -2.5 to 2.5, with higher values corresponding to better institutional outcomes.
- Overall institutional quality (governance indicator) is the average of these six composite indicators.
- Highly correlated measures: only one governance measure used at a time in empirical analysis to avoid misleading inference.
- Alternative measure considered: Heritage Foundation’s Index of Economic Freedom (mentioned as also considered).

### Empirical patterns (figures)
- Figure 5 regression line and fit:
  - y = -11.39x  + 34.648
  - R² = 0.4352
  - Depicts: Size of shadow economy (% GDP) vs Overall governance - average of WGI scores.
- Figure 6 regression line and fit:
  - y = -10.28x  + 34.592
  - R² = 0.4727
  - Depicts: Size of shadow economy (% GDP) vs Rule of law - WGI score.

### Main regression findings (summary)
- Better institutions are associated with a significantly lower share of the shadow economy:
  - If overall institutional quality improves by one standard deviation, an almost 11 percentage point reduction in the size of the shadow economy is achieved.
  - A one standard deviation improvement in the rule of law score is associated with an 8 percentage point reduction in the share of the shadow economy.
  - Results are robust across a number of different measures of institutional quality.
- Institutions are the most important determinant of the size of the underground economy:
  - Once controlling for institutions, taxes, inflation, and per capita income are no longer statistically significant.
  - Interpretation: it is not higher taxes per se that lead to increased shadow economy but rather weak institutions and rule of law.
  - Businesses have an incentive to go underground to reduce the burden of regulation, consistent with Friedman and others (2000).
- Corruption effect:
  - Countries with more corruption tend to have larger underground economies.
  - A one standard deviation decrease in the corruption index leads to a 7 percentage point increase in the size of the shadow economy.

### Table 1. Determinants of the Size of the Shadow Economy (selected items as reported)
- Dependent variable: size of shadow economy (in percent of GDP) 1/
- Coefficients reported (as in source):
  - Top marginal income tax rate 2/: -0.345* -0.300* -0.234* -0.195 -0.191 -0.24
  - Inflation 3/: 0.674** 0.828** 0.059
  - Per capita income (log): -5.919** -2.170 -2.517 -1.325
  - Rule of law 4/: -8.172*
  - Control of corruption 4/: -7.077*
  - Overall governance 5/: -10.725*
  - Constant: 45.578** 27.615** 35.708** 88.258** 59.810** 62.185* 55.639*
- Observations (as reported): 94135919182 82 82
- R-squared (as reported): 0.0990.1170.2590.5230.576 0.572 0.558
- Notes:
  - Robust t-statistics in parentheses; ** p<0.01, * p<0.05.
  - 1/ Average of estimates for 1999–2000, 2000–01, 2002–03, from Schneider (2005).
  - 2/ Fraser Institute; data from the year 2000.
  - 3/ CPI inflation in 2000.
  - 4/ Kauffman, Kraay and Mastruzzi, World Bank 2009; data are average from 1996-2008.
  - 5/ Overall institutional quality is measured as the averaged of six institutional variables as in KKM 2009.

### Conclusions and policy implications
- The underground economy constitutes a significant portion of the overall economy in a number of countries.
- Drivers: onerous regulation, weak and inconsistent enforcement, and corruption increase incentives for businesses to hide activities in the underground economy.
- Importance of the rule of law in curbing shadow economic activity is emphasized.
- Policy implication:
  - Large reductions in tax rates or increasing the number of regulations will not shrink the shadow economy.
  - Governments should emphasize:
    - strengthening the rule of law,
    - simplifying access to the formal economy,
    - strict enforcement of the minimum necessary set of regulations, rather than increasing the plethora of regulatory requirements.

### IMF engagement
- The IMF has been involved in strengthening economic institutions through surveillance advice and technical advice to members.
- Since the global recession, the IMF has played a key role in reforming the financial regulatory and supervisory framework.
- To combat the underground economy directly, the IMF has supported members by providing technical assistance on combating money laundering and counter terrorist finance policy, and on larger governance and institutional issues when large illicit sectors are thought to be macro critical.

*Source: Excerpt from the provided PDF content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2012/_wp1247.pdf_