Shadow Economy In The Relationship With Fdi, Institutional Quality, And Income Inequality.doc

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MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECONOMICS HO CHI MINH CITY
HUYNH CONG MINH
SHADOW ECONOMY IN THE RELATIONSHIP WITH FDI,
INSTITUTIONAL QUALITY, AND INCOME INEQUALITY:
EMPIRICAL EVIDENCE FROM ASIAN COUNTRIES
PhD THESIS

MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECONOMICS HO CHI MINH CITY
HUYNH CONG MINH
SHADOW ECONOMY IN THE RELATIONSHIP WITH FDI,
INSTITUTIONAL QUALITY, AND INCOME INEQUALITY:
EMPIRICAL EVIDENCE FROM ASIAN COUNTRIES
Major: Development Economics
Code: 9310105
PhD THESIS
Advisors:
1. Dr. Nguyen Hoang Bao
2. Dr. Nguyen Vu Hong Thai

i
This thesis submitted to the School of Economics, University of Economics Ho Chi
Minh City, in partial fulfillment of the requirements for the degree of Doctor of
Philosophy in development economics.

ii
DECLARATION
I hereby declare that this thesis is my own research. Data and results are reliable,
clearly originated, and have never been published in any other study.
The author

iii
ACKNOWLEDGEMENTS
First of all, I would like to express my great gratitude to Dr. Nguyen Hoang Bao
and Dr. Nguyen Vu Hong Thai for their invaluable supervision and inspirations. Thank
you so much for keeping me on track throughout the research process, giving wise
comments, advices and encouragement during such a long academic journey.
Then I am honestly grateful to Dr. Pham Khanh Nam, Dr. Truong Dang Thuy,
Dr. Le Van Chon, Dr. Vo Tat Thang, Dr. Vo Hong Duc, Associate Pro. Dr. Nguyen
Huu Dung, Dr. Nguyen Luu Bao Doan, Dr. Pham Thi Thu Tra, Dr. Pham Thi Bich
Ngoc, Associate Pro. Dr. Vuong Duc Hoang Quan and the two independent Reviewers
for their valuable comments and encouragements so that I can improve the quality of
my thesis.
I cannot forget showing my special thanks to lecturers at school of economics as
well as those at University of Economics HCMC such as Professor Dr. Nguyen Trong
Hoai, Dr. Pham Khanh Nam, Dr. Truong Dang Thuy, Associate Pro. Dr.Nguyen Manh
Hung, Dr. Tran Thi Tuan Anh, Associate Pro. Dr. Tran Tien Khai… for their academic
and practical instructions during my time of study and research at the university.
Last but not least, I am deeply grateful to my beloved family, including my
deceased father, my 83-year-old mother as well as my sisters and brothers who always
support and encourage me in time for completing the thesis.

iv
TABLE OF CONTENTS
Declaration
Acknowledgements
Table of contents
List of Abbreviations
List of Tables
List of Figures
Pages
Chapter 1: Introduction....................................................................................................................................1
1.1. Research context and gaps......................................................................................................1
1.2. Research objectives...................................................................................................................13
1.3. Research questions………………………………………………..............................13
1.4. Research subjects and scope...................................................................................................14
1.5. Research methodology and data ………………………………….............................14
1.6. Contributions...............................................................................................................................15
1.7. Limitations...................................................................................................................................18
1.8. Thesis outline..............................................................................................................................18
Chapter 2: Literature review and hypotheses...........................................................................................19
2.1. Shadow economy ......................................................................................................................20
2.1.1. Theories on shadow economy.......................................................................................20
2.1.1.1. Definition..................................................................................................................20
2.1.1.2. Schools of thought..................................................................................................21
2.1.2. Empirical studies on shadow economy......................................................................31
2.1.2.1. Methods to estimate the size of the shadow economy.................................31

v
2.1.2.2. Determinants (causes) 35
2.1.2.3. The impacts of shadow economy (effects) 40
2.2. Shadow economy, FDI and Institutional quality 44
2.2.1. FDI and institutional quality 44
2.2.1.1. Theories on FDI (Definition, Theories, Determinants) 44
2.2.1.2. Theories of institutional quality (Definition, Theories, Determinants) 47
2.2.1.3. The relationship between institutional quality and FDI 48
2.2.2. Institutional quality and shadow economy 54
2.2.2.1 The effect of institutional quality on shadow economy 55
2.2.2.2 The effect of shadow economy on institutional quality 57
2.2.3. Shadow economy and FDI 59
2.2.3.1 The effects of FDI and FDI-institutional quality interaction on shadow
economy 59
2.2.3.2 The effects of shadow economy on FDI 59
2.3. Shadow economy and income inequality 61
2.3.1. Income inequality 61
2.3.1.1. Definition 61
2.3.1.2. Theories 62
2.3.1.3. Measurements 65
2.3.1.4. Determinants 66
2.3.2. The impact of shadow economy on income inequality 67
Chapter 3: Methodology, model specifications, and data ...................................................................73
3.1. Analytical framework 74
3.2. Empirical models and data 77
3.3. Econometric methodology 88
3.4. The sample selection of 19 Asian countries and their backgrounds on research
problems 93

vi
Chapter 4: Shadow economy, FDI and Institutional quality: empirical evidence from Asian
countries ..............................................................................................................................................96
4.1. Introduction .................................................................................................................................96
4.2. Data analysis ...............................................................................................................................97
4.2.1. Data descriptive statistics...............................................................................................97
4.2.2. Unit-root test......................................................................................................................99
4.2.3. Correlation analysis.........................................................................................................101
4.3. Estimation results and discussions........................................................................................102
Chapter 5: The impacts of shadow economy on income inequality in developing Asia
113
5.1. Introduction .................................................................................................................................113
5.2. Data descriptive statistics........................................................................................................116
5.3. Empirical results and discussions .........................................................................................119
Chapter 6: Conclusions and policy implications ......................................................................................125
6.1. Conclusions.................................................................................................................................125
6.2. Policy implications....................................................................................................................128
6.3. Limitations and further research implications...................................................................129
List of publications ...............................................................................................................................................131
References ................................................................................................................................................................132
Appendices...............................................................................................................................................................159

vii
LIST OF ABBREVIATIONS
2SLS: Two-stage Least Squares
3SLS: Three-stage Least Squares
ARDL:
AR1:
AR2:
ECM:
EFR:
FDI:
FE:
FH:
Autoregressive-distributed lag model
First-order Autocorrelation
Second-order Autocorrelation
Error correction model
Economic Freedom Report
Foreign direct investment
Fixed Effects
The Freedom House
GCI: Global Competitiveness Index
GDP: Gross Domestic Products
GLS: Generalized Least Squares
GNI: Gross National Income
MENA: Middle East and North Africa
MIMIC: Multiple Indicators Multiple Causes
MNCs: Multinational Corporations
HDR: Human Development Report
HF: The Heritage Foundation
ICRG: The International Country Risk Guide
IEF: Index of Economic Freedom

viii
ILO:
IMF:
International Labor Organization
International Monetary Fund
IQ:
JGLS:
OLI:
OLS:
POLS:
PRS:
RE:
SEM:
SGMM:
SURE:
UNESCO:
UNCTAD:
UNDP:
Institutional quality
Joint Generalized Least Squares
Ownership, Location, and Internalization
Ordinary Least Squares
Pooled Ordinary Least Squares
Political Risk Services Group
Random Effects
Simultaneous equation model
Two Steps System Generalized Method of Moments
Seemingly Unrelated Regression
United Nations Educational Scientific and Cultural Organization
United Nations Conference on Trade and Development
United Nations Development Programme
WB: World Bank
WDI: World Development Indicators
WEF: World Economic Forum
WGIs: Worldwide Governance Indicators

ix
LIST OF TABLES
Table 2.1. Labor market classification..............................................................................................23
Table 2.2. Structure of informal work typology...........................................................................29
Table 4.1. Summary statistics..............................................................................................................98
Table 4.2. Unit root tests for all variables .......................................................................................100
Table 4.3. The estimation results of the SEM by 3SLS and Two Steps System GMM
...........................................................................................................................................................................103
Table 4.4. The effect of FDI on shadow economy......................................................................110
Table 5.1. Definition and summary statistics.................................................................................118
Table 5.2. Final estimation results for the impact of shadow economy on income
inequality by FE and RE.........................................................................................................................120
Table 5.3. Estimation results for the impact of shadow economy on income inequality
by 2 Steps SGMM......................................................................................................................................121

x
LIST OF FIGURES
Figure 1.1. Institutional quality by 5 components in Asian countries on average from
2002-2015 ................................................................................................................... 3
Figure 1.2. The size of shadow economy as a share of official GDP and FDI as the
percentage of GDP in Asian countries on average from 1999-2015 .......................... 4
Figure 1.3. Recent trends of income inequality in Asian developing countries ......... 5
Figure 2.1. The place of institutions in the FDI determinants pattern ........................ 49
Figure 2.2. The theoretical framework for the link between shadow economy and
income inequality ........................................................................................................ 70
Figure 3.1. The analytical framework for the relationship among FDI, institutional
quality, shadow economy and income inequality ....................................................... 74
Figure 5. The shadow economy and income inequality in Asian countries (1990-2015)
……………………………………………………………………………….. 115

1
CHAPTER 1
INTRODUCTION
Chapter Outline
1.1. Research context and gap
1.2. Research objectives
Research questions Research
subjects and scope Research
methodology and data
Contributions Limitations
Thesis outline
1.1 Research context and gaps
1.1.1 Practical background
For recent decades, shadow economy, investment from abroad, institutional quality
and income inequality have attracted a great deal of attention in development
economics because all of them relate to economic growth. Both of foreign direct
investment (FDI) and institutional quality (IQ) are considered important determinants
of economic growth and development (Borensztein, Gregorio, & Lee, 1998; Nair-
Reichert & Weinhold, 2001; Rodrik, Subramanian, & Trebbi, 2004; Acemoglu,
1.7.
1.8.
1.6.
1.5.
1.4.
1.3.

2
Johnson, & Robinson, 2005; Hansen & Rand, 2006; Varsakelis, 2006; and Kandil,
2009); while the official economy is closely related to the shadow economy (Schneider
& Bajada, 2003; Vo & Pham, 2014). Moreover, economic growth is associated with
income inequality (Kuznets, 1955; Barro, 2000). Especially, these variables and their
relationships become worth studying in the context of Asia for its rising thorny
features, such as high flow of FDI but low institutional quality, large shadow economy
and rising income inequality.
First, global foreign direct investment has significantly grown since the 1970s,
reached $1.76 trillion in 2015, fell 13% in 2016 ($1.52 trillion) and recovered in 2017;
especially, developing Asia is now the largest recipient and accounts for almost one-
third of total FDI inflows (UNCTAD, 2017). It is seen as the result of Asian countries
in effort to attract FDI for economic development by adopting an open door policy,
governance changes & institutional innovation (Haggard, 2004; Lee, 2002). However,
the positive impact of FDI on economic growth depends on the institutional quality in
the host countries (Brahim & Rachdi, 2014; Jude & Levieuge, 2017). It is also Asia’s
specific concern, especially when there are many countries might be stuck in middle
income trap in the region and deficient institutional quality is one of the main causes
(Dollar, 2015). Figure 1.1 describes the institutional quality by 5 components
(including Voice and Accountability, Political Stability and Absence of Violence,
Government Effectiveness, Regulatory Quality, and Rule of Law) in 19 Asian
countries1
on average from 2002-2015. The scale of measurement ranks from -2.5
(lowest quality) to 2.5 (highest quality). In general, the institutional quality in Asian
countries is low. The improvement has been seen but it is a slow progress. FDI has
flowed into Asian countries in great amounts, but institutional quality is still
1
Including Bangladesh, Bhutan, Cambodia, China, India, Indonesia, Kazakhstan, Kyrgyzstan, Laos, Malaysia,
Maldives, Mongolia, Myanmar, Nepal, Pakistan, Philippines, Sri Lanka, Thailand, and Vietnam.

3
problematic in the region. Whether institutional quality really helps attracting FDI and
FDI in its turn helps improving institutional quality. Does this bidirectional relationship
exist in Asian countries?
0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
-0.1
-0.2 Government Effectiveness
-0.3
Political Stability
-0.4
Regulatory Quality
-0.5
-0.6
Rule of Law
-0.7 Voice and Accountability
-0.8
-0.9
Government…
Figure 1.1. Institutional quality by 5 components in Asian countries on
average from 2002-2015.
(Source: Worldwide Governance Indicators, World Bank, 2017b)
Second, the shadow economy problematizes policy-makers in Asia, because the
size of the shadow economies in Asian countries has grown considerably since 1989,
suggesting that national accounts data is on average significantly underestimated as
national accounts are not supposed to capture shadow economies (Bajada and
Schneider, 2005). The estimated average size of shadow economy in Asian countries
over 1999 to 2015 is 30.94 % of official gross domestic products (GDP), and this
period experiences an increase of 10.24% in the shadow economy size (Medina &
Schneider, 2018). The lowest and the highest sizes are 29.04% and 33.41% in 2006 and
2009 respectively. The size of shadow economy in Asian countries is empirically

4
attributed to the money demand, tax burden, private consumption, interest rate and
Gross National Income (GNI) per capita (Bajada & Schneider, 2005; Vo et al., 2015).
The presence of shadow economy distorts the allocation of resources, alters income
distribution and reduces governments’ tax revenue (Alm & Embaye, 2013). If we
ignore this sector, it is biased to evaluate the consequences of various economic
policies. Thus, it is imperative to comprehensively understand about the shadow
economy in Asia in relation with other variables such as FDI and institutional quality.
Whether FDI is a channel to improve institutional quality and the improvement in
institutional quality helps reduce shadow economy when institutional quality is a driver
of shadow economy? The figure 1.2 shows the shadow economy and FDI in Asian
countries on average from 1999-2015.
35.0 6
34.0
5
economy(%ofGD
P)
33.0
FDI(%ofGDP)
32.0 4
31.0
3
30.0
Shado
w
29.0 2
27.0
Shadow
28.0
economy
1
FDI
26.0 0
19992000200120022003200420052006200720082009201020112012201320142015
Figure 1.2. The size of shadow economy as a share of official GDP and FDI as
the percentage of GDP in Asian countries on average from 1999-2015.
(Source: World Bank, 2017a; and Medina & Schneider, 2018)

5
Third, recent rapid economic growth in Asia has reduced poverty but widened
income gap in many countries. To Zhuang, Kanbur, and Maligalig (2014), the Asia-
wide Gini index rose at an annual rate of 1.4% from 0.39 in the mid-1990s to 0.46 in
the late 2000s; 14 of 37 Asian economies now have a Gini coefficient of 0.40 or
greater, widely considered the threshold for “high inequality”. However, the
comparison between the two periods of mid-1990s and around-2012 shows that the
average Gini index for 19 developing Asian countries decreases by 5.22%. This
improvement in income inequality mostly came from Central Asian countries such as
Kyrgyz Republic, Kazakhstan, and Maldives. Gini indexes were also seen falling in
Cambodia, Thailand, Nepal, Malaysia and Mongolia. On the contrary, China,
Indonesia and India - covering 82% of the population in the region- experienced a
rapid rising income inequality with their increases in Gini indexes by 18.8%, 14.9%
and 14.1% respectively. The income inequality was also found rising in Sri Lanka,
Laos, Pakistan, Vietnam and Tajikistan. The figure 1.3 provides the recent trends of
income inequality in 19 Asian developing countries.
60
Gini index
50
40
30 Gini
1990s
20
10 Gini
around
0
2012

6
Figure 1.3. Recent trends of income inequality in Asian developing countries
(Source: World Bank, 2017a)
The rising inequality matters for many reasons. First, highly unequal societies
with the concentration of wealth on the rich are less likely to consolidate democracy,
and may end up with social unrest or even coups (Acemoglu & Robinson, 2001).
Second, it hampers the pace at which growth enables poverty reduction (Ravallion,
2004). Third, the inequality undermines the growth process through many channels of
economic, social, and political mechanisms; it negatively affects growth and its
sustainability (Ostry, Berg, & Tsangarides, 2014). Fourth, income inequality causes
low quality of institutions- one of key factors for development (Chong & Gradstein,
2007b; and Zhuang et al., 2010); and excessively high levels of inequality erode
institutional quality even in democracies (Kotschy & Sunde, 2016).
From the practical background above, there is a need to study the relationships
amongst these variables so that policy makers can be provided with empirical studies
for their decision-making in dealing with these aggregate variables simultaneously.
However, the motivation for carrying out this study is arisen not only from the practical
background but also from the theoretical background.
1.1.2 Theoretical background
FDI, institutional quality and shadow economy
The failure in explaining economic phenomenon by one theory has led to the
tendency of using an integrative approach to bring insights in recent decades (Torgler
& Schneider, 2009). In fact, FDI is long documented as the main driver of host
countries’ economic growth (Borensztein et al., 1998; Nair-Reichert & Weinhold,
2001; and Hansen & Rand, 2006), while the emerge of the new institutional economics
in recent decades gets a great deal of attention from economists (Kotschy &

7
Sunde, 2016; Neyapti & Arasil, 2016). On the other hand, a vast literature has
attempted to study the shadow economy, especially from the transformation of the
socialist economies such as China, Russia, and Vietnam in 1990s where institutional
weaknesses and corruption are major obstacles to their market reforms (Gupta & Abed,
2002; Torgler & Schneider, 2009). Knowing the unknown and estimating the shadow
economy are still a difficult task that has posed notable challenges in statistical studies
in the past decades (Torgler & Schneider, 2009). Fortunately, the availability of
shadow economy’s dataset re-highlighted the interests of economists into the
relationships between shadow economy and other factors from both sides of economics
and institutions (Gupta & Abed, 2002).
The nexuses between FDI, institutional quality and shadow economy can be
divided into three strands with ambiguous relationships. In the first strand, the
relationships between FDI and institutional quality are concentrated, following
theories of international trade and institutions. In particular, Dunning (1980) uses the
eclectic paradigm, also known as the OLI-Model or OLI-Framework, to explain the
various reasons why a multinational corporation (MNC) enters into a host country. To
him, an MNC decides to invest in the host country when advantages of OLI
(Ownership, Location, and Internalization) are met. In this context, governance and
institutions can be seen as a location factor that may encourage or deter the investment
inflows. Similarly, North (1990) with the institutionalization theory shows that
institutions set “the rule of the games” which organizations and MNCs must follow in
pursuit of their own learning and goals for resource allocation. To him, institutions
affect uncertainty level and allow individuals and firms interact effectively. To attract
investments, governments improve their governance to lower transaction costs in
which investors might get higher profitability. In addition, Westney (1993), by using a
framework of MNCs theory, explores the potential significant role of MNCs in

8
improving the organizational patterns in host countries through subsidiaries. Thus, to
the above theories, institutional quality is a key determinant of FDI and FDI in its turn
helps improve institutional quality in the host country. However, He (2006) with the
Pollution Haven Hypothesis suggests that the motives of some FDI firms are to find a
place to hide pollution, and developing countries with lax environmental regulations is
the destination for these businesses. By this view, low institutional quality will attract
polluting FDI firms.
Most of studies argued the role of institutional quality in determining FDI inflows
with three categories: i) FDI is positively affected by institutional quality represented
by single indicators such as transparency (Zhao et al, 2003), democratic accountability
(Busse & Hefeker, 2007), intellectual property rights and contract enforcement (Du et
al, 2008), political rights and civil liberties (Tintin, 2013); ii) There is no impact of
institutional quality on attracting FDI (Kandil, 2009; Bellos & Subasat, 2011; Farla et
al., 2014; and Iloie, 2015); and iii) the new argument, especially in the case of China’s
outward FDI, is found that the low institutional quality attracts higher FDI inflow (Fan,
Morck, Xu, & Yeung, 2009). Meanwhile, the feedback effect of FDI on institutional
quality of host countries has received less attention from researchers. Larrain &
Tavares (2004) find that FDI significantly reduces corruption levels. Long, Yang, &
Zhang (2015) find the same results on the effects of FDI inflows on institutional
quality. However, the bidirectional relationship between FDI and institutional quality is
largely ignored except by a few including Fukumi & Nishijima (2010) for Latin
America & the Caribbean, and Shah et al. (2015) for Pakistan. Then what is the
bidirectional relationship between FDI and institutional quality in Asian countries and
is it illustrated by the Eclectic paradigm (Dunning, 1980), the Institutionalization
theory (North, 1990), the MNCs theory (Westney, 1993), or He (2006) with the
Pollution haven hypothesis? It is an empirical gap needed to fill, giving policy-makers

9
with evidences to consolidate their decision on FDI attraction and institutional
innovation. If FDI inflows and institutional quality have a positive nexus (as supported
by Dunning, 1980; North, 1990; and Westney, 1993), governments can combine the
policies to deal with FDI and institutional quality at the same time to take the
advantage of this causal relationship. Otherwise, environmental regulations should be
adjusted to limit polluting FDI firms if Asian countries confirm the Pollution haven
hypothesis (proposed by He, 2006).
The second strand focuses on institutional quality as a driver of shadow economy,
basing on Legalism school of thought on the informal economy. Following this view,
better institutional quality reduces the shadow economy because of two reasons: i)
better institutional quality lessens the burden of regulations and procedures - the main
cause that explain why people participate in informal activities - and thus lowers
shadow economy (Demsetz, 1974; ii) better institutional quality reveals informal
transactions which consequently turn official and hence reduces shadow economy (De
Soto, 1989, 2000). The negative impact of institutional quality on shadow economy is
empirically confirmed by Johnson et al. (1998); Friedman et al. (2000); Fugazza &
Jacques (2003), Torgler & Schneider (2009), Dreher et al. (2009), Dreher & Schneider
(2010), Singh et al. (2012), Razmi et al. (2013), and Hassan & Schneider (2016). There
is no study on the feedback effect of shadow economy on institutional quality.
However, this theoretical and empirical gap needs to be filled for 2 reasons: i) if the
feedback effect of shadow economy on institutional quality is found, Legalism theory
may be modified in the view that institutional quality is not only the cause but also the
consequence of shadow economy; and ii) studies on this relationship should take the
endogeneity problems into consideration. To fill this gap, I argue that shadow economy
reduces the tax revenue and falling tax revenue diminishes government income which
leads to less capacity to provide public goods with high quality.

10
The third strand examines the linkage of FDI and shadow economy. To the best of
my review, this strand is represented by three studies by Nikopour et al. (2009),
Davidescu & Strat (2015) and Ali & Bohara (2017). The result from Nikopour et al
(2009) indicates that higher FDI reduces shadow economy. However, Nikopour et al.
(2009) do not explain through which channels that FDI can negatively affect shadow
economy. Similarly, Davidescu & Strat (2015) find a negative unidirectional short-run
causality that runs only from FDI to the shadow economy in the case of Romania.
Meanwhile, Ali & Bohara (2017) confirm that higher shadow economy increases FDI
inflows since MNCs take advantages of tax evasion in host countries with higher size
of shadow economy. However, this bidirectional nexus needs to be further re-examined
for both theoretical and empirical aspects for 2 reasons. First, it is imperative to
research through which channels that FDI can affect shadow economy as well as
shadow economy can affect FDI. Second, policy makers in Asia will be provided by
empirical results to deal with FDI and shadow economy simultaneously whereas FDI
inflows contribute to economic growth (Borensztein et al., 1998; Nair-Reichert &
Weinhold, 2001; and Hansen & Rand, 2006), but shadow economy is regarded as one
of the major threats of development (Friedman et al., 2000; Ihrig & Moe, 2004; Alm &
Embaye, 2013; and Porta & Shleifer, 2014). Taking institutional quality into the
bidirectional relationship between FDI and shadow economy is the contribution to the
third strand by combining the three theories including international trade,
institutionalization and Legalism. It is argued that FDI can reduce shadow economy
through the channel of institutional quality improvements resulted from FDI inflows;
and higher shadow associated with lower institutional quality which may discourage
FDI inflows. Besides, FDI inflows may have potential impacts on shadow economy by
other channels such as creating jobs and increasing the official economic growth.

11
As argued above, though FDI, institutional quality and shadow economy are inter-
correlated and even inter-dependently, their mutual relationships remain the gap in the
literature. This gap is imperative to be filled in because of two reasons. First, studying
on this mutual relationship formulates the mechanism in which these variables interact
to foster economic growth, by using an integrative approach of combining three
relevant theories. Second, FDI, institutional quality and shadow economy attract great
attention from policies makers because all of them are closely associated with
economic growth and development. The demonstrated results of their mutual
relationships indicate that policies to tackle any one of them can affect the other two at
the same time, and governments need empirical evidences to consolidate their policy-
making on dealing with these aggregate variables simultaneously.
Shadow economy and income inequality
The shadow economy attracts researchers on studying not only its causes but also
its effects. The shadow economy has an impact on many variables such as the labour
market (Voinea and Liviu-Albu, 2011; Castells & Portes, 1989; Portes & Benton,
1984); the productivity (Friedman et al., 2000; Ihrig & Moe, 2004; La Porta & Shleifer,
2014); economic growth (De Soto, 1989; Johnson et al., 1997; and Loayza, 1997); and
poverty (Kim, 2005; Nikopour & Habibullah, 2010; and De Martiis, 2014). However,
attempts to investigate the impact of shadow economy on income inequality are still
scarce. Rosser et al. (2000, 2003), by macroeconomic approach of using empirical data
for 16 transition economies between 1987 to 1989 and 1993 to 1994, conclude with
caution that there is a positive relationship between the degree of income inequality
and the size of the informal economy. An increase in inequality causes more informal
activities due to the decline in social solidarity and trust, and expanding informal
activities lead to more inequality because of falling tax revenues and weakened
redistributive policies.

12
However, I propose new arguments in this thesis that shadow economy has a
negative impact on income inequality by combining three schools of thought on
shadow economy, including Dualism, Legalism and Voluntarism, with two theoretical
points as follows. First, Dualists with the residue theory depict the shadow economy as
a set of survival activities performed in a marginal society, generating income for the
poor (Hart, 1973; Sethuraman, 1976; and Tokman, 1978). Although the classical theory
of distribution concludes that income inequality increases in the process of economic
growth because the expanding industrial sector absorbs the labor force surplus from the
agriculture without increasing wages; classical economists did not forecast that
marginal people who cannot be absorbed in the industrial sector may work
underground, and increase their income by this way. Thus by taking point into account,
the shadow economy is expected to increase the income share of the poor. Second,
Legalists and Voluntarists with the alternative theory of shadow economy contend that
the rising shadow economy creates unfair competition for businesses and employees
between the formal and informal sectors (Chen, 2012). Nevertheless, this unfair
competition between the two sectors eventually turns out to be a channel to help reduce
income inequality because to dual approach, shadow economy attracts most of the poor
and small businesses, but not the rich and big businesses. Therefore, the unfair
competition from shadow economy may reduce the income share of the rich as the poor
get more benefit from working underground. As a result, the shadow economy may
lessen the income inequality. This new argument needs to be empirically confirmed in
the context of Asia for two reasons. First, if this negative affect is demonstrated, the
research will extend theories in the context of Asian developing countries on the
positive effects of shadow economy in the literature. Second, the result may provide
policy-makers with empirical evidences that policies to deal with the shadow economy
should take the poor into close consideration with other simultaneous solutions for
poverty eradication and income inequality reduction.

13
In summary, for the above practical background, theoretical background and
research gaps, the thesis is carried out to examine the inter-relationship among FDI,
institutional quality and shadow economy, as well as to investigate the impact of
shadow economy on income inequality in Asian countries. The research objectives will
be presented in details as below.
1.2 Research objectives
The thesis has two main objectives: (1) to examine the causal relationship
among FDI, institutional quality and shadow economy in Asian countries; (2) to
investigate the impact of shadow economy on income inequality and the channel of the
impact in Asia.
1.3 Research questions
To solve the two main objectives as mentioned above, the thesis aims at answering
5 questions as below.
First, what is the bidirectional nexus between FDI inflows and institutional
quality?
Second, what is the bidirectional linkage between institutional quality and
shadow economy?
Third, what is the bidirectional relationship between shadow economy and
FDI?
Fourth, how does the interaction of institutional quality and FDI affect
shadow economy?
Fifth, how does shadow economy affect income inequality and what are the
channels of the effect?

14
The above first four questions are designed to solve the first research objective.
The last question is to deal with the second research objective.
1.4 Research subjects and scope
The above research questions will be answered correctly and specifically when
the subject and scope of the study are limited in a specific way. In the thesis, research
subjects are: the bidirectional relationships among FDI, institutional quality, and the
shadow economy; and the impact of shadow economy on income inequality in Asia.
These concepts are legibly defined in the chapter 2 (section 2.1.1, 2.2.1, 2.3.1). The
research scope is limited in 19 Asian countries, including China, Mongolia, India,
Bangladesh, Bhutan, Maldives, Nepal, Pakistan, Sri Lanka, Cambodia, Indonesia,
Laos, Malaysia, Myanmar, Philippines, Thailand, Vietnam, Kazakhstan, and
Kyrgyzstan. Data for variables in the thesis are annually collected in the period 1999-
2015.
1.5 Research methodology and data
The quantitative methodology is employed to deal with both research objectives.
To examine the relationship among FDI, institutional quality and shadow economy in
Asian countries, the author uses the simultaneous equation panel data model (SEM)
including three equations for three independent variables: FDI, institutional quality and
shadow economy. The SEM model is estimated by both econometric methods: The
Three-stage Least Squares (3SLS) and the Two-step System Generalized Method of
Moments (System GMM). 3SLS is as an appropriate estimation method for the SEM
model when Ordinary Least Squares (OLS) estimator for SEM will be biased,
inconsistent, and inappropriate (Zellner and Theil, 1962). The Two-step System GMM
can perform with linear dynamic panel-data estimation to solve the problems of
endogeneity, heteroskedasticity and autocorrelation (Blundell and Bond, 1998).

15
Meanwhile, the linear equation model is applied for studying the impact of show
economy on income inequality, using two ways of estimations: Fixed Effects (FE) and
Random Effects (RE), which can remove the effects of country unobserved
characteristics. The Two-step System GMM is also employed to check the robustness
of the estimation and to control endogeneity caused by the feedback effect of income
inequality on shadow economy.
Data for all variables in the models are collected from: Medina & Schneider
(2018); World Development Indicators (WDI) from World Bank (WB), Worldwide
Governance Indicators (WGIs) from WB; The International Country Risk Guide
(ICRG) provided by the Political Risk Services (PRS) Group; UNESCO Institute for
Statistics; Global Wage Report 2017 provided by International Labor Organization
(ILO); Freedom in the World, Freedom House; Index of Economic Freedom, The
Heritage Foundation; Economic Freedom Report 2016, the Fraser Institute; Global
Competitiveness Index (GCI), World Economic Forum; KOF Globalization Index,
collected from KOF Swiss Economic Institute; International Monetary Fund (IMF);
Human Development Report, United Nations Conference on Trade and Development
(UNCTAD).
1.6 Contribution
The research will be expected to have certain significance for both academic and
practical contributions.
First, the research combines the three theories of investment, institutions and
shadow economy with an integrative approach to investigate the three-way linkages
between FDI, institutional quality and shadow economy in the context of Asian
countries, formulating the mechanism these variables interact to foster economic
growth. To the best of my knowledge, this is the first study that explores the three-way

16
linkages amongst these variables. In particular, the thesis fills the empirical gap of the
positive bidirectional relationship between FDI inflows and institutional quality in the
context of Asian countries by combining the Eclectic Paradigm (Dunning, 1980) and
the Institutionalization Theory (North, 1990), opposing the Pollution Haven Hypothesis
(He, 2006) on aggregate level. In addition, the negative bidirectional nexus between
institutional quality and shadow economy found from the thesis modifies the Legalism
theory of shadow economy: institutional quality is not only the cause (main arguments
of Legalists) but also the consequence of shadow economy (findings from the thesis);
and therefore studies on this relationship should take the endogeneity problems into
consideration. Furthermore, the negative bidirectional relationship between FDI and
shadow economy fills the theoretical and empirical gaps in Asia by taking institutional
quality into account: FDI inflows reduce shadow economy through the channel of
institutional quality improvements resulted from FDI inflows; higher shadow economy
is associated with lower institutional quality which discourages FDI inflows; and the
interaction of FDI and institutional quality also has a negative impact on shadow
economy, indicating that FDI inflows negatively affect the shadow economy and
institutional quality improvements intensify this effect.
Second, a simultaneous-equation modelling approach of both non-dynamic and
dynamic functions is employed to examine the three-way relationships between FDI,
institutional quality and shadow economy for the first time. In specific, the Three-stage
Least Squares (3SLS) and the Two Steps System Generalized Method of Moments
(SGMM) are applied to estimate the three-way causality effects: i) institutional quality
and shadow economy on FDI; ii) FDI and shadow economy on institutional quality;
and iii) FDI and institutional quality on shadow economy. Especially, with the dynamic
simultaneous-equation model, taking the impacts of the past values of three
independent variables on their current values into account, the author estimates the

17
short-run elasticities, instead of long-run elasticities in which panel cointegration and
panel unit root approach were used in the literature for some of the above separate
linkages such as FDI – institutional quality nexus or the impact of institutional quality
on shadow economy.
Third, the research examines the negative impact of shadow economy on income
inequality by increasing the income share held by lowest quintile and decreasing the
income share held by highest quintile. This result is opposite to previous studies
(Rosser et al., 2000, 2003), adding more arguments to the literature which supports the
view on advantages of shadow economy especially to the poor. The findings can be
explained by combining the three schools of thought on shadow economy: Dualism,
Legalism and Volutarism with two theoretical points: First, Dualists with the residue
theory depict the shadow economy as a set of survival activities performed in a
marginal society, generating income for the poor (Hart, 1973; Sethuraman, 1976; and
Tokman, 1978). Thus the shadow economy is expected to increase the income share of
the poor. Second, Legalists and Voluntarists with the alternative theory of shadow
economy contend that the rising shadow economy creates unfair competition for
businesses and employees between the formal and informal sectors (Chen, 2012).
Nevertheless, this unfair competition between the two sectors eventually turns out to be
a channel to help reduce income inequality because to dual approach, shadow economy
attracts most of the poor and small businesses, but not the rich and big businesses.
Therefore, the unfair competition from shadow economy may reduce the income share
of the rich as the poor get more benefit from working underground. As a result, the
shadow economy may lessen the income inequality.
Fourth, research results are expected to provide policy-makers with empirical
evidence for their social-economic decision-making in the region by two aspects: i)
policies to simultaneously promote FDI and institutional quality are solutions for

18
reducing the size of shadow economy and vice versa; ii) policies to deal with the
shadow economy should take the poor into close consideration with other simultaneous
solutions for poverty eradication and inequality reduction.
1.7 Limitations
The measurement of shadow economy seems to be sensitive to the estimation
method. Although the data set from Medina & Schneider (2018), released by IMF in
which the most popular MIMIC approach is used for shadow economy estimation, is
the newest one that I use in this thesis, it is more robust if various scenarios of how the
shadow economy estimated should be considered. Besides, the unavailability of data is
also the weakness of the thesis when all Asian countries cannot be investigated.
1.8 Thesis outline
The thesis is organized into six chapters. Following the introduction in chapter one,
the remainder of the thesis is structured as follows. Chapter two depicts the review of
theoretical and empirical literature. Chapter three justifies the methodologies, model
specifications, data and samples. In chapter four, the empirical results for the first
research objective are discussed. Chapter five shows the empirical results and
discussion for the second research objective. Finally, chapter six provides conclusions
and policy implications.

19
CHAPTER 2
LITERATURE REVIEW AND HYPOTHESES
Chapter Outline
2.1. Shadow economy
2.1.1. Theories on shadow economy
2.1.1.1. Definition
2.1.1.2. Schools of thought
2.1.2. Empirical studies on shadow economy
2.1.2.1. Methods to estimate the size of the shadow economy
2.1.2.2. Determinants (causes)
2.1.2.3. The impacts of shadow economy (effects)
2.2. Shadow economy, FDI, and institutional quality
2.2.1. FDI and institutional quality
2.2.1.1. Theories on FDI (Definition, Theories, Determinants)
2.2.1.2. Theories of institutional quality (Definition, Theories, Determinants)
2.2.1.3. The relationship between institutional quality and FDI
2.2.1.3.1. The impact of institutional quality on FDI
2.2.1.3.2. The impact of FDI on institutional quality
2.2.1.3.3. Bidirectional relationship between FDI and institutional quality
+ Hypothesis 1: Better institutional quality in the host countries helps attract FDI
inflows and FDI inflows improve institutional quality in the host countries.
2.2.2. Institutional quality and shadow economy
2.2.2.1. The effect of institutional quality on shadow economy
2.2.2.2. The effect of shadow economy on institutional quality
+ Hypothesis 2: There is a negative bidirectional linkage between institutional quality
and the shadow economy.
2.2.3. Shadow economy and FDI
2.2.3.1 The effects of FDI and FDI-institutional quality interaction on shadow
economy
2.2.3.2 The effects of shadow economy on FDI
+ Hypothesis 3: There is a negative bidirectional nexus between FDI inflows and
shadow economy.
+ Hypothesis 4: The interaction of institutional quality and FDI is negatively associated
with the shadow economy.

20
2.3. Shadow economy and income inequality
2.3.1. Income inequality
2.3.1.1. Definition
2.3.1.2. Theories
2.3.1.3. Measurements
2.3.1.4. Determinants
2.3.2. The impact of shadow economy on income inequality
+Hypothesis 5: Shadow economy negatively affects income inequality through the
channels of increasing the income share held by lowest quintile, and decreasing the
income share held by highest quintile.
2.1. Shadow economy
2.1.1. Theories on shadow economy
2.1.1.1. Definition
The “shadow economy” labeled by Frey, Weck, & Pommerehne (1982) and
Schneider & Dominik (2000) is an associated part of the official economy. It is also
known as the irregular economy (Ferman, 1973; Feige, 1979), the parallel economy
(Contini, 1981), the black economy (Dilnot & Morris, 1981), the underground
economy (Simon & Witte, 1982; Feige, 1989), the informal economy (Smith, 1985),
and the unofficial economy (Johnson, Kaufmann, & Zoido-Lobaton, 1998). There is
not an adequate and coherent definition on the shadow economy in the literature. Smith
(1985) defines the shadow economy as “market based production of goods and
services, whether legal or illegal, that escapes detection in the official estimates of
gross domestic products (GDP)”. In other words, the shadow economy includes those
economic activities and incomes derived from them to avoid government regulations,
taxation or observation (Feige, 1989; Dell’Anno & Schneider, 2003). Dell'Anno (2007)
regards the shadow economy as “non-observed economy” (NOE) which comprises all
product activities that can be categorized into three areas: Underground production,

21
informal production and illegal production. Based on a taxonomy of underground
economic activities, a broad definition of the shadow economy includes unreported
income from all market-based production of goods and services, either under monetary
or barter transactions that would generally be taxable if they were reported to the tax
authorities (Mirus and Smith, 1997). To Alm & Embaye (2013), the shadow economy
consists of “all market-based goods and services that escape inclusion in official
accounts”.
In spite of adopting inconsistent definitions of shadow economy, researchers have
generally concurred on a typical aspect of the shadow economy: the sector covering
economic activities that are not recorded in the national accounts. However, this typical
aspect of the shadow economy does not specify on the incentive goals of hidden
economic activities. Schneider (2007, 2010, 2016) in a narrower way, defines the
shadow economy includes all production activities of goods and services based on
market but they are deliberately hidden from public authorities for avoiding of income
payment, tax payment, payment for social security contributions; for avoiding of
"having to meet legal labor market standards", such as maximum working hours,
minimum wages, safety standards...; for avoiding of "complying with certain
administrative procedures" such as completing administrative forms or statistical
questionnaires. Medina and Schneider (2018) estimate the size of shadow economy of
158 countries all over the world by using this definition. This definition of the shadow
economy will be also used in this research due to its comprehensive and specific
meaning.
2.1.1.2. Schools of thought
The theories on shadow economy can be viewed from different approaches such
as dual economy sectors, labor market sectors, by-product theory, alternative theory,

22
complementary theory, the context of working, and individuals’ rational choice under
uncertainty, being categorized into five dominant schools of thought.
2.1.1.2.1. The Dualist school with the residue theory (Dual-sector model, Harris-
Todaro model, and Dual labor market theory)
The appearance of shadow economy is initially described by Boeke (1953),
Lewis (1954) and Harris and Todaro (1970) in their models by the concepts of a dual
economy and social marginality.
Boeke (1953) and Lewis (1954), in their Dual-sector model that gives the
grounded base for shadow theories, divide the economy into two sectors: the capitalist
and the subsistence. The capitalist sector includes those who use capital and labor,
standing for industrial (modern, urban) sector with high productivity. The subsistence
sector stands for labor supply from the agricultural (traditional, rural) sector with low
productivity. The expansion of capitalist sector draws labor from the subsistence
sector, but this rural-urban migration does not affect the output of agricultural sector
since marginal product of labor is assumed to be zero with fixed land and unlimited
labor supply. Therefore, the transfer of labor from the agricultural sector to industrial
sector continues until the industrial marginal product of labor equalizes the agricultural
marginal product of labor in equilibrium. Harris and Todaro (1970) in their named
model argue that in this equilibrium there will be positive unemployment in the urban
sector because the rural-urban transition is greater than the capacity of urban sector
which may invest in capital-intensive production methods rather than labor-intensive
ones. As a result, those people who are not absorbed in formal sector will participate in
the informal economy. The informal economy is “just as a residue” (Williams, 2008).
Similarly, the Dual labor market theory proposed by Doeringer and Piore
(1971) gives initial background implications for the presence of shadow economy. To

23
this theory, the labor market can be classified into primary and secondary sectors. The
primary sector includes the privileged jobs with high salaries, status, responsibilities,
good working conditions and job security. On the other hand, the secondary sector
comprises jobs characterized by negative quality like lower wages, poor working
conditions, lacking of respect and job security, and less promotion prospects. Cross &
Johnson (2000) expand the Dual labor market theory by splitting labor market into
more other 2 sectors: informal and illegal. The informal sector includes people who are
unable to access the primary and secondary sectors. Jobs in the informal markets are
those of self-employment, unregulated arrangement and off-the-book working.
Meanwhile, all criminal activities are grouped in the illegal sector. The primary and
secondary sectors follow labor regulations and tax duties but the informal and illegal
sectors do not. The labor market categories are displayed in the table 2.1.
Table 2.1. Labor market classification
Primary Sector Secondary Sector Informal Sector Illegal Sector
•High wage •Low wage •Self-employment •Criminal
•High security •Low security •Casual labor •Unregulated
•Well regulated •Poorly regulated •Unregulated
(Source: Cross & Johnson, 2000: 102)
Followers for this doctrine with Dual-sector model, Harris-Todaro model, and
Dual labor market theory are called dualists who view the shadow economy as
encompassed by autonomous activities that have few linkages with the formal sector
and generate income for the poor (ILO, 1972; Hart, 1973; Sethuraman, 1976; and
Tokman, 1978). To this school of thought, two reasons for rising shadow economy are
the imbalanced rates between population growth and industrial employment, and the
mismatch between people’s skills and industrial requirements. By this view, the
shadow economy is distinguished by some characteristics such as ease of entry, family
enterprises, small-scale of operations, unregulated and competitive markets… Dualists

24
view shadow economy as a marginal society in underdevelopment and it will disappear
as a result of development advancement. Although paying less attention to the relation
between informal enterprises and government regulations as well as formal sector,
scholars suggest that governments should create more formal jobs and provide
financial and business development services to informal firms.
However, the residue theory (dualistic approach) is criticized by three reasons.
First, the concept of a dual economy is later criticized for its descriptive rather than
explanatory feature (Harding and Jenkins, 1989). Second, the informal sector does not
disappear as expected in advanced economy (Willman-Navarro, 2008). The shadow
economy still expands with modern and industrial growth at present. Third, it is
impossible for a “disconnection” between the two sectors (Potts, 2008). Other schools
of thought find that the shadow economy is linked to the formal economy through
production, trading, and distribution (Chen, Vanek & Carr, 2004).
Chen, Vanek & Carr (2004) debated that the residue theory should be rethought.
Out of the above criticism on the residue theory, they summarize the discrepancies
between the new and old concepts of informal economy. First, the shadow economy is
not only a social marginality, but also an important provider of jobs, goods and
services for lower-income groups. Second, the shadow economy includes not only
street traders and very small-scale producers, but also a wide range of informal jobs—
both ‘old forms’ such as casual day labor in agriculture and construction, as well as
‘new forms’ such as temporary and part-time jobs plus homework for high tech
industries. Third, underground employment includes not only self-employment but also
salary employment, and informal firms include not only survival activities but also
stable businesses and dynamic growing enterprises. Finally, instead of not being the
subject for economic policies, informal activities are virtually affected by economic
policies.

25
2.1.1.2.2. The Structuralist school with By-product theory
Similar to Dualists, Structuralists with by-product theory view the informal
economy as a marginal sector, but in contrast to the former, describe the informal
sector as an integral part of the formal sector – a necessary by-product of the formal
economy. The shadow economy composes of subordinated economic units and
workers to reduce costs of input and labor of large capitalist companies, and thereby
increase their competitiveness (Castells and Portes, 1989; Moser 1978). The presence
of shadow economy by this thought is due to the structural nature of capitalism, the
process of industrialization and globalization (sub-contracting chains, off-shore
industries, flexible specialization). The marginalized population accepts the
exploitative work for a part of their “survival strategy”.
Another reason that structuralists explain for the appearance of shadow
economy is formal labour market imperfections such as minimum wage laws or
collective bargaining agreements. These regulatory distortions keep labor costs high
and structural unemployment happens as a result. Those who cannot find formal jobs
will work in the shadow economy (Fields, 1975). However, Stiglitz (1974) and
Mazumdar (1976) argue that the labour turnover and efficiency wages can lead to a
similar formal/informal dualism. Structuralists admit the intrinsic link between the
shadow and official economies and therefore recommend that governments should
regulate both commerce and employment relationships to reduce inequality between
“big businesses” and subordinated producers and workers.
Both of dualists and structuralists have a feature in common for depicting the
shadow economy: the engagement in the shadow economy is a necessity rather than a
choice. However, the concept of a dual economy (dualists) and social marginality

26
(structruralists) are opposed by legalists and voluntarists who approach the shadow
economy under the alternative theory and the theory of individuals’ rational choice.
They do not view the informal economy as a set of survival activities performed in a
marginal society. They find a dependency of unofficial economy on official one
although it can be either alternative or complementary.
2.1.1.2.3. The Legalist school with alternative theory
The Legalist school sees the shadow economy as comprised of businessmen
who choose to operate informally to avoid costs, time and effort of formal registration
(Demsetz, 1974; De Soto, 1989, 2000; Schneider and Dominik, 2000). This school of
thought considers low institutional quality (such as bad governance, weak legal system,
heavy burden of regulations, high corruption, ineffective rules of law…) as the key
causes of working in the shadow economy. The shadow economy is considered as a
positive alternative to the formal economy. It is “a site of resistance to the formal
economy that is growing” (Williams, 2012). By this approach, the participation in the
shadow economy is a choice, rather than a necessity, with three perspectives including
the neo-liberal perspective, green perspective, and post-capitalist theory.
In the neo-liberal perspective, informal activities are attributed to hostile legal
system with cumbersome government rules and procedures. Responding to the lack of
free market space, people choose to take part in informal activities by bypassing
inappropriate legal regulations with easier informal norms, rules and laws. Neoliberal
theorists suggest that governments should simplify bureaucratic procedures to reduce
costs of becoming formality (registration, license) and remaining formality (taxes,
compliance with regulations and laws) for decreasing the size of shadow economy.
Both green perspective and post-capitalist theory claim that people choose to
join in informal activities because they are dissatisfied with the negative sides of

27
modern and capitalist free market, such as polarization and pollution. People seek for
an alternative economy which is more local, sustainable, environmental and
community-based.
2.1.1.2.4. The Voluntarist school with the theory of individuals’ rational choice
Another approach to the shadow economy is based on the theory of individuals’
rational choice under uncertainty. Individuals respond rationally. They make choices to
maximize the utility. Their decision to work underground is similar. An individual
faces trade-off between gains if their informal activities are not exposed and losses if
disclosed and punished. If the expected benefits from working underground exceed the
formal costs and potential fines, individuals voluntarily participate in the shadow
economy. Schneider and Buehn (2016) theorize the shadow economy by individuals’
rational choice approach in details with a structural equation. To this framework,
informal activities are negatively associated with the probability of detection and
potential fines (which determined by enforcement actions by the tax authority and
facilitating activities accomplished by individuals to avoid detection); and positively
associated with the opportunity cost of being formal (that determined by tax burden
and high labor costs). Followers of this approach are early named Voluntarists.
The Voluntarist school looks at the shadow economy as comprised of
entrepreneurs who decide to operate in the informal economy to avoid taxes and social
security contributions (Tanzi, 1982, 1999; Schneider, 1994, 1997; Gile, 1999; and
Maloney 2004). These businesses are not willing to pay taxes. By operating
underground, they try to keep all economic profits for themselves. Being different from
Legalists, Voluntarists argue that entrepreneurs do not complain governments for
inconvenient rules and procedures, they voluntarily choose operating informally after
weighting costs of formality (payroll taxes and social protection contributions) and
benefits of informality (earning income while avoiding costs of formality). To

28
Voluntarists, governments should expose informal businesses to formal environment to
increase the tax and competitiveness.
2.1.1.2.5. The school of complementary theory and shadow economy
Different from legalists and voluntarists, who view the shadow economy as an
alternative for the official economy, scholars argue that shadow economy and official
economy are complementary in that they grow or decline in tandem. This view is
advocated by Adam and Ginsburgh (1985), Jensen et al. (1995), and Williams &
Round (2008). They find that those who are better-off have more chances to earn
informal income while lowest-income households are the least likely to report informal
activities. Greenfield (1993) sees the development of the informal and formal sectors in
a parallel way, with the notion that the direct and indirect demand for goods and
services produced in the informal sector will increase its size as the formal economy
expands. The positive relationship between formal and informal economies is due to
the advantages from the informal economy such as social cohesion through mutual aid
and reciprocity, social networks of material support, provision of goods and services to
those in need…
Besides, another approach to the shadow economy is one based on the context
of work (International Labour Organization, 2002; and Losby et al., 2002). A person
who is self-employed or works for someone else can be categorized into contexts of
work as depicted in the table 2.2.

29
Table 2.2. Structure of informal work typology
Arrangements Context of work
A person who works Primary work for company Extra work for employer
for someone else
•Off-the-books working •Works extra hours in
•Under-the-table working evenings or on weekends
•Cash payment and non-taxes (cash payment and none-
taxes)
A person who is self- Operating his/her own small Doing occasional odd
employed business products, services, or jobs
•Exchanges by cash only •Seasonal jobs
•Continuing, regular •Helps reduce household
•Primary income is from expenses by offering low-cost
business products or bartering for
•May use income to invest into services
business •Not being considered as a
formal “small business”
(Source: Adapted from International Labour Organization, 2002: 12-13; and Losby et
al., 2002: 4).
In summary, the five dominant schools of thoughts on shadow economy have
their own pros and cons. Dualists view the shadow economy as a residue or a social
marginality that appears when laborers migrating from rural area to urban area cannot
fully be absorbed in the industrial sector. Two reasons for rising shadow economy are
the imbalanced rates between population growth and industrial employment, and the
mismatch between people’s skills and industrial requirements. By this approach, the
shadow economy is a survival for the poor and marginal population in the process of
industrialization and modernization. However, the Dualist school denies the linkage
between the shadow economy and the official one. This drawback from Dualists is
overcome by Structuralists who describe the informal sector as an integral part of the
formal sector. To the Structuralist school, the presence of shadow economy is a result

30
of the structural nature of capitalism, industrialization, and globalization as well as the
labour market imperfections. The shadow economy composes of subordinated
economic units and workers to reduce costs of input and labor of large capitalist
companies, and thereby increase their competitiveness. By this approach, Structuralists
explain the participation in the shadow economy including not only street traders and
very small-scale producers, but also wide range of informal occupations and large
enterprises. Nevertheless, both Dualists and Structuralists admit that the engagement in
the shadow economy is a necessity rather than a choice, which then is opposed by
Legalists and Voluntarists. The Legalist school sees the informal activities as a
resistance to the formal economy with low institutional quality, and as a response to
modern and capitalist free market. By this view, shadow economy is an alternative to
the official economy. Although with the same approach of individual choices,
Voluntarists argue that entrepreneurs do not complain governments for heavy
regulations, they voluntarily choose operating informally after weighting costs of
formality and benefits of informality. Different from Legalists and Voluntarists, who
view the shadow economy as a substitute for the official economy, scholars of
complementary theory argue that shadow economy and official economy are
complementary in that they grow or decline in tandem. The positive relationship
between formal and informal economies is attributed to: i) the advantages from the
informal economy such as social cohesion, social network, and spending of informal
income in the formal economy; ii) the increase in demand for goods and services
produced in the informal sector coming from expansion of official economy. Many
empirical studies have been done for the past decades, basing on the above various
schools of thought on shadow economy.

31
2.1.2. Empirical studies on shadow economy
Previous studies on shadow economy concentrate on three main problems:
methods to measure the size of shadow economy, determinants of shadow economy,
and its impacts on other variables.
2.1.2.1. Methods to estimate the size of the shadow economy
The hidden nature of the shadow economy makes it difficult to measure. There are
three major approaches widely used to assess the size and development of the shadow
economy, including direct methods, indirect methods and lastly the model methods.
First, direct approaches include methods that are based on microeconomic theories
to employ well-designed surveys, tax auditing or other similar compliance methods.
This approach was used for estimating the shadow economy in Norway by Isachsen et
al. (1985), in Denmark by Mogensen et al. (1995), in Germany by Haigner et al.
(2013)… By this approach, the information about shadow economy activities and the
structure of labor in the shadow economy can be gained in details. However, the results
from this approach depend on how the questionnaires are formulated and how
respondents are willing to cooperate in interviews. Most of them often hesitate to
confess their hidden jobs. Moreover from this approach, the size of shadow economy
may be estimated in the short-run point, but not in the longer period of time. For the
above disadvantages, the results of the shadow economy from direct methods are
clearly lower-bound in comparison with other approaches.
Second, indirect approaches, so called “indicator” approaches, include methods
that are based on macroeconomic indicators containing information about the
development of the shadow economy over time. There are five indirect indicators
proposed for the estimation of shadow economy, including the discrepancy between
national income and expenditure statistics, the discrepancy between the official and

32
actual labor force, the transaction, the physical input or electricity consumption, and
the currency demand. The advantages and disadvantages of the above indicators are
legibly discussed by Schneider and Buehn (2017).
i) The discrepancy between national income and expenditure statistics is an
indicator to measure the shadow economy size because total income must be
equal to total expenditure in measuring Gross national product (GNP). This
indicator is used by Smith (1985) and Thomas (1999). It is a good method if
all the components on the expenditure side are computed without errors.
However, mistakes are unavoidable in the process of national account
statistics, and most national statisticians tend to minimize this discrepancy
before publication. Thus, this method may face of questionable reliability.
ii) The discrepancy between the official and actual labor force can be used to
measure the shadow economy size (Contini, 1981). If the total labor force
participation is constant, a decline in official labor participation rate can be
seen as an indicator of underground activities. Nevertheless, this method has
its own disadvantages. For example, differences in the rate of participation
may be caused by other reasons and people can supplement their income by
moonlighting (have the official job and also work underground).
iii) The transaction method was elaborated by (Feige, 1979, 1989). Basing on
Fisher quantity equation: M*V = P*T (with M money, V velocity, P prices,
and T total transactions), Feige (1979) assumed that total value of
transactions P*T equals total nominal GNP (official + unofficial). Then the
unofficial GNP can be calculated by subtracting official GNP from total
nominal GNP. However, the main weakness of this method is the
assumption of a constant relationship between the transactions and official
GNP over time. Moreover, it is not convincing for the assumption that the

33
underground economy is the only factor influencing on the money quantity
in transactions.
iv) The physical input or electricity consumption method was developed by
Kaufmann and Kaliberda (1996) and Lackó (2000). Kaufmann and Kaliberda
(1996) showed that electricity-to-GDP elasticity is approximately close to
one, indicating the positive one-one relationship between electricity
consumption growth and GDP growth. Therefore, the difference between
official GDP growth and electricity consumption growth is the increasing
shadow economy. Simplicity and appealingness are the strength of this
method, but the weakness is also inevitable. For example, not all activities in
the shadow economy use electricity but other resources such as oil, gas,
coal… Thus, only a part of the shadow economy can be estimated by this
method. In addition, technical progress leads to use electricity more
efficiently, minimizing the difference between official GDP growth and
electricity consumption growth.
v) The currency demand method was first proposed by Cagan (1958) in his
work to find out key factors of money demand (tax rate, per-capita income,
and the interest rate). Then Tanzi (1983) extended Cagan’s work to estimate
the currency demand and used the result to measure the size of the shadow
economy in the United States during 1930–1980. This method is also
employed by Alm & Embaye (2013) to measure the shadow economy size
for 111 countries over the period of 1984–2006. Measuring the shadow
economy basing on the currency demand approach stems from the idea that
transactions in the shadow economy are paid in cash to avoid governments’
control, and the growth of the shadow economy leads to the increase in
currency demand. Therefore, the difference of currency demand between
low tax rate and higher tax rate reflect the size of shadow economy. By this

34
way, the shadow economy size can be estimated for a long period. However,
this method faces several criticisms (Alm & Embaye, 2013). First, the
method may not capture all shadow economy activities with the assumption
from the approach that all transactions in the shadow economy are paid in
cash. Second, most studies consider high taxes as the only one cause of the
shadow economy while many causes of shadow economy (such as labor
market regulations, the complexity of tax system, tax morality, and welfare
benefits ) are not examined due to unavailable data for all countries. Third,
the velocity of money in official and that in shadow economies are different
in reality (because they depend on the income elasticity of cash demand) but
they are assumed the same in most studies by the currency demand approach.
Third, the model approach comprehensively considers multiple determinants (causes)
and multiple effects (indicators), instead of focusing on a particular side of the
phenomenon as the previous approaches do. One of the most popular models used to
estimate the shadow economy is the MIMIC approach (Multiple Indicators Multiple
Causes). By this way, the shadow economy (unobserved or latent variable) can be
measured through a set of observed variables (causes and indicators of the shadow
economy). The MIMIC approach consists of two simultaneous parts. The first one, known
as a measurement model, links the unobserved variable (the shadow economy) to observed
indicators. The second one, called the structural equation model, specifies causal
relationship between shadow economy and observed causes. The MIMIC approach is
employed to estimate the size of shadow economy by many scholars such as Giles and
Tedds (2002); Schneider and Bajada (2003); Bajada and Schneider (2005), Buehn and
Schneider (2012); Vo and Pham (2014), Hassan and Schneider (2016), Schneider and
Buehn (2017); and Medina & Schneider (2018)… Many causes of the

35
shadow economy distinguished in these studies include tax and social contribution
burdens, regulatory burden, unemployment rate, self-employment rate, institutional
quality, and tax morality. The size of the shadow economy is reflected in various
indicators such as the official economic growth, currency/cash outside banks, and labor
force participation rate.
It is commonly accepted by most scholars that there is no best method in
comparison with the MIMIC approach for its several dominant advantages (Schneider
and Buehn, 2017). First, the MIMIC approach offers a wider approach since it takes
many causes and indicators of the shadow economy into account. Second, this
methodology allows wide flexibility in its application when the choice of causal and
indicator variables can be changed to fit with particular features of the shadow
economic activity studied. Third, formal estimation and testing procedures can be
achieved by this model approach. Thus, this research will use the data of shadow
economy size estimated by Medina & Schneider (2018) by the MIMIC approach in
which many causes (including government size, regulatory burden, unemployment,
GDP per capita, trade openness) and effects (consisting of currency demand, labor
force participation rate, and GDP per capita growth) were taken into consideration. The
estimation procedure is described above.
2.1.2.2. Determinants of the shadow economy
Burdens of taxes and social security contributions
To Voluntarist school of thought, the rising burdens of taxes and social security
contributions are considered one of the most essential causes for the increase of
shadow economy. The higher the taxes, the smaller the after-tax earnings, and the
stronger the incentive to work in the shadow economy to reduce the tax wedge. This
positive relationship is concluded by Feige (1989), De Soto (1989), Tanzi (1982,

36
1999), Gile (1999), Schneider & Bajada (2003), Schneider (2007, 2010), and Hassan &
Schneider (2016). However, some countries with high institutional quality can
experience a large tax base but not large shadow economy because taxpayers are
willing to pay the taxes when get better goods and services from the state (Johnson,
Kaufmann, & Zoido-Lobaton, 1998; Friedman et. al., 2000). The ‘tax morality’
(citizens’ attitudes toward the state as a moral obligation to pay taxes) is negatively
associated with the size of shadow economy (Alm & Torgler, 2006; Feld & Frey, 2007;
Torgler & Schneider, 2009; and Schneider, 2010).
Intensity of Regulations
Legalists debate that burdens of regulations and procedures induce the rise of
shadow economy. For example, over-regulations on labor market (minimum wages,
limited official working hours) or trade barriers (import quotas) increase labor costs
and structural unemployment, and reduce individuals’ choice in the official economy.
This leads to higher motivation to work underground. The conclusion that heavily
regulated burden causes larger shadow economy is found from various studies
including those by Loayza (1996), Friedman et al. (2000), and Schneider et al. (2010).
Corruption
The nexus between corruption and shadow economy is theoretically ambiguous.
On one hand, many researchers such as Johnson et al. (1997), Hindriks et al. (1999),
Hibbs and Piculescu (2005), and Dreher & Schneider (2010) have a common
conclusion from their empirical studies that corruption and the shadow economy are
complements. To these scholars, corruption increases the size of shadow economy
because: i) corruption is viewed as a particular form of regulations and taxation which
are drivers of shadow economy (Johnson et al., 1997), ii) inspectors collude with
taxpayers for getting bribes in exchange of underreporting the tax liability of the

37
taxpayers (Hindriks et al., 1999), and iii) businesses bribe dishonest bureaucrats for
ignoring their unofficial production activies (Hibbs and Piculescu, 2005). On the other
hand, the view that corruption and the shadow economy are substitutes is supported by
Choi and Thum (2005) and Dreher et al. (2008). These authors argue that the option to
go underground of businesses will reduce corrupt officials’ ability to ask for a bribe.
Unemployment, self-employment and retirement
It is supposed in most schools of thought on informal economy that unemployment
rate has a positive impact on the shadow economy because high unemployment rate
gives individuals more incentive to work unofficially to earning a living. This
significant positive relationship is confirmed by Boeri & Garibaldi (2002), and
Dell'Anno & Solomon (2008). However, Tanzi (1999) implicates that the impact of
unemployment on the shadow economy is ambiguous since informal labor force can
heterogeneously include not only the officially unemployed, but also the retired and
those who work both officially and unofficially. The negative impact of unemployment
on the shadow economy is supported by Giles and Tedds (2002) with the justification
that the unemployment is negatively related to the growth of the official economy
(Okun’s law) and the shadow economy tends to increase with the growth of the official
economy. To Okun’s law, 1% increase in the unemployment rate will lead to 2%
decrease in a country's GDP. The fall in GDP reduces the shadow economy as
explained by the complementary theory. Besides, the shadow economy growth is
attributed to the increase of self-employment and retirement (Dell’Anno, Gomez-
Antonio, & Pardo, 2007; Williams, Horodnic, & Windebank, 2016).
Institutional quality/ public sector services
The quality of public institutions is another important driver of shadow economy
under the view of Legalists. Higher quality of public institutions such as good rule of

38
law, regulatory quality, government effectiveness securing contract enforceability and
property rights reduces transaction costs and increases benefits of remaining formal.
Conversely, a bureaucracy with lower institutional quality, such as high level of
corruption and regulatory burden, acts as barriers for businesses and individuals to be
official and pushes them participate in the unofficial economy. The negative impact of
institutional quality on shadow economy is empirically confirmed by Johnson et al.
(1998); Friedman, Johnson, Kaufmann, & Zoido-Labton (2000); Fugazza & Jacques
(2003); Torgler & Schneider (2009); Dreher, Kotsogiannis & McCorriston (2009);
Dreher & Schneider (2010); Singh et al. (2012); Razmi et al. (2013); and Hassan &
Schneider (2016).
Development of the official economy
The effect of official economy on informal sector is ambiguous (Schneider &
Bajada, 2003; Schneider & Dominik, 2013; and Vo & Pham, 2014). To dual approach,
the economic growth negatively affects shadow economy because dualists view the
shadow economy as a residual or a by-product of the official economy and economic
growth is the cure for the shadow economy (La Porta and Shleifer, 2008, 2014;
Williams, 2008). Nevertheless, Elgin & Oztunali (2014) explore that higher GDP per
capita is correlated with the larger informal sector in countries with low institutional
quality. This explanation is a combination of both schools of Legalists and
complementary theory.
The trade openness and the globalization
The trade theory implies that trade liberalization causes an increase in the shadow
economy because it is more difficult to control economic activities happening in the
economy with higher level of trade openness. This postulation follows the view of
Structuralists. It is empirically proved by Johnson, Kaufmann & Zoido-Lobaton

39
(1998). Fugazza and Fiess (2010) find a similar result with macro-level data but it is
not supported by micro-founded data. Moreover, Goldberg and Pavcnick (2003) find
no evidence for the correlation between trade openness and shadow economy in cases
of Brazil and Colombia.
The impact of globalization on the shadow economy is also ambiguous. To
Structuralists, the globalization may increase the shadow economy in developing
countries because of consequence of globalization, including rising costs, more
challenges and higher competitiveness which may shift local small- and medium- sized
companies operate underground (Goldberg and Pavcnik, 2003; Bacchetta et al., 2009).
Nevertheless, this thought is opposed by the argument that the globalization reduces
the shadow economy size due to benefits generated from the globalization such as
productivity improvement (Melitz, 2003), more income, new job opportunities, labor
market deregulation (Potrafke, 2014).
Urbanization
To dualist school, urbanization is positive related to the shadow economy as the
shadow economy appears in the process of industrialization and urbanization when
migrants move from rural sector to urban sector (Safa, 1986). However, Elgin & Oyvat
(2013) assert that there is an inverted-U relationship between the level of urbanization
and the share of shadow economy. To their interpretation, the share of the shadow
economy rises in the early phase of urbanization due to several pull and push factors;
but it tends to fall in the latter phase when the impact of these pull and push factors are
reduced as a natural result of rural dwellers getting wealthier.
In short, the drivers of shadow economy comprise of burdens of taxes and social
security contributions, intensity of regulations, unemployment, self-employment,
retirement, institutional quality, public sector services, the official economy

40
development, trade openness, globalization and urbanization. However, the effects of
these factors on shadow economy can be different from various schools of thought. A
similar tendency is also observed in the studies on the impacts of shadow economy on
social-economic indicators.
2.1.2.3. The impacts of the shadow economy
The shadow economy has both negative and positive effects on social-economic
indicators, examined by macroeconomic approaches (cross countries) and
microeconomic approaches (firms and laborers).
Distortions of national accounts, allocation of resources, and tax revenue
The rising shadow economies suggest that national accounts data is on average
significantly underestimated (Schneider & Bajada, 2003). The informal activities
actually operate, but it is not recorded in official economic indicators of the formal
economy such as national income, growth rate, unemployment, inflation…
The presence of shadow economy also distorts the allocation of resources, alters
income distribution and reduces governments’ tax revenue (Alm & Embaye, 2013).
Moreover, Loayza (1997) found the evidence that in time of rise of the underground
economy the availability of public services for everyone in the economy decreased, and
as result economic growth weakens. This explanation is closely related to the notion
that the shadow economy decreases government income which leads to less capacity to
provide public goods with high quality, thus decreases quality of life. This postulation
is in accordance with schools of Legalists and Volutarists who view the shadow
economy as a substitute for the formal economy.

41
Unfair competition
A study by the McKinsey Global Institute (Farrell, 2004) shows that informal
companies can offset their low productivity and small scale by their lower overall cost
burden gained from avoiding taxes and regulations. These inefficient informal firms
still stay in business and prevent more productive, formal companies from gaining
market share. It is an evidence of unfair competition, a consequence of the shadow
economy that is commonly agreed by most schools of thought on informality.
Impact of the informal economy on the labour market
A survey conducted by Voinea and Liviu Albu (2011) indicates that 31.4% of
the total employed population is involved in informal employment in Romania. They
also reveal two important highlights: “youths aged 15–24 are twice as likely to be
involved in the informal sector as older people”; and “the risk of being entrapped in the
informal sector is 12 times higher for people with a low level of educational
attainment”.
The shadow economy reduces the costs of labor, contributing directly to the
profitability of capital (Castells & Portes, 1989). This advantage in turn leads to the
labor absorption in the shadow economy (Portes & Benton, 1984). However, the
shadow economy with it natures (such as unprotected workforce, small units of
production, multiple intermediaries between laborers and capital…) will undermine the
formal organized labor market, contributing to the de-collectivization of the labor
process (Castells & Portes, 1989).
To standard economic theory of dual labor markets, a rising formal minimum
wage increases structural unemployment and shifts surplus workers from the formal
sector to the informal one, increasing labor supply and lowering wages in the informal
sector. However, Boeri et al. (2011) find the reverse pattern: a minimum wage hike

42
leads to an increase in informal salaries in developing countries in Latin America. This
is due to not only that the level of “fair remuneration” has increased after a minimum
wage hike, but also that the skill composition of workers and sorting accounts arise.
The effects of shadow economy on the productivity
To Legalists and Voluntarists, the effect of shadow economy on the productivity
seems to be negative. As mentioned above, many authors make uniform of informal
activities with low productivity (Friedman et al., 2000; Ihrig & Moe, 2004; and La
Porta & Shleifer, 2014) by two reasons: less advanced production technologies are
used in underground activities and most of them are service activities connected to
consumer services. By definition, it is easier and less capital required by choosing
entering informal sector, in other words, informal sector is a collection of low
productivity activities. Thus, the shadow economy cannot help improve productivity.
Moreover, many factors of the productivity gap between formal and informal firms
have been studied, including the lack of access to markets, public services, and credit
by informal firms (Straub, 2005; Perry et al., 2007), small-scale informal firms (Perry
et al., 2007). Using a survey of 48,000+ small firms in Brazil, De Paula and
Scheinkman (2011) also find that informal firms pay no taxes, but face a higher cost of
capital, limited scale, lower capital–labor ratio and lower entrepreneurial ability in
comparison to formal firms.
The effects of shadow economy on economic growth
The effects of shadow economy on economic growth have been controversial
for a long time. On the one hand, many researchers from schools of legalists and
voluntarists (with the alternative theory of shadow economy) contend that the rising
shadow economy hinders economic growth as this sector causes a reduction in the
availability and efficiency of public services (De Soto, 1989; Loayza, 1997; Johnson et

43
al., 1997), and a low productivity (Friedman et al., 2000; Ihrig & Moe, 2004; Porta &
Shleifer, 2014).
On the other hand, other authors (from complementary theory) argue that the
shadow economy is positively associated with the official economy because an
expansionary fiscal policy from the government stimulates not only the official
economy but also the shadow economy (Adam & Ginsburgh, 1985). Furthermore, Nabi
and Drine (2009) conclude that the extra products from the shadow economy can help
increase the official economy. To Schneider and Dominik (2000), at least two thirds of
the income earned in the informal economy is immediately spent in the official
economy. The positive contribution of the shadow economy to the economic growth
via increasing consumers’ expenditure is also confirmed by Bhattacharyya (1993).
The effects of shadow economy on poverty
Kim (2005) shows a positive relationship between the poverty and informal
economy participation in Romania, implying that the informal participation is driven
by low-income households with the motivation to escape from poverty. However, De
Martiis (2014) finds a negative impact of poverty on shadow economy in 33 OECD
countries. Nikopour & Habibullah (2010) conclude that the shadow economy decreases
poverty in developed countries but increases poverty in developing countries through
government expenditure and economic growth.
Besides, some studies examine the impacts of shadow economy on other
variables such as fiscal and monetary policies, macroeconomic volatility, inflation,
quality of life, and pollution. Specifically, Castillo & Montoro (2007) show that the
presence of informal labor market can lessen the pressure of demand shocks on
aggregate wages and inflation, indicating that the interest rate channel of monetary
policy is relatively weaker in economies with higher level of shadow economy.

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