The ever-growing silhouette of the shadow economy

In the recent news, the Pandora Papers investigations shocked the world by unmasking various
owners of offshore companies, incognito bank accounts, private jets, yachts, mansions, even
artworks by Picasso. Names of prominent Indian business personalities like Anil Ambani, Biocon
Executive Chairperson Kiran Mazumdar Shaw’s husband, corporate lobbyist Niira Radia, and
Ajit Kerkar of Cox and Kings have been mentioned in the long list. What these investigations
actually reveal is the extent to which the shadow economy has spread in today's world.

“The Pandora Papers reveal the inner workings of a shadow economy that
benefits the wealthy and well-connected at the expense of everyone else,”
- International Consortium of Investigative Journalists

What is a shadow economy?

The term shadow economy typically refers to the full range of economic activities that are not
reported to tax authorities. For a transaction to be considered as a shadow transaction it doesn't
have to be a billion dollar shifting of profits to an offshore shelter or a huge illegal activity. It can
be as simple as a factory worker driving an unlicensed taxi at night, the income from which is
not disclosed to the regulator. Activities, both legal and illegal, that add up to trillions of dollars a
year that take place "off the books," out of the gaze of taxmen and government statisticians.

Estimating the size of shadow economy

It's often difficult to capture the extent of the shadow economy in monetary terms. The currency
demand and the latent variable approach are the most widely used.
● Currency demand : Estimates size of shadow economy from the demand for cash,
assuming shadow transactions are undertaken in cash and that an increase in the
shadow economy will raise demand for cash.
● Latent variable approach : Estimates the size of the shadow economy as a function of
observed variables that are assumed to influence the shadow economy—for example,
the burden of taxation, the burden of government regulation—and of variables where
shadow economic activities leave traces, like cash, official working time, unemployment,
etc. Advantageous method because it considers multiple causes and effects
simultaneously.

Some methods estimate the size of the shadow economy in EMEs such as Brazil, India, and
Mexico relative to GDP range from 24 to 46 percent. While India’s informal sector has been
estimated at 65% of GNP, its black economy was put at 22% by Schneider’s research in 2007.
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Whatever the size maybe, the shadow economy is a problem.

Why is the shadow economy a problem?

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The Pandora Papers show that the offshore money machine operates in every corner of the
planet, including the world’s largest democracies. And the existence and growth of this shadow
economy has potentially dangerous consequences. Especially now its pervasiveness is of
particular concern because it makes it harder to achieve the inclusive development that is
needed to undo the damage of the COVID-19 pandemic.

● A prospering shadow economy makes official statistics unreliable thus rendering policies
and programs inappropriate and self-defeating.
● The destructive cycle. Transactions in the shadow economy escape taxation and thus
lower the tax revenues. In turn, governments may respond by raising tax rates
encouraging a further flight into the shadow economy that worsens the budget
constraints on the public sector.
● Increasing and widespread informality: A growing shadow economy provides strong
incentives to attract domestic and foreign workers away from the official economy.

As per a research, Greek banks have their own internal underwriting models for estimating the
actual incomes of their clients, implying that tax evasion is an open secret. Using such a model,
the researchers estimated that nearly half of the self-employment income of people who had
received loans from the bank went unreported and, thus, untaxed. The implication was that, in
2009, these lost tax revenues accounted for about one-third of the government budget deficit.

Factors behind growing shadow economy

Macroeconomic and microeconomic modeling studies based on data for several countries
suggest that the major driving forces behind the size and growth of the shadow economy are an
increasing burden of tax and social security payments, combined with rising restrictions in the
official labor market. Wage rates in the official economy also play a role.

Eliminating shadow economy

Various countries around the world have taken steps to keep the far reaching impacts of shadow
economy in control.
In June 2021, Brazil’s economics minister, Paulo Guedes, proposed a tax reform package that
included a 30% tax on profits earned through offshore entities. However, this proposition could
not materialize due to strong opposition from bankers and business leaders.

Moreover, the shadow economy is extremely adaptable and pervasive. For example, increased
scrutiny on “traditional” offshore havens such as the Bahamas, the Caymans and other island
paradises have led to South Dakota, Nevada and more than a dozen other U.S. states being
transformed into leaders in the business of peddling financial secrecy.
Thus, just tight regulations and fines won’t curb the underground activities. Plus these measures
have time and again proved to be costly and ineffective.

Much literature has been found on the web in support of restricting the use of cash in an
economy and using digital modes of payments instead. Cash supports the shadow economy,
crime and terrorism and is risky, old fashioned and unnecessary, especially if one considers the
fast increase in electronic payments.

Image suggesting a high correlation between use of cash in a country and shadow economy as
a % of GDP.

A case for CBDC.

Replacing cash with a CBDC can thus put a substantial crimp in the shadow economy. It gives
the government the power to track the transactions and act as a powerful deterrent against its
use for unreported transactions.

“SWITCHING FROM CASH TO A CENTRAL BANK DIGITAL CURRENCY WOULD MAKE

EVERY TRANSACTION TRACEABLE, MORE TRANSPARENT, AND SUBJECT TO
SCRUTINY.”

Other measures might include legalization of certain shadow economy activities like many
countries have taken steps towards legalizing the cultivation of cannabis and liberalization of the
labor market.

A case for shadow economy

On the other hand, at least two-thirds of the income earned in the shadow economy is
immediately spent on the official economy, resulting in a considerable positive stimulus effect on
the official economy.