key topic

The shadow economy

The shadow (or informal) economy includes illicit economic activity that exists alongside a country's official economy. Examples include black market transactions and undeclared work. Estimates of its size vary widely across countries, but they suggest it is fairly large and important.

  • Does increasing the minimum wage reduce poverty in developing countries?

    Whether raising minimum wages reduces—or increases—poverty depends on the characteristics of the labor market

    T. H. Gindling, November 2018
    Raising the minimum wage in developing countries could increase or decrease poverty, depending on labor market characteristics. Minimum wages target formal sector workers—a minority in most developing countries—many of whom do not live in poor households. Whether raising minimum wages reduces poverty depends not only on whether formal sector workers lose jobs as a result, but also on whether low-wage workers live in poor households, how widely minimum wages are enforced, how minimum wages affect informal workers, and whether social safety nets are in place.
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  • The shadow economy in industrial countries

    Reducing the size of the shadow economy requires reducing its attractiveness while improving official institutions

    Dominik H. Enste, November 2018
    The shadow (underground) economy plays a major role in many countries. People evade taxes and regulations by working in the shadow economy or by employing people illegally. On the one hand, this unregulated economic activity can result in reduced tax revenue and public goods and services, lower tax morale and less tax compliance, higher control costs, and lower economic growth rates. But on the other hand, the shadow economy can be a powerful force for advancing institutional change and can boost the overall production of goods and services in the economy. The shadow economy has implications that extend beyond the economy to the political order.
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  • Defining informality vs mitigating its negative effects

    More important than defining and measuring informality is focusing on reducing its detrimental consequences

    There are more informal workers than formal workers across the globe, and yet there remains confusion as to what makes workers or firms informal and how to measure the extent of it. Informal work and informal economic activities imply large efficiency and welfare losses, in terms of low productivity, low earnings, sub-standard working conditions, and lack of social insurance coverage. Rather than quibbling over definitions and measures of informality, it is crucial for policymakers to address these correlates of informality in order to mitigate the negative efficiency and welfare effects.
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  • Inequality and informality in transition and emerging countries

    Higher inequality decreases capital accumulation and increases informality, which, in turn, raises the income of the poor

    Roberto Dell'Anno, December 2016
    Higher inequality reduces capital accumulation and increases the informal economy, which creates additional employment opportunities for low-skilled and deprived people. Despite this positive feedback, informality raises problems for public finances and biases official statistics, reducing the effectiveness of redistributive policies. Policymakers should consider the links between inequality and informality because badly designed informality-reducing policies may increase inequality. However, convincing empirical evidence is still lacking and is usually limited to correlations rather than causal effects.
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  • Do economic reforms hurt or help the informal labor market?

    The evidence is mixed on whether and how economic reforms benefit informal labor

    Saibal Kar, June 2016
    The evidence is mixed on whether informal labor in developing countries benefits from trade and labor market reforms. Reforms lead to higher wages and improved employment conditions in the informal sector in some cases, and to the opposite effect in others. At a cross-country level, lifting trade protection boosts informal-sector employment. The direction and size of the impacts on informal-sector employment and wages are determined by capital mobility and the interactions between trade and labor market reforms and public policies, such as monitoring the formal sector. To guarantee best practice policymakers need to take these interdependencies into account.
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  • Measuring disincentives to formal work

    Does formal work pay? Synthetic measurements of taxes and benefits can help identify incentives and disincentives to formal work

    Michael Weber, December 2015
    Evidence from transition economies shows that formal work may not pay, particularly for low-wage earners. Synthetic measurements of work disincentives, such as the formalization tax rate or the marginal effective tax rate, confirm a significant positive correlation between these measurements and the probability of informal work. These measures are especially informative for impacts at lower wage levels, where informality is highest. Policymakers who want to increase formal work can use these measurements to determine optimal labor taxation rates for low-wage earners and reform benefit design.
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