What 45 Years of Data Tells Us About Globalization’s Influence on the Shadow Economy

May 8, 2018 Robert G. Blanton

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The shadow sector, or informal economy, includes everything from illicit sidewalk sales of counterfeit handbags to large corporations that evade taxes and ignore regulations. It makes up a substantial portion of the global economy. The OECD estimated in 2009 that 1.8 billion workers participated in this sector, generating over $10 trillion in goods and services. Indeed, in many countries the number of people employed informally exceeds the number in the formal workplace.

This is hardly a benign phenomenon; the shadow economy is a vital concern for broader issues of economic development, as it raises questions related to a state’s capacity to govern and manage its economy. The reduced tax revenues limit a government’s ability to provide services and necessary infrastructure, and the shadow sector is ultimately a drag on economic growth. For firms, shadow economies may increase the prospective costs of doing business, as they connote higher levels of corruption and put licit businesses at a competitive disadvantage, as compared with otherwise less productive firms operating in the informal sector.

Yet many aspects of the shadow economy remain underexamined and poorly understood. In a recent project we studied a foundational issue: the relationship between licit and illicit economies.

Specifically, we examined how two aspects of a country’s participation in the global economic order — being open to foreign trade and investment and participating in the International Monetary Fund’s (IMF) structural adjustment programs, or SAPs — affect the growth of the informal economy.

The shadow and legitimate markets are usually seen as operating in an essentially complementary fashion, with the informal economy expanding alongside the formal. We argue that a more complex relationship exists and that the specific impact of global ties on the shadow sector varies with the type of involvement.

First, we posit that openness to trade and capital flows leads to a smaller shadow sector. The reduction of tariffs and other barriers to commerce should remove economic incentives for illicit economic activity. Specifically, a substantial number of illicit markets, such as garlic and tobacco, exist because of the vast disparities in cost due to tariffs and other duties. More broadly, increased exposure to global competition and business interests can serve to raise economic standards and business practices. This “climb to the top” or “California effect” can increase the prospective benefits of conducting business in the formal sector.

By contrast, participation in IMF programs is conducive to growth in the informal economy. Most aspects of economic openness reflect a “globalization from below” dynamic, in which firms and individuals decide to complete globally. By contrast, IMF programs involve major economic changes that are externally mandated, most notably policy conditions (that is, shrinking the public sector and labor reforms) as well as macroeconomic targets (reduced public spending and budget deficits). While the intentions of these programs may be worthwhile, we argue that adherence to SAPs prompts shadow sector activity. In this case, the combination of short-term economic hardship and decreased state capacity can limit the opportunities and incentives to participate in the formal workforce, and thus encourage growth in the shadow sector.

To figure out whether our hypothesis was accurate, we analyzed these linkages across 145 countries over a 42-year period (see sidebar) and controlled for a battery of factors that may influence shadow economy growth, such as economic growth, inflation, democracy, and income level.

Taken as a whole, our results support our claims. Specifically, we find robust evidence that while economic openness is associated with a decline in annual shadow sector activity, participation in IMF programs is positively related to growth in the illicit economy.

Taking a closer look at specific countries sheds some light on why we may be seeing this effect. Both India and Chile provide examples of economic openness in action. From 1995 to 2010, both of these countries adopted a number of measures to increase their economic integration into the global economy since the 1980s, and the size of these countries’ shadow sectors decreased considerably as a result of their globalization efforts. India’s economic globalization score increased by 62% from 1995 to 2010, which coincided with its shadow sector contracting by 27%. Chile exhibited similar patterns, with a 24% increase in economic globalization and a 22% decrease in its informal economy.

The cases of Togo (1979 to 1998) and Tunisia (1986 to 1992) illustrate how participating in IMF programs can contribute to shadow sector growth. Though both received IMF loans to address their budgetary and other financial problems, both experienced considerable increases in their shadow sectors’ growth during the IMF years. In the case of Togo, there was an increase of about 18% in the size of its shadow economy during the years it was under IMF assistance. And while Tunisia was deemed a successful reformer by the IMF, its shadow sector also grew while under SAPs, due largely to the increased scarcity of formal work opportunities during that time.

To the extent that a pervasive shadow economy represents a risky business environment, our research provides a more nuanced set of implications for prospective investors. We find that increased commercial globalization through enhanced trade and investment or the adoption of liberalizing policies contributes to the reduction of shadow sector activity.

This suggests that multinational corporations can improve the conditions within their host countries’ economies, making them better places to do business in the long run. Yet while IMF reforms are intended to provide a better business climate, we find that in practice SAPs undercut efforts to expand the formal economy.

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