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Western Europe’s Shadow Economies

What are the prime reasons for the growth of shadow economies around the world?

December 12, 2003

What are the prime reasons for the growth of shadow economies around the world?

There are many reasons the shadow economy is growing dynamically in countries across Europe. To understand this disturbing trend, it is vital to look at its social and political implications.

The fact that this migration into the economic underworld occurs in OECD countries also is a surprise at first sight.

First and foremost, it symbolizes a revolt by the people against government intrusion into their lives. That revolt is based mostly on the ever-growing tax burden placed on them.

Over the years, this burden has become so heavy that people increasingly feel a very real sense of being weighed down — and confined — in their daily economic existence.

Instead of voicing their grievances in elections to inspire broader changes, people increasingly rely on the "exit option:" retreating into the shadow economy.

Casting a Long Economic Shadow
  In many OECD countries, the size of shadow economy is between one-fifth and one-fourth the size of the official, legal economy.


Data Source: Friedrich Schneider IZA. Copyright © 2003.

This, in turn, leads to a vicious cycle. The basis for a true assessment of individuals' tax contributions begins to erode as more and more people earn their livelihood in this shadow economy.

As a result, taxes increase for the people that remain in the system — in order to balance the revenue lost.

In turn, these tax hikes spark an even further withdrawal from the straight and narrow into the shadows.

In an extreme scenario, this cumulative process can lead to an acute governmental and financial crisis.

In effect, the consequence is a complete repudiation of a long-established and firmly-rooted economic order — essentially because formal institutions and rules of living together in a society have worn down.

Governments may aspire to ever-more perfect rules and regulations governing various institutions and social processes. But citizens sense that they have long lost their ability to comprehend these rules.

Hence, citizens' sense of moral obligation is declining — as is people's willingness to fulfill their civic duties. As a consequence of all this, people's readiness to exploit official institutions is increasing rapidly.

The increase in the volume of the shadow economy — and the corresponding increase in tax evasion — can be seen as a reaction by more and more citizens to the escalation of the state's lavishness in spending tax revenues.

This trend may actually represent a kind of "democratization" of the long-established tax opposition.

Unless it is possible in the medium or long term to significantly reduce the extra charges and incidental costs associated with labor across Europe — and unless it is equally possible to tax individuals only minimally for additional labor or overtime — fighting the shadow economy will stand no chance.

Additional rules and regulations that have a paralyzing effect on the economy should be studied closely and reduced to a minimum.

In the short term, these suggestions will not change the upward trend of the shadow economy, especially because joining its ranks occurs much more readily than leaving it.

Also, there are no immediate alternatives in the official economy for the loss of income incurred from having terminated work in the shadow economy.

However, in the long term these proposals stand a definite chance to stabilize or even curb the shadow economy. What is missing, then, is not the necessary instruments for change.

Rather, it is courageous politicians to step up to these challenges and impose much-needed measures to fight the rising influence of the shadow economy.

In light of these assessments, it seems that a tightening of controls and sanctions to control illegal employment is likely to be of limited success only.

This is true especially because such a tightening is going to encourage the creativity of the afflicted and their attempts of finding new ways to circumvent the law.

Besides the shortfall in tax revenues and social security contributions, the increase in the activities of the shadow economy also brings to light other problems.

One of these problems is that economic statistics start to misrepresent the actual state of the economy, frequently resulting in an overestimation of the unemployment rate.

At the same time, economic policies which rely on official statistics become misguided as a result of erroneous information. More specifically, unemployment figures are inflated and consumer index figures deflated.

The question remains whether harsher punishments and firmer restrictions can really reduce activity in the shadow economy. Could a reduction of the shadow economy really lead to a significant increase in the availability of jobs in the official economy?

The answer is that jobs in the official economy would only increase if the tax and social security burdens on labor were reduced, making it cheaper to produce goods and provide services in the official economy.

At least two-thirds of all shadow economy activities have a complementary, not substitutive, character. Hence, if one were successful in completely eliminating the shadow economy, official jobs would rise only by approximately one-third.

The consequences of illegal employment are therefore not only negative.

Official German studies show, for example, that about 70% of income made illicitly flows straight back into the economy.

And yet, an increase in the acceptance of the shadow economy may have profoundly disturbing socio-political implications. Perhaps the most important negative outcome of a quickly growing shadow economy is that people will increasingly come to question the need to contribute to the public good — or government per se.

More specifically, a growing reluctance may emerge to pay taxes for official goods and services provided by the state.

If such a mindset ever takes hold, a key element of our civic system would collapse — and a confidence crisis would emerge.

It is obvious that the existence of the shadow economy presents a grave economic and socio-political challenge. Success will only arrive when the root causes of the growing appeal of the shadow economy are investigated.

Among these causes are the mounting tax burdens that citizens in Europe bear, as well as the pervasive rules and regulations that govern all areas of official employment.

Harsher punishments alone will not successfully limit the broad appeal of working illicitly.

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