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September 13, 2021

The shadow economy and the Covid-19 pandemic crisis

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The shadow (underground or informal) 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. Especially during crisis, the shadow economy can function as an economic buffer. Goods and services can be provided, so that people are not suffering from lack of food and other essential products. Nevertheless, working in the underground economy very often means no protection against the coronavirus or other illnesses. Hence, the shadow economy has implications that extend beyond the economy to public health and the political system.

The shadow economy should not be seen as solely an economic problem, to be resolved by attacking the symptoms through higher fines and tougher controls. A country-specific analysis of causes and consequences is necessary to develop policy measures appropriate to each country’s level of development and the state of the Covid-19 crisis. Policymakers should view illicit work as a signal of the need to decrease the attractiveness of the shadow economy through better regulation, a fair and transparent tax system, and more efficient institutions (good governance). 

Organized crime, corruption, and illegal employment should nevertheless be fought through stricter controls and enforcement. The strong correlation between corruption and the size of the shadow economy is a key problem in times of crisis. Corrupt institutions lead to further increases in distrust in official institutions—for example, when officials get vaccinated against Covid-19 much earlier than people with a much higher risk of dying from the disease. But trust is most valuable during a crisis with unexpected developments and little or no valid data (at least at its beginning). Countries with high trust in official institutions, the state, the economy, and society (social capital) have suffered much less from the Covid-19 crisis and have—in general—a much smaller shadow economy. Building trustful institutions is therefore an important measure to fight corruption, illicit work, and the pandemic crisis. 

The increasing resistance to existing norms and economic regulations that is reflected in the continuing importance of the shadow economy can be dealt with through a two-pillar strategy of reducing the attractiveness of the exit option (the shadow economy) while strengthening the voice option (voting and participation). Federal elements must be strengthened, and instruments of direct democracy, such as referendums and legal initiatives, should be introduced to give citizens more opportunities to participate in rule-making and the design of the tax system. Regional commitment and citizen initiatives could signal a wish to keep or regain control of political life. Increased participation will diminish the perception of being subjected to unfair restrictions on personal freedom for example, as seen during the current crisis, and it will strengthen trust in the system!

© Dominik Enste

Read Dominik Enste’s IZA World of Labor article: “The shadow economy in industrial countries.”

Find more content on the subject of the shadow ecomony.

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We recognize that IZA World of Labor articles may prompt discussion and possibly controversy. Opinion pieces, such as the one above, capture ideas and debates concisely, and anchor them with real-world examples. Opinions stated here do not necessarily reflect those of the IZA.