International Economic Journal

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The Economic Growth–Inflation–Shadow Economy

Trilogy: Developed Versus Developing Countries

Nedra Baklouti & Younes Boujelbene

To cite this article: Nedra Baklouti & Younes Boujelbene (2019): The Economic
Growth–Inflation–Shadow Economy Trilogy: Developed Versus Developing Countries, International
Economic Journal, DOI: 10.1080/10168737.2019.1641540

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INTERNATIONAL ECONOMIC JOURNAL
https://doi.org/10.1080/10168737.2019.1641540

The Economic Growth–Inflation–Shadow Economy Trilogy:

Developed Versus Developing Countries
Nedra Baklouti & Younes Boujelbene

Faculty of Economics and Management of Sfax, University of Sfax, Sfax, Tunisia

ABSTRACT ARTICLE HISTORY

This study investigates the nexus among the economic growth– Received 26 December 2018
inflation–shadow economy trilogy by including the role of political Revised 8 May 2019
stability for a sample of 33 developed and 14 developing coun- Accepted 5 June 2019
tries over the 2005–2016 period. For the OECD countries, our results KEYWORDS
showed a bidirectional nexus among economic growth and the size Shadow economy; economic
of the shadow economy while the causality running from economic growth; inflation; political
growth to inflation, on the one hand, and from inflation to the infor- stability
mal economy, on the other hand, is unidirectional. As for the MENA
JEL CLASSIFICATIONS
panel, the relationship between inflation and the underground econ-
E26; E31; O17; O47
omy remains bidirectional, while the relationship running from infla-
tion to economic growth, on the one hand, and from the informal
economy to economic growth, on the other hand, is unidirectional.
With the introduction of political stability, the nexus among the
informal economy and the inflation in the OECD countries becomes
unidirectional running from inflation to the shadow economy. How-
ever, in the case of MENA countries, controlling for political stability
reduces the magnitude of the coefficient of the shadow economy on
inflation. We note that with a low level of political stability, countries
facing the large size of the informal sector will shift their financing
from taxes to seigniorage.

1. Introduction
The more informal economy is neglected in public policies, the more its growth in the
developing economies exceeds 40% of production (Porta & Shleifer, 2008; Schneider &
Enste, 2000). The goods and services where produced, traded or consumed in violation of
the law, does not contribute to social well-being and should not be included in the national
accounts (Tanzi, 2002). In fact, the shadow economy has been found to be the result of
inefficient public policies (Blackburn, Bose, & Capasso, 2012; Capasso & Jappelli, 2013;
Schneider & Enste, 2000; Yereli, Seçilmiş, & Başaran, 2007). Moreover, the underground
economy reduces the State revenue, which results in either the decline of the public services
or the increase of taxes of other taxpayers who have to compensate for the shortfall. To
tax the informal economy and finance public spending, governments need to find other
sources of revenue. Therefore, inflation is such a source that encourages governments to
shift their sources of income from taxes to inflation (Bailey, 1956; Cavalcanti & Villamil,

CONTACT Nedra Baklouti nedra.baklouti@gmail.com

© 2019 Korea International Economic Association
2 N. BAKLOUTI AND Y. BOUJELBENE

2003; Koreshkova, 2006; Phelps, 1973). In fact, the amplification of the inflation rate is
strongly linked to that of the informal sector.
Therefore, a high level of economic growth and a stable level of prices are the main inter-
est of economic and political decision-makers. In general, evidence shows that inflation
can be harmful to an economy and hurt economic growth (Friedman, 1977). On the other
hand, an excessive or prolonged inflation is likely to have variability and significant price
movements that may cause adverse effects on future income generated by the investment,
while leading to lower economic growth. Particularly for the least developed countries,
inflation has an important aspect of political economy, the parallel economy as one of the
key variables that has not yet been sufficiently analyzed. The latter contains the economic
activities that are reported to the tax authorities and that would generally be taxable. More
specifically, the informal economy is larger in developing countries because it increases the
chances that public spending will be offset by an inflation tax to generate informal sector
income.
On the other hand, political stability can play an important part in the relation-
ship between inflation and the shadow economy (e.g. Acemoglu, Johnson, Robinson, &
Thaicharoen, 2003; Aisen & Veiga, 2008a). Specifically, with a stable political system, elec-
tions are fair and the media are freer. In such conditions, political leaders and all parties
involved in illegal operations may lose their power. Moreover, political stability can be con-
sidered as reinforcing checks and balances. However, in democratic transition countries
where the governments’ oversight is weak, the results imply that political instability and
democratic reforms that change the autocratic model of authority into democracy may
increase the informal economic activity. The latter, in turn, erodes the tax base and forces
the political authorities to offset the sources of tax revenues with inflation.
In fact, this paper provides a modest contribution to the existing literature by using a
three- equation system in the sub-sample of the developed countries as well as in that of
the developing countries to investigate the nexus among economic growth, inflation and
shadow economy, while emphasizing the effect of political stability.
This study is structured as follows. This study is structured as follows. Next section
provides a brief review of the literature and presents some of the major papers related to
this issue. Section 3 shows the data and methodology used. Section 4 discusses the esti-
mation results. Section 5 provides robustness checks. Finally, section 6 contains the main
conclusions.

2. Literature Review
2.1. Economic Growth and the Shadow Economy: The Causal Direction Is
Controversial
We formulate the empirical framework in which the nexus among the underground
economy and economic growth is studied based on the following literature review. As
regards the impact of the informal economy on economic growth, the empirical evi-
dence is ambiguous (e.g. Cooray, Dzhumashev, & Schneider, 2017; Goel, Saunoris, &
Schneider, 2019; Schneider & Enste, 2000; Williams & Schneider, 2016). In fact, some stud-
ies showed that the underground economy can hurt economic growth (Friedman, Johnson,
Kaufmann, & Zoido-Lobaton, 2000; Johnson, Kaufmann, & Zoido-Lobaton, 1998; Loayza,
 INTERNATIONAL ECONOMIC JOURNAL 3

1997). Escape to the informal sector would reduce public spending because of lower taxes
collected. In this context, Schneider (2011) used data on 21 OECD countries and 89 devel-
oping and transition ones from 1990 to 2000. He found that the underground economy has
a highly statistically significant effect on economic growth. Again their impact is negative
for the developing countries and positive for the transition and OECD ones. On the other
hand, Loayza (1997) examines this relationship in 14 Latin American countries. This sur-
vey finds a negative relationship between the underground economy and economic growth.
However, other research studies concluded that the informal economy could strengthen
competition and efficiency in the formal sector by outsourcing services at a lower cost or
removing strict regulations, which fosters economic growth (Bovi & Dell’Anno, 2010). The
same results are shared by Saunoris (2018) which adds that the productive factors in the
informal sector are more efficient compared to the official sector. Similar arguments were
put forward by Nabi and Drine (2009), who argued that legal goods that have been pro-
duced in the formal economy will be offset by an expansion of informal activities which
ensures economic growth. For his part, Williams (2006) shows that economic growth rises
with a larger size of the underground economy. He found that the informal sectors may pro-
vide more competitiveness absorbing excess demand and supply from the formal economy
and employs unemployed workers.
However, some empirical studies forward another stand, which is the nexus among
economic growth-shadow economy (Baklouti and Boujelbene, 2018; Medina & Schnei-
der, 2018; Wu & Schneider, 2019). This stand is based on the economic argument that the
wealth that comes from the informal economy will necessarily be used by the formal econ-
omy. Equally, with the rise in wealth created by the formal economy, the goods and services
that are produced by unobserved activities will be in greater demand.
More recently, Baklouti and Boujelbene (2018) have proposed a dynamic simultaneous-
equation model to investigate the relationship among economic growth and the under-
ground economy for 17 developing and 33 developed countries from 2005 to 2015.
The results obtained indicated that this relationship is unidirectional in the developing
countries but bidirectional in the developed ones.
The above-related research shows that the nexus between the informal economy and
economic growth cannot confirm that the positive effects dominate the negative effects,
or vice versa. In fact, the economic situations and the magnitude of the informal sector
are essential to determine the nature of this relationship. Therefore, these variables can
certainly interact simultaneously.

2.2. The Economic Growth-Inflation Relationship

Actually, the nexus among inflation and economic growth is a contentious issue. Over the
period 1980–2015, Mosikari and Eita (2018) estimated the optimal impact of inflation on
the economy of Swaziland. The results obtained using the OLS method showed that the
inflation rate beyond an optimal level of 12% decreases economic growth by 1.02%. In
fact, beyond a certain threshold, the 2SLS method shows that inflation exerted a negative
impact by around 18.5% while the results from granger causality analysis confirmed that
there is a causality running from inflation to economic growth. Moreover, using data from
21 countries for the period 1961–1987, Grimes (1991) shows that the inflation–economic
growth nexus is positive in the short term but negative in the long one.
4 N. BAKLOUTI AND Y. BOUJELBENE

As for Eggoh and Khan (2014), they find a no linear relationship between inflation and
economic growth. They also show that this non-linearity can be affected by the level of
income.
For their part, Umaru and Zubairu (2012) studied the inflation–growth nexus in Nigeria
for the period 1970–2010. In their study, the Granger causality test showed a unidirectional
causality running from the GDP to inflation. On the other hand, Erbaykal and Okuyan
(2008) adopted a Panel Cointegration Approach for Turkey from 1997 to 2006. Their result
sustains a unidirectional causality running from inflation to the GDP.

2.3. The Shadow Economy–Inflation Nexus: The Role of Political Stability

Actually, several authors, such as Aisen and Viega (2008b), Mazhar and Méon (2017) have
studied the nexus among the shadow economy and inflation. Earlier studies conducted by
Blackburn and Powell (2011) and Roubini and Sala-i-Martin (1995) stated that the under-
ground economy can be used to finance public expenditures. However, other authors, such
as Canzoneri and Rogers (1991) and Goel and Nelson (2016) showed that inflation can be
seen as a channel for imposing the informal economy. On the other hand, Koreshkova
(2006) and Ergene (2015) adopted similar arguments in the case of a system of tax evasion
and insufficient tax collection. It was found that the size of the informal sector is positively
linked with the inflation rate.
However, political stability has been ignored when explaining the nexus among the
informal sector and inflation. Therefore, this study contributes to economic research by
explaining the role of political stability in the underground economy–inflation relation-
ship, which makes it different from previous studies that focused on the direct impacts
of the shadow economy on inflation without worrying about its interaction with political
stability.
By focusing on the role of political stability, Desmet, Van Spanje, and de Vreese (2012)
showed that political instability may be accompanied by ethnic and religious divisions,
which incites governments to contribute to developing the underground economy (Cukier-
man et al., 1992). In turn, the underground economy causes the state a lack of tax revenues
and social contributions while forcing governments to use other means to finance their
expenses. To raise its income, the State will create money which makes appear the infla-
tionary tax or seignorage. As a result, the price level will increase and each holder of the
currency pays the tax in the form of a decrease in the buying power of the currency (;
Phelps, 1973; Sargent & Wallace, 1981).
The existing literature mentioned above denotes that the shadow economy effect of
inflation is determinate by the political situation of the country. Hence, it is interesting
to empirically test the nature of the relationship among these variables of interest.

3. Theoretical Considerations and Hypotheses

In the economic literature, the approach of the National Accounting defines the
underground economy as any economic activity that contributes to the gross domestic
product of a country, but she was not registered (Bhattacharyya (1999); Smith, 1997).
Unlike the previous approaches, the current alternative approach considers that the under-
ground economy is better defined by the individual characteristics of these activities. For
 INTERNATIONAL ECONOMIC JOURNAL 5

instance, Feige (1990) showed that the rejection of the established institutional rules is
a determining factor in participating in the underground economy. Moreover, Loayza
(1997) argues that the underground economy is an unregulated sector in a legal and
social framework that regulates similar activities. The underground economy would thus
be maintained by the existence of a system of excessive regulations. The Loayza model
revealed that an increase in the size of the informal sector leads to a lower level of economic
growth.
However, as emphasized by the neoclassical theory, the shadow economy stimulates eco-
nomic growth as it increases competition and limits the activities of the State. Moreover,
the theoretical model of the economic cycle showed that the underground economy and
economic growth are positively correlated.
From a theoretical point, the underground economy can influence the level of tax rates
by reducing tax revenues. Therefore, the presence of the high tax evasion should make sev-
eral countries to apply indirect taxation through rates of inflation (see Bailey, 1956; Phelps,
1973). Previous theoretical research studies, such as those of Cukierman, Edwards, and
Tabellini (1989) and Canzoneri and Rogers (1991) suggested that the political factor is a
significant determinant of inflation. In fact, seignorage is generally used as a source of gov-
ernment revenue because of tax evasion and inadequate regulation of politically unstable
societies.
Regarding the nexus among inflation and economic growth, the neo classical growth
model of Mudell (1963) and Tobin (1965) found that inflation could permanently increase
economic growth by stimulating capital accumulation. They also argued that inflation leads
agents to transform their money into another asset, which increases the capital extensive
and promoting higher economic growth. However, the monetarist theory and Stockman’s
(1981) model showed a negative relationship between inflation and economic growth.
Their argument emphasizes that an increase in the rate of inflation leads to a drop in the
level of stability of the level of well-being. The authors added that money is a complement
to the capital and represents a negative correlation linking the stable production level and
the inflation rate.
In light of the literature review and the theoretical considerations above, the following
hypotheses are formulated and the predictable signs of the estimated coefficients are cited
in the Table 1:

Hypothesis 1: Increasing the size of the underground economy leads to decrease in economic
growth, ceteris paribus.
Hypothesis 2: Increasing the size of the underground economy leads to increase in the inflation
rate, ceteris paribus.
Hypothesis 3: Increasing the inflation rate leads to decrease in economic growth, ceteris
paribus.

Table 1. Predictive the signs of the estimated coefficient.

Dependent variable Growth SE Inflation
Growth n.a _ ±
SE ± n.a +
Inflation ± + n.a
6 N. BAKLOUTI AND Y. BOUJELBENE

4. Applied Methodology and Data

4.1. Econometric Methodology
For the object of examining the nexus among the shadow economy, economic growth, and
inflation, a dynamic simultaneous-equation panel data models were used to estimate the
following equations system:
GDPit = αGDPit−1 + τ INFLit + γ SEit + βXit + λit , (1)
INFLit = α  INFLit−1 + τ  GDPit + γ  SEit + β  Yit + λit , (2)
   
SEit = α SEit−1 + τ INFLit + γ GDPit + β Zit + λit , (3)
where subscript i denotes the country and t denotes time period, GDP economic growth,
INFL the inflation rate, SE the size of the shadow economy, and the random error term
λ, λ and λ are the effects of all the omitted variables. Then, parameters α, α  and α 
are lagged dependent variables, while the interest variables are shown by τ and γ in
Equation (1), τ  and γ  in Equation (2), and τ  and γ  in Equation (3). The control vari-
ables of three equations are represented by the vectors β, β  , and β  . The description of the
variables and the correlation between the variables of interest are presented respectively in
Tables 2 and 3 of the following section.
Equations (1), (2), and (3) are estimated simultaneously by means of the GMM estimator
by Arellano and Bond (1991). To find solution to the Endogeneity problems of the regres-
sors and avoid correlation problems, the simultaneous-equation dynamic panel uses a set of
instrumental variables. The Hansen test, the first-order autocorrelation test AR(1) and the
second order autocorrelation test AR(2) aims at controlling the validity of the instruments
and the Durbin–Wu–Hausman test has been used to test the Endogeneity problem.

4.2. The Data

We employ the annual data for 50 countries during 2005–2016. The sample is a represen-
tative panel of 33 OECD1 countries and 14 MENA2 countries. The grouping of regions and
countries were decided on the basis of data of Medina and Schneider (2018).
We examine the causality between inflation, economic growth and the underground
economy, which are measured by GDP growth (% annual) (GDP), the consumer price
index (CPI) and the size of the shadow economy (SE), respectively.
In the first equation, the exogenous variables including the inflation, the shadow econ-
omy, the tax revenue, the foreign direct investment, the human capital and the public
expenditure determine the dependent variable, which is economic growth. The second
equation includes economic growth, the underground economy, the exchange rate, domes-
tic credit to the private sector, and political stability which have also been used to explain
inflation. Furthermore, the third equation includes an examination of the impact of eco-
nomic growth, inflation, self- employment, unemployment, tax burden variables on the
shadow economy. The data sources and the measurement units are provided in the Table 2.

1 Austria, Lithuania, Australia, the United States, Belgium, the United Kingdom, Italy, Sweden, Greece, Chile, Iceland, Spain,
the Czech republic, Norway, Denmark, Slovak Republic, Estonia, Portugal, Finland, France, New Zealand, Germany, the
Netherlands, Mexico, Slovenia, Luxembourg, Ireland, Hungary, Latvia, Poland, Canada, Korea, and Japan.
2 The United Arab Emirates, Algeria, Jordan, Egypt, Lebanon, Tunisia, Kuwait, Libya, Qatar, Morocco, Iran, Oman, Saudi Arabia,
and Turkey.
 INTERNATIONAL ECONOMIC JOURNAL 7

Table 2. Data sources.

Variables Measurement unit Sources
Economic growth (GDP) GDP growth (annual %) WDI (2016)
Inflation (CPI) The annual percentage change in consumer price WDI (2016)
index,
Shadow economy (SE) Shadow economy % of GDP Medina and Schneider (2018)
Government spending (GS) Government spending Heritage Foundation
Foreign Direct Investment (FDI) Foreign direct investment, net inflows (BoP, current WDI (2016)
US$)
Tax revenue (TR) Tax revenue (% of GDP) WDI (2016)
Human Capital (HC) School enrollment. tertiary (% gross) WDI (2016)
Gross Fixed Capital Formation (GFCF) Gross fixed capital formation (% of GDP) WDI (2016)
Self-employed (Self. E) Self-employed, total (% of total employment) WDI (2016)
Tax Burden (TB) Tax Burden Heritage Foundation
Political Stability (PS) Political Stability index(ranges from approximately Kaufmann et al. (2016)
−2.5 (high political instability) to 2.5 (greater
political Stability and Lack of Violence)
Credit to the private sector, (CREDIT) Domestic credit to private sector,(% of GDP) WDI (2016)
Exchange Rate (ER) Real effective exchange rate index WDI (2016)
Unemployment (UNEM) Unemployment, total (% of total labor force) WDI (2016)

Table 3. Descriptive statistics of the variables.

OECD MENA
Variables Mean SD CV Mean SD CV
GROWTH 4.045 7.081 1.750 1.756 3.043 1.732
INFLATION 99.754 8.233 0.082 98.162 25.945 0.264
SE 19.301 6.778 0.351 22.184 5.397 0.243
PS 0.774 0.463 0.598 −1.422 0.938 −1.515
HC 70.059 16.364 0.233 30.053 17.350 0.577
GFCF 22.405 4.081 0.182 22.060 6.002 0.272
FDI 6.473 17.494 2.702 3.174 3.517 1.108
GS 42.974 19.930 0.463 65.562 12.873 0.196
TR 19.039 7.321 0.384 86.080 11.261 0.130
Self. E 16.506 7.306 0.442 27.613 16.007 0.579
UNEM 7.895 4.305 0.545 10.964 5.362 0.489
CREDIT 104.999 47.420 0.451 44.202 25.501 0.576
ER 100.382 9.229 0.091 99.063 9.295 0.093
TB 64.934 13.516 0.208 84.385 11.214 0.132
Notes: SD denotes the standard deviation. CV denotes the coefficients of variation

The descriptive statistics of the variables and the correlation matrix between the key
variables are accessible in Tables 3 and 4, respectively. On average, the highest levels of eco-
nomic growth (4.045) are found in OECD countries, whereas the lowest averages (1.847)
are found in the MENA ones. On the other hand, the highest average of inflation and
underground economy are found in the MENA countries, while the lowest averages of
these variables are recorded in the OECD ones. As for the highest mean of political stabil-
ity, human capital, foreign direct investment, credit to the private sector, and the exchange
rate is recorded in the countries that have the highest economic growth.
Nevertheless, the highest average level of government spending, tax revenue, self-
employment, unemployment, and the tax burden are recorded in the countries that have
the lowest economic growth. It is also noted that the two groups of countries possess almost
the same average of gross fixed capital formation. Regarding the volatility of the variables,
which is given by the Coefficient of Variation (CV), the OECD countries are more volatile
8 N. BAKLOUTI AND Y. BOUJELBENE

Table 4. The correlation matrix between the three variables of

interest.
Countries Variable GDP CPI SE
OECD GROWTH 1.0000
INFLATION −0.2438 1.0000
SE 0.0250 −0.1667 1.0000
MENA GROWTH 1.0000
INFLATION −0.2523 1.0000
SE −0.1518 −0.0827 1.0000

in terms of the shadow economy, unemployment, foreign direct investment, tax revenue,
and the tax burden while the MENA countries are more volatile for the other variables.
The descriptive values of the economic situation of the MENA countries found that
unable to meet the basic needs of their production besides, and they cause the regressive
trend in the income distribution.
Remaining in the same circumstances, the informal economy would concretize attempts
of social inspiration to correct the weakness of the government. The consequences engen-
dered by the informal economy are qualitatively and quantitatively variable, depending on
the prevailing economic and financial structures. For example, in countries where tax col-
lection is weak or social protection is non-existent or embryonic, the impacts of the shadow
economy are not the same for those countries where the State revenues are taxed or those
with a high level of social protection.
In the OECD countries, which fall into this second category, the underground economy
could probably act as a social buffer, ultimately increasing economic difficulties by depriv-
ing the State of fiscal resources, therefore, the gradual shift in the informal economy of
part of the working population can thus be seen as a translation of the desperation of those
who no longer have the prospect of finding a job in the short term. However, in the MENA
countries that are more exposed to the underground economy, the problem is naturally dif-
ferent. They are characterized by low political stability, a high inflation rate, low economic
growth and a high tax burden, which often make the informal economy a necessary evil
for a generally poor population.
According to the correlation matrix between the key variables, the problem of multi-
collinearity is solved in our regression models. In fact, Table 4 shows that for the MENA
countries, inflation and the underground economy are negatively related to economic
growth, while the link between the shadow economy and inflation is (−0.0827), indicating
a negative relation between them. The table also shows that the OECD countries, eco-
nomic growth, and the shadow economy are negatively correlated with inflation. Actually,
the correlation among the shadow economy and economic growth is evaluated at (0.0250),
indicating a positive relation between them.

5. Findings
To ensure that the results shown in Table 3 are not driven by unobserved heterogeneity, a
three-step least-squares method is applied. Further precisely, Zellner’s (1962) SUR method
is used to estimate the three equations presented above. In fact, three specifications are
reported for each of our variables of interest. The first specification takes as a regressor
 INTERNATIONAL ECONOMIC JOURNAL 9

economic growth while inflation and the size of the informal sector are respectively the
regressors of the second and third specifications.
The estimated results for the global panel are provided in Table 5. The SUR estimator
indicates that all our models are statistically significant with a high level at 1%. The overall
findings show a bidirectional causal link among economic growth and inflation, between
economic growth and the shadow economy and between inflation and the shadow econ-
omy. From the first specification, we observe that CPI has significant and negative effects
on the GDP at 1% level. This suggests that a 1% point increase in the inflation rate for the
global panel by about 0.050%. This result is consistent with that of the endogenous growth
theory and proves that with the taxation of human capital, the inflation acts negatively on
economic growth (Lucas, 1988). The same specification proved that economic growth is
likewise negatively and significantly influenced by the shadow economy as a 1% point the
increase in the informal economy decreases the economic growth by around 0.40%. This
finding is in line with those of the previous works of (Friedman et al., 2000; Loayza, 1997),
which proved that the expansion of the underground economy could erode tax bases and
reduce both tax revenues and economic growth.
At the second specification, the results show that the effect of economic growth on
inflation is statistically and significantly negative at 1%. This suggests that a 1% point the
increase of economic growth reduces inflation by around 0.55%, which is compatible with
the findings of Gillman et al. (2004). This also implies that the most prosperous coun-
tries have the ability to overcome macroeconomic problems while the informal economy
has a positive impact on inflation. Accordingly, a 1% point of the increase of the shadow
economy’s size returns in a 0.148% increase of the inflation rate, meaning that illegal
market development can alleviate the reduction of supply, increased prices and lower of
consumption.
In the third specification, inflation acts significantly and positively on the underground
economy at the one-percent level. This indicates that a one percentage point development
of inflation raises the size of the shadow economy by 0.237%. On the other hand, a 1% point
of the increase of economic growth brings to a 0.015% decrease of the informal economy.
This signifies that the shadow economy is both a cause and a consequence of inflation.

Table 5. SUR estimation for the link among economic growth, inflation, and
the shadow economy: The global panel.
Specification 1 Specification 2 Specification 3
GDP CPI SE
GROWTH – −0.556*** −0.015***
(0.000) (0.000)
INFLATION −0.163*** – 0.237***
(0.000) (0.000)
SE −0.477 0.148 –
(0.000)*** (0.000)***
Constant −0.267*** 0.502*** −0.393***
(0.005) (0.000) (0.000)
RMSE 2.634 17.039 6.217
R2 0.042 0.148 −0.152
χ2 74.63*** 45.62*** 230.04***
Notes: The values in parentheses represent the estimated p-values such as:
***p-values < .01, **p-value < .05, and *p-value < .1.
10 N. BAKLOUTI AND Y. BOUJELBENE

6. Robustness Checks
We evaluate the validity of the empirical results by using different methods. Firstly, we
reproduce the regressions on two separate samples: developing vs. developed countries.
Secondly, we re-estimate our regressions by using simultaneous-equation models in order
to solve the Endogeneity problem. Finally, we introduce the control variables and an inter-
action term on the shadow economy × political stability to inflation by highlighting the
political factors of inflation.
Before presenting the finding based on the GMM estimator of Arellano – Bond (1991),
we must confirm that the diagnostic tests are verified. The instruments validity is checked
via the Hansen test. The Arellano and Bond (1991) tests show that the errors in the first-
difference model exhibit, no 1st but rather a 2nd order serial correlation. However, the
Durbin Wu–Hausman test checked whether the impacts of the endogenous regressors on
our estimates are substantial and that the GMM technique is appropriate.
Table 6 presents the previous regressions by dividing the sample into developed and
developing countries. From the OECD countries, the findings showed that the coefficient
of GDP is negative in CPI and SE equations. In both series of equations and in both cases, it
is statistically significant at the one-percent level, but it is insignificant in MENA countries
case.
Although the rate of inflation is low in developed countries, it can push economic agents
to exercise the legal activities declared, but it cannot reduce their economic growth. In this
topic, the inflation has a positive and significant impact on the size of the underground
economy at a rate of 1%, but it is insignificant on economic growth. However, most coun-
tries in the MENA region showed high inflation. In fact, it has a slower economic growth,
which is consistent with our results showing that the CPI coefficient is significant and neg-
ative in the GDP equation at 5% and significant and positive in the SE equation at 1%.

Table 6. Estimation results of dynamic simultaneous-equation: developing vs. developed countries.

OECD countries MENA countries

Specification 1 Specification 2 Specification 3 Specication 1 Spacification 2 Specification 3

GDP CPI SE GDP CPI SE
GROWTH – −1.882*** −2.205*** – 1.401 0.189
(0.000) (0.000) (0.792) (0.882)
INFLATION −0.039 – 0.524*** −0.262** – 0.246***
(0.627) (0.001) (0.021) (0.000)
SE −0.096** −0.076 – −0.273*** 2.021*** –
(0.019) (0.655) (0.000) (0.000)
Constant −0.594* 0.526*** −0.569*** −0.921*** −0.582** 0.423***
(0.086) (0.000) (0.004) (0.006) (0.025) (0.000)
Hansen test (p-value) 0.322 0.608 0.825 0.326 0.651 0.279
D.W.Hausmn test 0.014 0.043 0.076 0.004 0.015 0.028
(p-value)
Arellano–Bond Test 0.486 0.641 0.995 0.804 0.776 0.862
for 2nd order
(p-value)
Arellano–Bond Test 0.000 0.002 0.021 0.015 0.016 0.027
for 1st order
(p-value)
Notes: The values in parentheses represent the estimated p-values such as: ***p-values < .01, **p-value < .05, and
*p-value < .1.
 INTERNATIONAL ECONOMIC JOURNAL 11

Moreover, the impact of the shadow economy is statistically significant and negative in the
economic growth equation in both sub-samples, but at 5% level for developed countries
and at 1% level for the developing ones. However, the coefficient of the informal economy
is statistically significant and positive in the inflation equation of the developing countries,
but insignificant in the developed countries.
In contradiction with the results of the global panel, we show that there is a positive
bidirectional link between CPI and SE for MENA countries, but for the OECD ones, it is
positive unidirectional link running from CPI to SE. This result strengthens the argument
that economies confronted with a larger informal economy push governments to further
raise inflation and move the revenue sources of taxes to inflation.
Then, for the OECD countries, the findings indicate a negative bidirectional causal link
between GDP and SE, while for the MENA countries we observed a negative unidirectional
linkage running from SE to GDP. This finding is consistent with the results achieved by
Baklouti and Boujelbene (2018).
Regarding the linkage between economic growth and inflation, we found that it is uni-
directional and negative in both sub-samples, but its direction is from GDP to the CPI for
the developed countries and the CPI to GDP for the developing countries. This means that
with a high inflation rate, we can achieve low economic growth, but with a low inflation
rate it’s cannot be reduced. Moreover, the more prosperous countries can lower inflation,
while the less prosperous ones cannot do it.
In Table 7, we estimate the previous regressions taking into account some variables. The
results of both developed and developing countries show that the tax revenues are positive
and statistically significant at 5% and 10%, respectively. This implies that a larger informal
economy leads to greater tax evasion and a lower prosperity economic. This finding is in
line with the results reported by Cooray et al. (2017) and Baklouti and Boujelbene (2018).
Similarly, we found that the impact of FDI and GFCF on GDP is statistically significant
and positive in both the sub-samples. However, the HC and government spending have a
significant and positive impact on the economic growth of the OECD countries but not sig-
nificant on that of the MENA ones. This result is explained by the fact that the developing
countries included in this study have a low human development. Regarding government
spending, we found inefficient public spending and the resources that come from the gov-
ernment do not serve the purpose for which they were intended, which leads to economic
decline.
In the CPI equation, we notice that the exchange rate is insignificant in the OECD case,
but significant and positive in the MENA case. Similarly, the coefficient of political stability
is not significant in the OECD countries, but it is significant and positive at a rate of 5%
for the MENA ones. Finally, the domestic credit to the private sector coefficient is signif-
icant and negative at a 5% rate for the OECD countries and positive at a 1% rate for the
MENA ones. These results are interpreted in such a way that domestic credit to the private
sector can correct the inflation in the developed country, while the political stability can
correct the inflation in the developing countries. On the other hand, since they have good
governance, the developed countries do not need it to reduce inflation.
In fact, in the shadow economy equation, self-employment and tax burden coeffi-
cients are significantly positive in both groups of countries, as predicted by Schneider and
Enste’s (2000) argument. More specifically, we found that these coefficients are higher in
regressions in the MENA countries. Moreover, the unemployment coefficient is significant
12 N. BAKLOUTI AND Y. BOUJELBENE

Table 7. GMM estimation with control variables.

OECD countries MENA countries

Specification 1 Specification 2 Specification 3 Specication 1 Spacification 2 Specification 3

GDP CPI SE GDP CPI SE
GROWTH – −0.721*** −1.205*** – 0.642 0.225
(0.000) (0.005) (0.826) (0.641)
INFLATION −0.020 – 0.048** −1.063** – 0.345***
(0.578) (0.041) (0.044) (0.000)
SE −0.008** −0.040 – −0.014*** 0.148*** –
(0.007) (0.539) (0.000) (0.000)
Tax revenue 0.052** – – 0.184* – –
(0.011) (0.074)
FDI 0.005** – – 0.042** – –
(0.042) (0.022)
GFCF 0.278*** – – 0.324** – –
(0.000) (0.052)
HC 0.031** – – −0.171 – –
(0.014) (0.151)
Gov. Spending 0.005*** – – 0.274 – –
(0.000) (0.143)
Self-Employment – – 0.425** – – 0.159***
(0.043) (0.000)
UNEM – – 0.511 – – 0.184***
(0.882) (0.006)
Tax burden – – 0.089** – – 0.236***
(0.039) (0.001)
Exchange Rate – −0.032 – – 0.337** –
(0.582) (0.048)
CREDIT – −0.036** – – 0.642*** –
(0.011) (0.000)
PS – −0.228 – – −0.714** –
(0.871) (0.059)
Constant −0.609* 0.719*** −0.886** −0.019** −0.074*** 0.406***
(0.091) (0.000) (0.024) (0.081) (0.000) (0.000)
Hansen test (p-value) 0.792 0.608 0.825 0.472 0.514 0.294
D.W.Hausmn test 0.004 0.007 0.013 0.018 0.037 0.052
(p-value)
Arellano–Bond Test 0.706 0.641 0.780 0.425 0.573 0.442
for 2nd order
(p-value)
Arellano–Bond Test 0.000 0.000 0.001 0.022 0.006 0.017
for 1st order
(p-value)
Notes: The values in parentheses represent the estimated p-values such as: ***p-values < .01, **p-value < .05, and
*p-value < .1.

and positive in the developing countries’ sub-sample and insignificant in the developed
countries one. According to this comparison, we noted that the self-employment and the
tax burden effect on the underground economy are smaller in the developed countries
whether in the developing ones. This finding reinforces the view that the adjustment of
the size of the parallel economy is more difficult in the developing countries because of the
unemployment rate, which is too high compared to that of the developed ones. As a result,
the developing countries need to make more efforts than the developed ones to reduce the
unemployment rate, and subsequently the underground economy size.
In the above analysis, we can use inflation to tax the informal economy, and the ampli-
fication of inflation is strongly linked to the expansion of underground economy size.
Consequently, an increase in the informal sector size may encourage governments to
 INTERNATIONAL ECONOMIC JOURNAL 13

Table 8. GMM estimation with more control variables.

OECD countries MENA countries

Specification 1 Specification 2 Specification 3 Specication 1 Spacification 2 Specification 3

GDP CPI SE GDP CPI SE
GROWTH – −1.882*** −2.205*** – 1.473 0.025
(0.000) (0.000) (0.779) (0.955)
INFLATION −0.039 – 0.524*** −0.982** – 0.160***
(0.627) (0.001) (0.016) (0.000)
SE −0.096** −0.076 – −0.075*** 0.428*** –
(0.019) (0.655) (0.004) (0.000)
SE*PS −0.325 1.404**
(0.905) (0.062)
Tax revenue 0.034*** – – 0.037** – –
(0.000) (0.032)
FDI 0.342** – – 0.098** – –
(0.030) (0.026)
GFCF 0.152*** – – 0.593* – –
(0.000) (0.068)
HC 0.719*** – – 0.136** – –
(0.002) (0.056)
Gov. Spending 0.281** – – 0.436* – –
(0.076) (0.072)
Self-Employment – – 0.827* – – 0.215**
(0.089) (0.042)
UNEM – – 0.511 – – 0.626***
(0.470) (0.000)
Tax burden – – 0.168*** – – 0.307***
(0.000) (0.000)
Exchange Rate – −0.032 – – 0.236*** –
(0.863) (0.000)
CREDIT – −0.249** – – 0.382*** –
(0.041) (0.000)
PS – −0.228 – – −0.238** –
(0.759) (0.033)
Constant 0.167*** 0.316*** 0.170*** 0.060*** 0.129*** 0.816***
(0.003) (0.005) (0.000) (0.000) (0.000) (0.000)
Hansen test (p-value) 0.266 0.354 0.412 0.183 0.292 0.143
D.W.Hausmn test 0.004 0.008 0.006 0.003 0.048 0.051
(p-value)
Arellano–Bond Test for 0.845 0.639 0.720 0.450 0.652 0.734
2nd order (p-value)
Arellano–Bond Test for 0.006 0.000 0.004 0.006 0.018 0.023
1st order (p-value)
Notes: The values in parentheses represent the estimated p-values such as: ***p-value < .01, **p-value < .05, and
*p-value < .1.

shift the sources of income from taxes to inflation. Given these elements, to deal more
specifically with the impact of the informal economy size on the inflation, we take into
account the interaction effect among the underground economy and political stability. This
interaction enables us to evaluate how political stability level in a country influences the
effect of the underground economy size on the inflation rate. Table 8 provides the results
when the SE * PS interaction term is introduced. The results show that the estimated coeffi-
cient of the interaction term is insignificant in developed countries, however, in the MENA
ones the partial effect of the shadow economy on inflation is yet positive, but at the 5% level.
This means that the partial effect of the shadow economy on inflation decreases with the
level of political stability. More specifically, with a stable political regime, several controlling
14 N. BAKLOUTI AND Y. BOUJELBENE

mechanisms will apply well. In these conditions, political leaders and all parties involved in
illegal operations may lose their power. Political stability can, therefore, be considered as
reinforcing checks and balances. Nevertheless, in democratic transition countries where
the government oversight is weak, the political instability and democratic reforms that
change the autocratic model of authority to democracy may expansion the informal sec-
tors. The latter, in turn, forces governments to use inflation as a source of tax revenue, as it
reduces tax revenues.
As a result, the results of this comparative study show that the OECD countries have
the capacity to reduce inflation and the informal economy through their high level of
economic growth. Similarly, the MENA countries can achieve greater economic growth
if they are able to reduce the rate of inflation likely to come in an economy framework
with larger informal sectors and less political stability. Moreover, a low inflation rate has
an insignificant impact on economic growth, but if this rate is high, it can slow the eco-
nomic prosperity. By cons, whatever the size of the shadow economy, it impedes economic
growth.

7. Conclusion
This study investigates the nexus between economic growth, inflation and the shadow
economy. It additionally takes into account the role of political stability in the nexus
among the inflation and the shadow economy. The empirical analysis is based on the
SUR model and the dynamic simultaneous-equation models by using the three-stage least-
square method. The SUR model made the preliminary estimate of these three relationships
throughout the sample covering 50 countries. We observed a bidirectional causality link
economic growth-inflation–shadow economy, but this link is negative in the nexus among
economic growth and inflation and among economic growth and the shadow economy,
and positive in the nexus among inflation and the shadow economy.
Three relationships undergo several robustness checks. We reproduce the regressions on
two separate samples: developing vs. developed countries. To address Endogeneity prob-
lems, we estimate the three-way linkages by using the GMM estimator. Then, we add some
control variables among others, the interaction term among the underground economy
and political stability.
Political, economic, and monetary differences among the developed and the developing
ones can affect the causal links in the underground economy–inflation–economic growth
differ from one country to another. The estimates of the Organization for Economic Co-
operation and Development countries indicate the same results as those of the full sample
except the impact of underground economy on inflation and the impact running from the
inflation on economic growth, which is insignificant.
For the Middle East and North Africa countries, the difference is in the effect of eco-
nomic growth on inflation on the one hand, and on the underground economy on the other
hand, which also become insignificant.
This comparison indicates that the most prosperous countries have the capacity to curb
the underground economy size and inflation, which decreases tax evasion which makes
it unnecessary to finance public expenditure by an inflation tax. On the other hand, the
less prosperous countries will increase tax revenue further, which will, in turn, increase
the informal economy, and results in a fall of public revenues, which will be compounded
 INTERNATIONAL ECONOMIC JOURNAL 15

by an increased demand for money. Indeed, governments will shift the sources of revenue
from taxes to inflation.
The introduction of the interaction term among the shadow economy and political sta-
bility shows that the shadow economy can increase inflation in the developing countries,
but it has an insignificant impact for that of the developed ones. We argue that the politi-
cal environment has an effect on the governments’ incentive to use other means to finance
their expenditures. Consequently, political instability is associated with a broader under-
ground economy that causes for the state a lack of tax revenues and social contributions
while forcing governments to use seigniorage to finance their expenses.
As a matter of fact, the level of political stability is an indispensable tool for helping
public decision-making in the conduct of economic policies from which economists can
make a diagnosis to know the state of the country’s economic situation. By increasing
political stability, a country can decrease the informal economy size while increasing the
government’s incentive to develop a fiscal capacity and achieve economic growth.

Disclosure statement
No potential conflict of interest was reported by the authors.

Notes on contributors
Nedra Baklouti holds PhD in Economics at the Faculty of Economics and Management of Sfax,
Tunisia, and is currently a contractual assistant in Economics at the Department of Economics of
the Faculty of Economics and Management of Sfax. Her research interests include Political econ-
omy, Economic Growth, applied economics, panel data econometrics and institutional analysis in
developed and developing countries.
Younes Boujelbene is Professor in Economics at the Faculty of Economics and Management of Sfax,
Tunisia. His research interest is in development economics, macroeconomics, corporate governance,
public economics and economic policy modelling.

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