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Journal of Policy Modeling 42 (2020) 307–327

Economic liberalization in Egypt: A way to reduce the

shadow economy?
Mohammad Reza Farzanegan a,b,c,∗,1 , Mai Hassan a ,
Ahmed Mohamed Badreldin a
a Philipps-Universität Marburg, Center for Near and Middle Eastern Studies (CNMS), School of Business and
Economics, Economics of the Middle East Research Group, Deutschhausstr. 12, 35032 Marburg, Germany
b CESifo, Munich, Germany
c ERF, Cairo, Egypt

Received 9 December 2018; received in revised form 12 June 2019; accepted 14 September 2019
Available online 3 December 2019

Abstract
This study examines the relationship between economic liberalization and the size of the shadow economy
in Egypt. We use annual data from 1976 to 2013 and show that economic liberalization policies in Egypt have a
statistically significant decreasing effect on the size of the shadow economy as a percent of Gross Domestic
Product (GDP). This effect is confirmed for both short- and long-term oriented economic liberalization
policies. Based on our results, policies which promote trade and economic liberalization can reduce the
extension of the shadow economy in Egypt. Therefore, we suggest conditioning international development
assistance to Egypt on demonstrable policy actions with respect to economic liberalization.
© 2019 The Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.

JEL classifications: E26; O17

Keywords: Shadow economy; Economic liberalization; Time-series analysis; Arab Spring; Egypt

∗ Corresponding author at: Philipps-Universität Marburg, Center for Near and Middle Eastern Studies (CNMS), School

of Business and Economics, Economics of the Middle East Research Group, Deutschhausstr. 12, 35032 Marburg, Germany.
E-mail address: farzanegan@uni-marburg.de (M.R. Farzanegan).
1 Web: http://www.uni-marburg.de/cnms/wirtschaft.

https://doi.org/10.1016/j.jpolmod.2019.09.008
0161-8938/© 2019 The Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.
308 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327

1. Introduction

The Arab Spring may have been the defining moment for the Middle East for decades to come.
Nevertheless, its fruition remains quite limited with perhaps only Tunisia being actually seen as
a (partial) success (Guedoir, 2018), Morocco, Algeria and some GCC countries have witnessed
minor democratic improvements, while Yemen, Libya and Syria remain in armed conflicts (Turan,
2018). All the while, the more populous Egypt is being hurled through numerous political changes
from the rise of the Muslim Brotherhood, to the re-establishment of authoritarian rule (Pratt &
Rezk, 2019). In the wake of these changes, Egypt witnessed a potential loss in GDP per capita
growth rate over the years 2011–2017 of about 12% (Echevarria & Garcia-Enriquez, 2019).2
Egypt has also witnessed rises in informal employment for both high- and low-educated workers
(Elsayed & Wahba, 2019).
The large shadow economy has already been linked to political instability through losses
in tax-income and consequently decaying infrastructure and has been attributed as one pos-
sible cause for the Arab Spring (Farzanegan & Badreldin, 2017). Thus, it is quite prudent
of post-Arab Spring governments to find policies to reduce and control the shadow econ-
omy and not allow it to grow out of hand since this may well lead to a new wave of
unrest.
The current Egyptian government under President Abdelfattah Al-Sisi has embarked on a
path of economic liberalization with the aim of creating employment and ensuring economic
and political stability. This has also been internationally driven since the approval of an IMF
Extended Fund Facility (EFF) in 2016 for a sum of US$ 12 billion, which includes a number
of economic liberalization policies such as floating the exchange rate, reducing fiscal deficits,
introducing a new value-added tax (VAT) and reducing energy subsidies.3 Such liberalization
steps are known to have an effect on the shadow economy (Momani, 2018), yet the direc-
tion of that effect itself, remains unclear: On the one hand, higher VAT and income taxes
are known to push people towards the informal sector and numerous arguments in the liter-
ature undermine the constructive contribution of economic liberalization in dealing with the
shadow economy. Studies such as Carr and Chen (2002), Goldberg and Pavcnik (2003) and
Bacchetta, Ernst, and Bustamante (2009) suggest that economic liberalization may increase
the size of the shadow economy through intensifying competition, increasing costs, and under-
privileging domestic low-skilled labor to the global work force. On the other hand, much literature
shows that growth-driven economic liberalization may move people out of the informal sec-
tor by creating more formal employment opportunities, increasing productivity, reducing labor
market rigidities, improving institutional quality, increasing wages, and reducing trade restric-
tions (Aleman-Castilla, 2006; Dreher, Kotsogiannis, & Martens, 2009; Geronazzo, 2016; Melitz,
2003).
Given the ambiguity surrounding the relationship between economic liberalization and the
shadow economy in general, and the absence of empirical studies that have addressed the effects
of economic liberalization policies in Egypt in specific, this study aims to test whether policies
taken to liberalize the Egyptian economy are indeed able to reduce the size of the shadow economy
in Egypt.

2 In their work, Echevarria & Garcia-Enriquez attempt to quantify the foregone GDP growth that would have been

achieved had the Arab Spring and its ensuing political instability not occurred.
3 IMF Press Release, November 11, 2016 No.16/501.
 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327 309

Our study sheds light on the historical impact of economic liberalization4 on the development
of the shadow economy5 in Egypt using time series data from the period of economic liberalization
in 1976 until post-Arab Spring in 2013. Our aim is to learn from historical data and observations
on how previous liberalization policies have affected the shadow economy. We use an innova-
tive approach that traces the response of Egypt’s shadow economy to a positive development in
Egypt’s economic liberalization over the following years. Our estimated impulse response func-
tions (IRF), based on a vector autoregressive model (VAR), show a negative (decreasing) response
of the shadow economy to a positive development in economic liberalization. This response is
statistically significant for the first three years directly following the shock, lending support to
such policies’ effect in bringing down the shadow economy in Egypt, at least in the short-term.
We test the long-term effects by conducting a bounds test based on the Autoregressive Distributed
Lag (ARDL) method and confirm long-term associations between economic liberalization and
the shadow economy. Our results support the importance of promoting economic liberalization
to address the sizable shadow economy in Egypt.
The findings of this paper should act as direct policy recommendations as to whether the
Egyptian government (or other developing countries) should pursue such economic liberalization
strategies as a method of (indirectly) reducing participation in the shadow economy (leading to
higher government revenues and political stability). We suggest to explicitly condition interna-
tional development assistance to Egypt on demonstrable policy actions with respect to economic
liberalization to ensure the sustained economic development and political stability required for
moving Egypt into the more successful countries of the Arab Spring and reduce the probability
of defaulting on foreign financing.
The paper is organized as follows: Section 2 presents a review of related literature on the
relationship between liberalization and the shadow economy and economic liberalization efforts
in Egypt. Section 3 focuses on the data and methodology. We present and discuss the results in
Section 4. Section 5 covers some policy recommendations. Finally, Section 6 concludes the paper.

2. Literature survey

2.1. The shadow economy

The shadow economy is sizable in most parts of the developing world. According to Schneider
et al. (2010), from 1999 to 2007 the average size of the shadow economy in developing countries
reached almost one third (32%) of GDP, compared to 18% of GDP in high income OECD coun-
tries, with most informal jobs associated with low wages, poor working conditions and worker
safety, and no social security benefits, such as public health insurance, unemployment security
or pensions. In addition, a relatively large portion of the shadow economy has negative exter-
nalities on the overall economy: The shadow economy hinders overall economic development
by absorbing capital resources and labor from the formal economy. Furthermore, it limits the
efficient use of public resources, and the effectiveness of policies because it creates distortions
in official statistics. This in turn creates unfair competition against formal firms that abide by the
laws. The informal firms add minimum value to the formal economy due to their low productivity

4 Measured using the economic globalization index introduced by Dreher (2006).

5 The shadow economy involves all market-based activities that should have been included in the official GDP of a
country (Schneider, Buehn, & Montenegro, 2010).
310 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327

(Gerxhani, 2004; La Porta & Shleifer, 2014; Schneider & Enste, 2000). Additionally, expansion
of the shadow economy can increase budget deficit, reducing infrastructure quality and lead to
political instability (González-Fernández & González-Velasco, 2014; Farzanegan & Badreldin,
2017).
Moreover, the existence of the shadow economy increases environmental problems which is
already a significant policy concern in the Middle East and North Africa region (Farzanegan
& Markwardt, 2018; Gholipour & Farzanegan, 2018). The informal firms do not have access
to financial means to employ green technology (Biswas, Farzanegan, & Thum, 2012). Also,
the existence of the shadow economy creates distortions in the social norms by encouraging
corruption, weak rule of law, and disrespect to official institutions, making the shadow economy
an indicator of low institutional quality and illegitimacy (Schneider & Enste, 2000). Exceptions
do, however, exist such as the study by Choi and Thum (2005) who argued that the presence of
shadow economy in a corrupt environment enhances formal economic activities and thus acts as a
complement to the official economy by mitigating government-induced distortions. The existence
of a large shadow economy hinders a country’s integration into the global economy by preventing
it from creating a large and diversified export market. An ever growing informal labor is no longer
competitive due to their lack of access to formal education and training programs (Bacchetta et al.,
2009).

2.2. The economic liberalization and shadow economy nexus

The literature on the impact of economic liberalization on the shadow economy can be grouped
into two main streams: The first stream affirms that economic liberalization or globalization has
positive impacts in terms of reducing informality, whereas the second stream highlights its negative
consequences.
Elaborating on the first stream: Kearney (2006: 80)6 concluded that there is a negative relation-
ship between the globalization index (which we refer to it as a proxy for economic liberalization)7
and informality. This means that the higher the level of trade openness in a country, the smaller
the size of the shadow economy. Other studies have elaborated on how this comes about, showing
that liberalization increases productivity through a better allocation of production factors and
resources in the formal economy. Thus, the formal economy expands, opening opportunities for
more productive firms to enter the formal economy, whereas less efficient and less productive
firms (i.e., informal firms) either relocate to join the official economy or disappear (Melitz, 2003).
These positive spillover effects of liberalization are evident in studies that focused on developing
countries. For instance, Utkulu and Özdemir (2004), Herath (2010) and Chaudhry, Malik, and
Faridi (2010) concluded that liberalization had a positive impact on economic growth for the cases
of Turkey, Sri Lanka and Pakistan, respectively by generating more income, increasing wages and
creating job opportunities, thus reducing the attractiveness of informal firms. Increases in wages
widens the wage gap between formal and informal jobs, making it more attractive for informal
labor to seek jobs with higher income and better benefits in the formal economy rather than in the
informal economy (Geronazzo, 2016; Temkin & Veizaga, 2010).
Furthermore, economic globalization and liberalization may lead to more deregulation of labor
markets (Potrafke, 2014). Flexible labor markets attracts foreign and domestic labor and capital

6 The A.T. Kearney Global Cities Index (GCI) ranks 125 cities according to 27 metrics across five dimensions, including

business activity, human capital, information exchange, cultural experience, and political engagement.
7 We use economic globalization and economic liberalization interchangeably.
 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327 311

to the formal economy since various authors such as Buehn and Schneider (2008), Johnson,
Kauffman, and Zoido-Lobaton (1998) and Schneider (2005) concluded that the regulatory burden
increases informality.
By the same token, Aleman-Castilla (2006) argues that the positive spillover effects of liberal-
ization, such as the reduction of tariffs and trade restrictions,8 make it more profitable for firms to
operate in the official economy and engage in international trade rather than remain in the shadow
economy. Given the status of informal firms as being unregistered in the formal economy, they
cannot import or export and cannot benefit from trade agreements. Liberalization brings about
trade openness, which in turn induces public officials to reduce governmental restrictions and to
provide incentives to integrate domestic firms in international trade and attract foreign investors
(Schneider & Enste, 2000).
In addition, Acosta and Gasparini (2007) and Geronazzo (2016) argue that firms can reduce
costs and improve working conditions through the adoption of advanced technologies. Con-
sequently, more informal firms join the formal economy to have better access to advanced
technologies and intermediaries brought about by the opening up the economy. Brock and German-
Soto (2017) mention that opening up the economy to foreign investment increases technical
efficiency in the economy, however, in countries with large public sectors, this can also be asso-
ciated with a reduction in secure public sector jobs which may push some labor into informal
sectors.
Moreover, liberalization improves institutional quality and reduces corruption, which in turn
reduces the growth of the shadow economy (Dong, Dulleck, & Torgler, 2012; Dreher et al., 2009).
The complementary relationship between low institutional quality, weak rule of law, corruption
and the shadow economy is supported in the literature (Buehn & Farzanegan, 2012; Razmi,
Falahi, & Montazeri, 2013; Schneider, 2010). These positive spillover effects of liberalization
allow policymakers to reduce the shadow economy by incentivizing the relocation to the formal
economy, rather than coercing or forcefully removing them as is more commonly the case in
developing countries.
A more recent study by Minsoo, Alba, and Park (2018) suggests that foreign direct investment
to developing countries is conditional to some extent on their degree of protecting intellectual
property rights, which in turn are found to have a negative relationship between policies aimed at
protecting intellectual properties, and the relative size of the shadow economy.
The second stream, however, claims that liberalization does not reduce informality, especially in
developing countries, because their low-skilled domestic labor is underprivileged when compared
to the global workforce, who can easily move and integrate into international markets. Global firms
take advantage of large informal economies and cheap unskilled labor in developing countries by
pushing for more informal employment. Additionally, many small- and medium-sized companies
are highly disadvantaged due to increased competition. Local small- and medium-sized companies
might lose their local market niches to imported products and to international conglomerates,
which can capture markets quickly (Carr & Chen, 2002). A consequence of liberalization is
increased costs which push local companies, particularly small- and medium-sized companies in
developing countries, to lay-off employees or replace them with temporary workers on an informal
basis (Bacchetta et al., 2009; Goldberg & Pavcnik, 2003). In conclusion, the second stream shows

8 Higher tariffs and trade restrictions increase the incidence of smuggling as a part of the shadow economy (Buehn &

Farzanegan, 2012; Farzanegan, 2009).

312 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327

that economic liberalization may lead to negative consequences on the overall economy, which
might increase the spread of the shadow economy.9
As can be seen, the literature stream leaning towards negative spillover effects of liberalization
is limited in terms of number of studies, nevertheless, it is enough to raise doubts as to the impact
of liberalization on the size of the shadow economy. This controversy may simply imply that
the response of the shadow economy to economic liberalization may differ from one country to
another, depending on their institutions and socio-economic conditions. In this study, we contribute
to clearing up this controversial nexus for the case of Egypt.

2.3. Economic liberalization and the shadow economy in Egypt

Egypt, like many developing countries, has undertaken major policy reforms to liberalize
the national economy and benefit from liberalization in the last decades. Throughout the years,
policymakers in Egypt have taken steps to improve the ease of doing business and encourage
individuals to move away from the shadow economy pervasive since the fall of the socialist era
(Nasserism) and participate in the formal economy in the form of private sector initiatives. These
business regulatory reforms included lowering of registration fees, reducing the costs of start-ups
and reducing the minimum capital requirement to open a new business. In addition, the reforms
focused on abolishing bar association fees, and an automatic tax registration system was initiated.
Moreover, the process of opening a new business in Egypt was improved by merging procedures
at the one-stop shop by introducing a follow-up unit in charge of liaising with the tax and labor
authority on behalf of companies. Additionally, policymakers in Egypt improved the integration of
the domestic economy into the global economy by improving customs administration, upgrading
port facilities, speeding up customs clearance, and introducing an electronic system for submitting
export and import documents.10
The main phase of economic liberalization began in 1974, with the implementation of the
Open Door Policy (Infitah), which moved away from the state-led development of Nasser’s era to
expand the local private sector and increase foreign investment. The main objective of the Open
Door Policy led by Sadat’s government was to integrate the Egyptian economy into the global
economy and to attract foreign investment to create new and more employment opportunities for
Egypt’s expanding labor force (Alissa, 2007; Gray, 1998). Starting in 1985, Egypt experienced an
industrial liberalization phase that led to positive trends in industrial development. In 2004, another
set of reforms occurred led by the Prime Minister Ahmed Nazif and his team. These reforms
concentrated on restructuring the financial sector, enhancing IT infrastructure, liberalizing trade
and privatizing state-led companies. These reforms stabilized the economy to some extent and
stimulated growth. In addition, the state undertook a policy of encouraging the export-oriented
industries and liberalizing imports to increase competition and integration with the global markets
(Loewe, 2013).
Prior to 2003, and in an effort to prevent exploitation of the underprivileged Egyptian workforce,
the Egyptian authorities required international firms to employ 10 Egyptians for each foreigner
and to offer them the necessary training and education, along with employment benefits, such as
social security. However, as part of the liberalization efforts of the Mubarak governments, a new

9 For further details, refer to Egharevba (2011), Pham (2011), Siggel (2010) and Verick (2008).
10 More information can be found in the “Doing Business” reforms published by the World Bank:
http://www.doingbusiness.org/Reforms/Overview/Economy/egypt.
 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327 313

Fig. 1. The development of economic liberalization and shadow economy in Egypt (1976–2013).
Source: the shadow economy data is from Hassan and Schneider (2016), and economic liberalization data is from Dreher
(2006) and http://globalization.kof.ethz.ch/.

labor law was introduced in 2003 that aimed at reduced labor market rigidities by introducing
more flexible labor regulations with minimum government intervention. Wahba and Assaad (2016)
concluded that the application of the new labor law in 2003 helped move some of the labor force
to the formal economy.
In addition to these reforms, Egypt engaged in different trading agreements, such as the Egypt-
EU partnership, Egypt-EFTA partnership, Greater Arab Free Trade Agreement (GAFTA), Egypt-
Turkey Free Trade Agreement, and Common Market for Eastern and Southern Africa (COMESA).
The main objectives of these trade agreements are to increase foreign investment, to liberalize
trade by removing tariffs and trade restrictions, to provide immediate duty-free access of Egyptian
products into the global markets and to achieve the ultimate goal of globalizing the domestic
economy (Alissa, 2007).
The impact of these major reforms and trade agreements was to ease the environment of
opening business in Egypt, to liberalize trade to globalize the domestic economy and to encourage
individuals to join the formal economy rather than the shadow economy.
Fig. 1 shows the historical data of the relative share of the Egyptian shadow economy to GDP.
We can see that during the 1970s and 1980s it reached more than 30% of GDP. Since the 1990s,
a continuous decline in the shadow economy of Egypt can be observed, reaching approximately
20% of GDP in 2013.11 This should not be understood as a decline in shadow economy itself,
but rather only as a percentage of GDP, i.e., only in the sense that as a portion of GDP, the
shadow economy played less of a role in the overall size of the Egyptian economy. This study
and ensuing policy recommendations go only as far as recommending how the shadow economy
as a percentage of GDP may be influenced by economic liberalization.
Although the development of the shadow economy shows a decreasing trend, its relative size
is still significant in terms of being a burden on the formal economy, hindering the country’s
development and growth. This becomes quite clear when one looks at those mostly involved in
the shadow economy: Based on the Egyptian Labor Survey (ELS), 60% of the informal labor force
are women, and the majority of workers are unmarried youth (15–29 years old). Moreover, 68%

11 For a review of definitions and measurements of the shadow economy, see Orviská et al. (2006).
314 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327

are illiterate compared to 26% who have above-intermediate education. The share of informal
workers is most prominent in the textile industry, furniture, paper and wood production, and metal
and leather production (Selwaness & Zaki, 2013), with an increase in higher-educated workers
joining the informal sector post-Arab Spring (Elsayed & Wahba, 2019).
Given the efforts to liberalize the Egyptian economy and the burden of the shadow economy
on the formal economy, it is interesting to analyze the relationship between these two concepts. A
win-win scenario may exist for the Egyptian economy if their attempts at economic liberalization,
given their current institutional context, can also play a role in reducing the burden of the shadow
economy on public and private resources.

3. Research design: data and methodology

3.1. Data description

To examine the dynamic interconnections between economic liberalization and the shadow
economy in Egypt, we use the following variables: the KOF index of economic globalization
as a proxy for economic liberalization (liberalization), the size of government consumption (%
of GDP) (government spending), gross enrolment ratio at tertiary level (%) (education),12 the
share of value added of industry (% of GDP) (industry), labor force participation, and the size of
shadow economy, hereforth referred to as the shadow economy (% of GDP) (shadow). The source
of data for KOF economic globalization index is Dreher (2006), and the source for the data on
shadow economy is Hassan and Schneider (2016). All other data are from the World Bank (2016),
whereas the labor force participation rate is from National Bank of Egypt yearly bulletins from
1976 to 2013 (National Bank of Egypt, 2018). Dreher (2006) and Dreher, Gaston, and Martens
(2008) follow Clark (2000), Norris (2000) and Keohane and Nye (2000) in defining globalization.
Globalization is defined as “the process of creating networks of connections among actors at multi-
continental distances, mediated through a variety of flows including people, information and ideas,
capital and goods.” More specifically, the KOF economic globalization index takes into account
the actual economic flows including trade, foreign direct investment, and portfolio investment.
Trade considers the flow of imports and exports, and portfolio investment considers the sum of a
country’s stock of assets and liabilities (all normalized by GDP). We thus see it as a broader proxy
of economic liberalization than simple trade openness or other import/export oriented measures.
The index still takes into account the trade and investment restrictions, such as import barriers,
mean tariff rates, taxes on international trade (as a share of current revenue) and an index of capital
controls. The scale of the index is from 1 (lowest degree of economic globalization) to 100 (the
highest economic globalization). The data are from 1976 to 2013 and are all on the aggregate
(country) level. We see no advantage of moving to smaller geographical units (governorate or
smaller) since economic liberalization is a more aggregate phenomena, and attempts to improve
economic integration are applied at a country-wide level by the Egyptian government and are not
governorate-specific. The next important variable in our analysis is the relative size of the shadow
economy. Hassan and Schneider (2016) use the Multiple Indicators Multiple Causes (MIMIC)
modeling approach to estimate the relative size of the shadow economy as a percentage of GDP in
Egypt. This confirmatory approach takes into account different indicators of the shadow economy

12 Buehn and Farzanegan (2013) and Farzanegan (2019) examine the effect of education on shadow economy and

corruption across countries.

 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327 315

instead of relying on only one proxy. It also considers a set of observable causes of the shadow
economy, such as taxes, regulatory burden, the structure of domestic production and quality of
institutions. We use annual data from 1976 to 2013 for our analysis. In our opinion, the MIMIC
approach used by Hassan and Schneider (2016) is superior other methods used in the literature such
as luminosity (Brock, 2015)13 or electricity consumption (Brock & German-Soto, 2017), since
they are based on assumptions that are not entirely clear. Taking the example of luminosity, Brock
(2015: 790) states that “If luminosity increases over time while GCP falls, the shadow economy
is growing. If the opposite occurs, the formal economy is growing”. Although the first condition
seems to fit common sense (to some extent), the second condition is problematic: A decrease
in luminosity with an increase in GCP (Gross County Product) can imply an increase in formal
activity, only if one assumes that formal activities do not raise luminosity, which seems quite a
weak assumption, upon which estimates of shadow economy are then being based. Furthermore,
in the specific case of Egypt, which has been witnessing power outages and shortages since the
start of the Arab Spring, it might not be the most suitable measure until the latest projects to solve
the power problem have taken place.14
With reference to the abovementioned theoretical discussions, we examine the following
hypothesis:
Hypothesis. Positive shocks to the economic liberalization lead to a decreasing and statistically
significant response in the shadow economy in Egypt.

3.2. Methodology

3.2.1. Unrestricted VAR model

We use the vector autoregressive (VAR) model to estimate the interrelationships among our
variables. VAR provides a multivariate framework that relates changes in a particular variable to
changes in its own lags and to changes in (the lags of) other variables:

yt = A1 yt−1 + . . . + Ap yt−p + Bxt + εt

where yt is a vector of k endogenous variables, xt is a vector of exogenous variables, A1 ,. . ., Ap

and B are matrices of coefficients to be estimated, and εt is a vector of innovations that may be
contemporaneously correlated but are uncorrelated both with their own lagged values and with
all the right-hand side variables (Dizaji, Farzanegan, & Naghavi, 2016).
Our vector of exogenous variables is defined as xt = [constant]. In the VAR model, all other
variables are endogenous and affect each other with some specific lags. Thus, simultaneity is not
an issue, and the ordinary least squares (OLS) leads to consistent estimates.
We apply an unrestricted VAR model. The Phillips-Perron and ADF unit root tests indicate
that all variables have a unit root and same order of integration (I(1)). The Johansen co-integration
test shows that there is long-run relationship among I(1) variables. In this case, differencing will
lead to the loss of long-run useful information within our data. Sims (1980), Sims, Stock, and
Watson (1990), and Doan (2000) have argued against the differencing of co-integrated variables.

13 Farzanegan and Hayo (2019) use night light intensity data to measure the shadow economy. They argue that night light

contains two components – one related to officially measured economic activity and one related to the shadow economy.
However, this data is available from 1993-2013.
14 See http://www.egypttoday.com/Article/1/54569/No-blackouts-in-Egypt-by-beginning-of-2019-electricity-spox
316 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327

Therefore, we use an unrestricted VAR model in levels of variables.15 Various authors16 have
concluded that the unrestricted VAR models perform better in the short term than Vector Error
Correction Models (VECM) in their simulations (Naka & Tufte, 1997). In our study, we are
interested in impulse response functions (IRF) rather than the interpretation of each coefficient
of the VAR model.
We use the impulse response functions (IRF) and Variance Decomposition Analysis (VDC) to
examine the dynamic response of the Egyptian shadow economy to positive shocks in economic
liberalization, while controlling for other factors. Using the IRF, we can trace the magnitude
of response to the shock over the years following the initial shock as well as their statistical
significance (Stock & Watson, 2001). The application of VDC helps us show the role and relative
importance of a specific variable innovation in explaining the fluctuations of other variables in
the VAR system.
We use a VAR model with six variables to examine the impact of economic liberalization
changes in Egypt on the relative size of the shadow economy. We assume that economic liberaliza-
tion is a natural process that is followed by many countries and is not affected contemporaneously
by other domestic factors in Egypt, such as the shadow economy, domestic production structure,
labor market or education. In other words, economic liberalization in Egypt affects education
participation, labor force participation, industrialization and shadow economy contemporane-
ously and is affected by them with some lag. A number of studies in the field of comparative
politics argue for the exogeneity of economic liberalization and treat international integration as
an exogenous force imposed by local politics and economics. Increasing international normative
pressure, such as the belief in the “market logic” in constructing the liberalization process, is play-
ing an important role in making liberalization inevitable (Fourcade-Gourinchas & Babb, 2002).
The second variable is tertiary education. Participation in the educational system is an accumu-
lation of human capital that is influenced by an individual’s motivation. Such motivation may be
influenced by demand for human capital and skills following the integration of an economy in
international markets as a result of economic liberalization. More incentives and investment in
education improve the necessary stock of human capital for the industrialization of an economy.
Thus, industrial production is our third variable. Government spending is responsive to economic
liberalization and privatization. The removal of subsidies and freezing governmental job positions
since the 1990s in Egypt has resulted in a continuous decline in the share of government spending
in the economy. This factor and the previous variables shape the labor force participation rate in
Egypt, which is the fourth variable in the model. We assume that the shadow economy is the most
endogenous variable in the VAR system. The development of the shadow economy is a function
of economic and institutional factors, including the trend of liberalization. In our unrestricted
VAR model, the vector of endogenous variables is as follows:
yt = [economic liberalization, tertiary education, industry,
government spending, labor force participation, shadow economy]

This is our first choice for the Cholesky ordering in the VAR system. The first variable in
a pre-specified Cholesky ordering has an immediate effect on all other variables in the system,

15 See also Dizaji et al. (2016), Farzanegan and Markwardt (2009), Farzanegan (2011) and Farzanegan and Raeisian

Parvari (2014) for a similar approach.

16 See Engle and Yoo (1987), Clements and Hendry (1995) and Hoffman and Rasche (1996).
 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327 317

excluding the first variable and so on. Granger causality/block exogeneity Wald test (Enders,
2003, p. 284) also supports the mentioned ordering of variables. This test detects whether the lags
of one variable can Granger-cause other variables in the VAR system. The null hypothesis is that
all lags of one variable can be excluded from each equation in the VAR system (see Farzanegan
& Markwardt, 2009 for a similar approach in ordering of variables). Changing the ordering of
variables in the system may affect the impulse response results. Thus, as a robustness check of our
main results, we use the generalized impulse responses (GIR), which are not sensible to a specific
ordering of variables (Pesaran & Shin, 1998). Another important step in estimating the VAR
model is the selection of an optimum lag length for variables. To find the optimum lag, we use
information criteria such as LR, FPE (final prediction error), AIC (Akaike information criterion),
SC (Schwarz information criterion), and HQ (Hannan-Quinn information criterion). We select
a lag length of 2 based on the LR, FPE, and AIC criteria and with respect to the stability and
diagnostic tests. The VAR stability condition test (roots of characteristic polynomial) indicates
that the VAR model satisfies the stability condition. All roots have a modulus less than one and
lie inside the unit circle, and the VAR model is stable (or stationary). The lack of auto-correlation
in the estimated VAR model’s residuals is also important for reliability of our results. In sum, all
diagnostic criteria show that our estimated VAR model as the basis for impulse response functions
is stable and satisfactory.

3.2.2. ARDL method to cointegration

To empirically analyze the long-run relationships and dynamic interactions among our variables
of interest, the autoregressive distributed lag (ARDL) cointegration method, developed by Pesaran,
Shin, and Smith (2001), is applied. Among other advantages of the ARDL method to cointegration,
it is highly preferred in our case because it is proven to be robust in small sample sizes (in our case,
n = 38). Because none of our variables as based on the unit root tests are I(2), the ARDL method
is valid (Pesaran et al., 2001). Based on the ARDL method, the bounds test for cointegration
is applied to test for the long-term association among our variables given that the size of the
shadow economy is the endogenous variable, whereas the other control variables are assumed to
be exogenous.
In our ARDL method, we model our long-run equation by applying a general VAR model of
lag order p in Zt , which is a column vector of our six variables. The best ARDL model, as chosen
based on information criteria, is an ARDL (2,1,2,0,2,2).
To ensure the stability of our ARDL model as a basis for testing for long-term cointegra-
tion, first, we apply the correlogram Q statistics to test that the errors of the model are serially
independent to ensure that the parameter estimates are consistent. The test finds no residual auto-
correlation. Second, the CUSUM test is applied to assess the parameter stability (Pesaran & Shin,
1999; Pesaran et al., 2001). The results indicate the absence of any instability of the coefficients
based on the plot of the CUSUM as the statistics fall inside the critical bands of the 5% confidence
interval of parameter stability. The ARDL model is satisfactory and can be further applied to test
for the long-run association among the variables of interest by applying the bounds test.

4. Results

4.1. Impulse response functions

Impulse response functions (IRF) trace out the size, direction and duration of the simulated
response of the shadow economy to a positive one standard deviation shock in the economic
318 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327

Fig. 2. Impulse responses of the shadow economy as a percentage of GDP to a one standard deviation shock in the
economic liberalization index (at 95% CI).
Note: The graphs show the impulse responses of shadow economy (as % of GDP) to one-standard-deviation shock in
the economic liberalization index. The dotted lines represent ±2 standard deviations. The deviation from the baseline
scenario of no shocks is on the vertical axis; the periods (years) after the shock are on the horizontal axis. The vertical
axis shows the magnitude of the responses.

liberalization of Egypt. The middle line in IRFs displays the response of the shadow economy to a
one-standard-deviation shock in the economic liberalization variable. The statistical significance
of the simulated responses is depicted by the dotted lines showing confidence bands at 95%
confidence intervals, which are built using 1000 Monte Carlo simulations. The estimated responses
are significantly different from zero if the error bands do not include the zero line. The vertical
axis in the IRF shows the magnitude of responses, and the horizontal axis represents the years
after the initial shock.
Fig. 2 shows that, based on historical data, an increase in the economic liberalization of Egypt
has a statistically significant and negative impact on the size of the shadow economy in Egypt. The
shadow economy reduction in the short term (2 years after the liberalization shock) is statistically
significant. In terms of economic significance, one can interpret this result as follows: Given
that one-standard-deviation in the economic liberalization index across our data set is equal to
6.33, which implies that a change of 6.33 units (out of the possible 100 units of the economic
liberalization index) would be expected to result in a 1% decrease in the share of shadow economy
in GDP in the first year, and 0.7% in the second year following the shock. The shock does not
appear to have significant effects on shadow economy after the second year at 95% confidence
level.
We observe that changes in the economic liberalization index are indeed possible and frequent.
For example, Egypt witnessed an increase from approximately 42 in 2004 to approximately 48
in 2005, i.e., an increase of approximately one standard deviation in only one year. On average,
such an increase in liberalization index would be expected to bring down the shadow of shadow
economy in GDP by a cumulative 1.7% after two years. With the maximum measured shadow
economy in Egypt being 36% in 1981, a decrease by 1.7% of this historic maximum would be a
4.7% reduction in that level of shadow economy as a percentage of GDP. In the actual observed
years 2004/2005 directly after the labor law reform of 2003, the shadow economy as a percentage
of GDP actually went down by about 4.8%.
This initial result has a number of implications: first, a preliminary answer to our research
question is reached, namely that economic liberalization in Egypt is indeed able to move eco-
nomic activity away from the shadow economy, i.e., new economic growth is able to generate
 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327 319

Fig. 3. Impulse responses to a one standard deviation shock in economic liberalization (at 68% CI).
Note: The graphs show the impulse responses of shadow economy (as % of GDP) to one-standard-deviation shock in the
economic liberalization index. The dotted lines represent ±1 standard deviation. The deviation from the baseline scenario
of no shocks is on the vertical axis; the periods (years) after the shock are on the horizontal axis. The vertical axis shows
the magnitude of the responses.

more production in the formal than the informal sector since the share of shadow economy as a
percentage of GDP falls. Second, this movement away from the shadow economy is quantifiable
in terms of its magnitude and timing: on average, 6.3 units increase in the economic liberalization
of Egypt is able to reduce the shadow economy as a share of GDP by 1.7%, with those 1.7% split
amongst the first two years following the increased economic liberalization (1% in the first year,
and 0.7% in the second year). Third, this means that policymakers can expect rather quick benefits
from economic liberalization. More specifically, and given Egypt’s latest available estimate in our
sample data of about 21.4% shadow economy as a percentage of GDP in 2013, policymakers can
possibly bring down the Egyptian shadow economy to the average of OECD countries (18%)
by improving the economic liberalization index by exactly 2 standard deviations (12.66 units).
It does however also imply, naively, that completely getting rid of the shadow economy is not
possible only through economic liberalization since even with an economic liberalization index
of 100 units, only 14.6% of shadow economy as a percentage of GDP can be reduced, bringing
it down to 6.8% (a possible reduction of 68% in the size of shadow economy as a percentage of
GDP), which, although comparable to the lowest shadow economy figures of developed OECD
countries (USA shadow economy estimated at 7.2% in 2007 (Schneider, 2009)), is still not enough
to completely eliminate the shadow economy in Egypt. In such cases, other factors and policies
must be undertaken to rein in the shadow economy, given that an economic liberalization index
of 100 units may be very challenging for a developing country. One such simple measure can be
publicity campaigns to raise awareness of the negative effects of the shadow economy as suggested
by Orviská, Čaplánová, Medved, and Hudson (2006), which may be cost-effective in increasing
the social cost of engaging in the shadow economy.
Since IRF are known to be sensitive to ordering of variables, it is important to check to what
extent the IRF in Fig. 2 is robust to the ordering of variables in the estimated VAR model. We
calculate the Generalized IRF, which does not depend on the VAR ordering and obtain an identical
result to the IRF in Fig. 2.
Furthermore, Sims and Zha (1999) suggest using one standard deviation for error bands in the
IRFs. Fig. 3 shows the above IRF by using a 68% confidence interval. As expected, the negative
response of the shadow economy and its duration do not change, but the statistical significance of
320 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327

Table 1
Variance decomposition.
Years after shock Liberalization Education Industry Government Labor force Shadow
spending participation economy

Variance decomposition of economic liberalization:

1 100 0 0 0 0 0
5 72 1 13 8 0 6
10 58 5 12 8 11 6
Variance decomposition of education:
1 10 90 0 0 0 0
5 22 66 3 0 9 1
10 34 45 2 1 14 3
Variance decomposition of industry:
1 16 5 79 0 0 0
5 22 6 46 1 10 15
10 23 13 41 1 9 13
Variance decomposition of government spending:
1 1 3 0 95 0 0
5 7 3 14 62 10 3
10 10 2 10 41 31 4
Variance decomposition of labor force participation:
1 0 0 8 31 60 0
5 1 17 6 17 57 3
10 15 21 19 10 32 4
Variance decomposition of shadow economy:
1 6 1 5 11 4 73
5 44 15 3 5 9 24
10 38 21 11 5 10 16

Cholesky ordering: liberalization, education, industry, government spending, labor force participation, shadow economy.

the response remains until 3 years after the initial shock, implying a possible total of 2.1% across
3 years (with the additional 0.4% in the third year).

4.2. Variance decomposition

In a next step, we explore how much of the variance in the Egyptian shadow economy is
explained by shocks in the shadow economy itself, and how much is explained by shocks in
liberalization and other control variables. The variance decomposition (VDC) results in Table 1
show the variance of each variable from each source of shock.
The first vertical column presents the number of years following a shock to which the decom-
position applies, and the row numbers show the percentage of variance explained by the shock
source. Table 1 shows that for almost all variables, the largest portion of variation is explained
by their own fluctuations in the first year. Variance decomposition of the shadow economy shows
that the importance of economic liberalization shocks in explaining the variation of the shadow
economy is increasing significantly, from 6% in the first year after the shock to 44% within the
first five years following the shock and stabilizing its share at approximately 40% a decade after
the shock. This implies that, not only is there a direct short-term effect, shown by the impulse
response functions, but also a longer term effect of economic liberalization exists that is able to
 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327 321

Table 2
Bounds test F-statistic.
Test statistic Value k

F-statistic 3.696927 5

Critical value bounds

Significance I0 bound I1 bound

10% 2.49 3.38

5% 2.81 3.76
2.5% 3.11 4.13
1% 3.5 4.63

Note: The null hypothesis is that there is no long-run relationship between the variables. We cannot accept the null
hypothesis (F-statistic is not smaller than critical value for I(0) regressors). The critical F test value is also larger than I1
bound at 10% level.

explain about 40% of fluctuations in the shadow economy up to 10 years after a change of one
standard deviation in the economic liberalization index. This is very interesting since it confirms
that such a policy could lead to short- and medium-term effects.
Another relatively important source of the shock in explaining the variance of the shadow
economy in Egypt is the fluctuations in education. It explains 15% and 21% of variance of the
shadow economy five and 10 years after the shock. The importance of government spending
in the variance of the shadow economy, which was relatively higher in the first year after the
shock (11%), reduces its significance five and 10 years after the shock. Economic liberalization
in Egypt, as evident in its variance decomposition, is largely explained by its own changes in
the trend of liberalization. This supports the arguments for the relatively exogenous nature of
economic liberalization in Egypt. The liberalization ideology is pushing countries to integrate
in international markets and adjust their local policies to facilitate such integration. The relative
importance of economic liberalization in explaining the shocks in education in the middle and
long terms can also be seen in Table 1. The same issue on the increasing role of liberalization
in explaining the variance of industrial production is shown in Table 1. In addition, we can also
refer to the relative increase in the importance of the shocks in the shadow economy in explaining
the variance of industrial production in Egypt over five and 10 years after the shock. The role
of education and government spending shocks is also relatively important in explaining parts of
fluctuations in the labor force participation rate in Egypt.

4.3. Bounds test for cointegration

The bounds test based on the ARDL model is applied to test for the existence of a long-run
relationship among our variables of interest. The bounds test is based on the F-test for the joint
significance of the coefficients of the lagged levels of the variables. The F-statistic tests the joint
null hypothesis that the coefficients of the lagged level variables are equal to zero, meaning no
long-run relationship exists between them, versus the alternative hypothesis that the coefficients
of the lagged level variables are not equal to zero, meaning a long-run relationship exists between
the variables (Pesaran & Shin, 1999; Pesaran et al., 2001). We denote the bounds test by testing
whether the shadow economy as the dependent variable has a long-term association with the
other control variables. As can be shown from the results in Table 2, we conclude that the value
322 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327

Table 3
Long run coefficients.
Long run coefficients

Dependent variable: shadow economy (% of GDP)

Variable Coefficient t-Statistic Prob.

Liberalization −11.156 −2.14 0.0446

Labour force participation −0.966 −2.05 0.0538
Industry −0.059 −0.42 0.6791
Government spending −0.443 −0.22 0.0535
Education −0.049 −0.53 0.6036

of the F-test statistic exceeds even the 1% critical value for the lower bounds and exceeds both
the lower and upper bounds at 10% significance. Accordingly, we reject the null hypothesis of no
long-run relationship among the variables. In other words, we find evidence that there is a long-
run relationship between the variables when the size of the shadow economy is the dependent
variable.
Once cointegration is established, the long-run model can be estimated using the ARDL model
(2,1,2,0,2,2). The results of the long-run coefficients by normalizing the size of the shadow econ-
omy as the dependent variables in the long run are shown below in Table 3. The estimated
coefficients of the long-run relationship show that the economic liberalization index has a sig-
nificant and negative impact on the size of the shadow economy in Egypt. On average and in
the long run, a one unit increase in the economic liberalization index leads to an approximately
11% decrease in the size of the shadow economy as a percentage of GDP, all else being equal.
This implies that a completely un-globalized country can shed its entire shadow economy by
moving from complete isolation to full integration on the long run. This supports the idea that
in completely globalized market, the efficiency gains in the economy through competition and
freedom of movement should make it most efficient to compete in a formal economy rather than
an informal one. Yet such a long run model should not be taken as the only measure of the effect
of liberalization on the shadow economy since it does not show the temporal effects like VAR
does (across a number of years in the future). Nevertheless, since shadow economic activities in
Egypt are labor-intensive, and at the same time, economic liberalization in Egypt has shown to
move the economy to more labor-intensive service sectors, it is likely that this is what is seen in
the long-run leading to the 11% reduction. The Egyptian government should, however, take this
into consideration since an overwhelming reliance on services sectors can only be sustained if the
quality of the labor force (in this sense, education and gender equality) can be improved upon,
or else a phenomenon similar to the GCC countries where foreign expatriates were used to fill in
the labor-skill gap in the economy.
Other variables of interest in the long-run model include improvements in labor force participa-
tion as well as government spending, however both of these variables’ effects on reducing shadow
economic activities pale in comparison to the effect of economic liberalization. It is important to
note that the negative sign of the effect of government spending highlights the argument that a
larger public sector tends to reduce the shadow economy. However, since IMF conditions specif-
ically push towards a smaller budget deficit and a smaller public sector, this may end up having
an opposing effect to economic liberalization when it comes to the shadow economy. Our results
show that this difference is generally overcome by the reductions in shadow economy due to
 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327 323

economic liberalization, i.e., in the long-run, the Egyptian government should not worry that jobs
lost from the public sector would increase the size of the shadow economy as a percentage of
GDP, since the effect of economic liberalization would easily compensate that loss.

5. Policy recommendations

Building on previous literature and based on our empirical analysis, we can suggest a number
of policy recommendations on economic liberalization-shadow economy nexus in Egypt:
First, the Egyptian government should take into consideration that economic liberalization is
commonly associated with a higher skill premium and consequently higher income inequality.
Thus without necessary social welfare schemes, the political stability advantages from solving
the economic informality problem may be overcome by the disadvantages of income inequality.
Second, we do not recommend overly investing in capital intensive industries since these
do little to help in the reduction of the informal sector. Instead economic liberalization in Egypt
should aim to increase allocation of resources toward labor intensive service sector such as tourism
which tend to be regulated and formalized due to security concerns. This structural reallocation
of resources toward internationally oriented service sectors is likely to reduce the size of shadow
economy in the long-run.
Third, to ensure the success of economic liberalization policies in reducing the size of shadow
economy, it may be wise to revise and possibly improve upon the intellectual property rights
policies in Egypt. It has been shown that protection of intellectual property rights is not only
important for attracting FDI but is also a relevant factor for controlling the size of the shadow
economy. Better protection of property rights reduces the ability of firms in the shadow economy
to imitate the intellectual property for their own advantages (Minsoo et al., 2018).
Fourth, one must keep in mind the response of the large public sector in Egypt (El Husseiny,
2019) to economic liberalization policies. The reduction of public sector employment as a result of
liberalization policies may negate much of the improvements of economic liberalization and end
up increasing the shadow economy by pushing those currently employed in the public sector–with
little or no qualifications suitable for the private sector–into the informal sector.
Fifth, we can support one positive aspect of the IMF conditions: the suggestion of imposing
a new VAT, which is always preferred to direct income taxes that tend to push the labor force
towards the informal sector (González-Fernández & González-Velasco, 2015).
Finally, one important policy to deal with worsening external debt situation (CBE, 2017;
CEIC, 2018) and public debt problem of Egypt is through reducing the size of shadow economy
by economic liberalization policies. This is also in line with study of González-Fernández and
González-Velasco (2014) who show a positive and significant relationship between reduction of
the shadow economy and decreasing public debt.

6. Conclusion

The objective of this paper is to analyze whether promoting economic liberalization in Egypt
has historically been able to impact the size of the shadow economy. Addressing the shadow
economy is one of the main concerns of policymakers. The agents in the shadow economy suffer
from a series of deficiencies, including lower productivity of labor and capital, a lack of access to
financial resources in the formal banking system, a lack of resources to improve the technology
of production, a higher reliance on emission intensive inputs for their production as well as a lack
of safety and environmental standards (Biswas et al., 2012). An increasing shadow economy is a
324 M.R. Farzanegan et al. / Journal of Policy Modeling 42 (2020) 307–327

burden to the government budget and may lead to political instability (Farzanegan & Badreldin,
2017).
One possible method of decreasing the shadow economy is economic liberalization. By reduc-
ing the economic costs of imports, exports and doing business, it is possible to expand productivity
and available opportunities in the formal economy, motivating informal agents to acquire skills
required for the formal economy.
To investigate the effect of economic liberalization on the shadow economy, we use time series
data for Egypt from 1976 to 2013. An unrestricted vector autoregressive model and its tools
of impulse response functions (IRF) and variance decompositions are applied to investigate the
response of the shadow economy to positive shocks in economic liberalization. Our IRF results
show a statistically significant negative response of the Egyptian shadow economy to a positive
shock in economic liberalization. The negative response of the shadow economy is at its lowest
level within the first year and remains statistically significant for the first 3 years following the
shock, resulting in an on average decrease of 2.1% of the shadow economy in the country for
every 6 units improvement in the economic liberalization index. We also apply the bounds test
and the long-run model based on the autoregressive distributed-lagged model (ARDL) model,
which indicate that the variables are co-integrated in the long-term. It further confirms that long
run improvements to the economic liberalization index have significant negative effects on the
size of the shadow economy, reaching up to 11% reduction.
To conclude, our results imply that policies that improve Egypt’s economic liberalization,
whether those motivated internally, or externally due to loan conditions, can reduce Egypt’s
shadow economy problem in the short- and long-term, which is expected to improve the country’s
budget deficits and promote political and economic stability. Nevertheless, we should recognize
that reductions in budget deficit and public debt cannot only be achieved through austerity and
reducing the informal sector. Studies such as González-Fernández and González-Velasco (2014)
show that the role of corruption cannot be ignored.

Acknowledgement

Mai Hassan acknowledges the support of Yousef Jameel Scholarship Fund Program.

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