Shadow Economy Booms as People Flee Red Tape and Poverty in Developing Countries

We may need to stop calling it
the “shadow” economy, since off-the-books work, manufacturing, and
services hidden from regulators and the taxman are the rule rather
than the exception in much of the world. That’s the takeway lesson
from research published in the Asia Pacific Journal of
Management, which finds that informal entrepreneurship makes
up the majority of economic activity in developing countries.
Shadow activity is a necessity for many people trying to make a
buck, but those people would be better off, researchers say, if
their political and economic institutions were freer and more
welcoming to private enterprise so that people could operate
above-board and with the full protection of the law.

Shadow economic activity is separate from “black market”
activity, referring to the provision of labor, goods, and sevices
that would be legal if taxes were paid and regulations obeyed. It’s
also the way things are done in many places. The Imperial College
of London
press release announcing the article by Professor Erkko Autio
and Dr Kun Fu points out:

In a study of 68 countries, Professor Erkko Autio and Dr Kun Fu
from Imperial College Business School estimated that business
activities conducted by informal entrepreneurs can make up more
than 80 per cent of the total economic activity in developing
countries. Types of businesses include unlicensed taxicab services,
roadside food stalls and small landscaping operations.

This is the first time that the number of entrepreneurs
operating in the shadow economy has been estimated.

The researchers found that Indonesia has the highest rate of
shadow economy entrepreneurs, with a ratio of over 130 shadow
economy businesses to every business that is legally
registered.  After Indonesia the highest rates of shadow
economy entrepreneurs are found in India, the Philippines,
Pakistan, Egypt and Ghana.

That people choose to risk the wrath of tax collectors and
regulators—and to give up the benefits of access to the courts,
insurance, and other aspects of the above-ground economy—is taken
by economists as a sign that legal, tax, and regulatory
institutions are strangling would-be entrepreneurs and laborers.

In a
2010 paper for the World Bank, Friedrich Schneider, one of the
world’s foremost experts on shadow economic activity, writing with
Andreas Buehn and Claudio E. Montenegro, argued that “the overall
tax and social security contribution burdens are among the main
causes for the existence of the shadow economy.” They also noted
that “[i]ncreased intensity of regulations is another important
factor that reduces the freedom of choice for individuals engaged
in the official economy,” and they cite research by others
concluding that “every available measure of regulation is
significantly correlated with the share of the unofficial
economy.”

Autio and Kun, in the
current paper, come to similar conclusions. They write:

The institutional qualities of a society and its economy—such as
economic freedom (Hasan, Quibria, & Kim, 2003), the presence of
policies that condition the operation of private sector (Hasan,
Mitra, & Ulubasoglu, 2007), and institutions regulating the
balance of political power and the structure of the bureaucratic
system—play an important role in either facilitating or inhibiting
economic growth and alleviating poverty (Lakshman, 2003). By
inhibiting economic dynamism, poorly functioning institutions can
decrease the productivity and innovativeness of an economy, confine
the benefits of growth to a narrow elite, and impede the
alleviation of poverty.

Their reference to “policies that condition the operation of
private sector”
cites a paper that sees benefits from “good governance” and a
“strong commitment to the rule of law.” That paper also finds that
“less restrictive regulations pertaining to starting a business are
associated with higher economic growth as well as lower rates of
$2-a-day poverty.”

So, when you have a country, like Indonesia, where 130 out of
every 131 businesses are operating illegally, you can be pretty
sure that the local politicians and bureaucrats have made it damned
near impossible to start a business legitimately.

That’s become the norm in much of the world. And while it’s
impressive that people can innovate around obstructionist
officials, the world would be a healthier and more prosperous place
if those officials would just get the hell out of the way.