Working In The Shadows

There’s a new Policy Research Working Paper from the World Bank, estimating the size of the shadow economy in a large sample of 162 countries:

Shadow economies all over the world : new estimates for 162 countries from 1999 to 2007 - Schneider, F., and Buehn, A. & Montenegro, C. E.

This paper presents estimations of the shadow economies for 162 countries, including developing Eastern European, Central Asian, and high-income countries over the period 1999 to 2006/2007. According to the estimations, the average size of the shadow economy (as a percentage of "official" gross domestic product) in 2006 in 98 developing countries is 38.7 percent; in 21 Eastern European and Central Asian (mostly transition) countries, it is 38.1 percent, and in 25 high-income countries, it is 18.7 percent. The authors find that the driving forces of the shadow economy are an increased burden of taxation (both direct and indirect), combined with labor market regulations and the quality of public goods and services, as well as the state of the "official" economy.

What’s the shadow economy? Basically it’s all the economic activity that isn’t captured in the official statistics, because the people involved don’t want the government to know. Good examples in the Malaysian context would be crime, street sellers, backyard industries, and the like, where data is hard or impossible to collect or estimate.

The authors in this case specifically excluded crime from their estimations, using the definition “all market-based legal production of goods and services that are deliberately concealed from public authorities" to avoid taxation and regulation. The informal household economy (which is not market based, and consists of provision of non-monetary services) is also not included in the estimates.

So how big is the shadow economy in Malaysia? The authors use 7 different estimation specifications, which yielded broadly similar results – averaging between 30.7% to 31.3% of official nominal GDP, from 1999-2007, with a 15% error rate. That’s a little below the median for the East Asia region as a whole, so we’re par for the course here. But it does imply that the Malaysian economy is 25%-35% bigger than implied by the official GDP statistics.

One obvious reaction here is to look at the potential shortfall in government revenue, though I’m going to resist the temptation to use simplistic mathematics and claim that we could get a 30% boost to government revenue by bringing these activities within the formal economy. Given the smaller scale of these activities, the net increase in taxation should be fairly small.

On the other hand, a more efficient taxation system and more consistent regulation would help bring these activities under the “official” economy, and no doubt help government finances as well as give a boost to “official” growth.

Time to bring on GST?

(H/T Bloomberg)

Technical Notes:

Schneider, Friedrich, and  Buehn, Andreas & Montenegro, Claudio E., "Shadow economies all over the world : new estimates for 162 countries from 1999 to 2007", World Bank, Policy Research working paper no. WPS 5356, July 2010