A shadow economy can as well be referred as an underground economy, parallel or underdog economy. They are terms made to define a market area in which commerce activities are carried through with a total evasion of regulations of trade and applicable taxes. This type of economy covers a vast array of activities in the modern society. It is highly pronounced in progressive and larger countries in which there is restriction of legitimate economic activities through regulations, legal monopolies or corrupt deals. It is small generally in nations that operate under high economic freedom, thus economic liberalization.
Such liberalization is accorded to both private and public sectors. Operations within the shadow economy are concealed from public activities in order to avoid paying value added, income or taxes (Schneider, Klinglmair, 2004, pp. 5). It is also geared at escaping social security contributions, escaping legal labor market standards. Such standards may include safety standards, minimum working hours and minimum wages. The desire to trade in this economy is also driven by evasion of complying with administrative procedures like filling administrative forms or statistical questionnaires (Zartman, 1997, pp. 0).
Shadow economic activities have been manifested around the world in several ways. Through pricing of commodities, this type of economy makes goods to be priced illegally through two main scenarios. For one, the goods may be cheaper compared to legal market price, since the supplier avoids taxes or incurs low production costs. This is a common characteristic of underground market for stolen goods. Secondly, the illegally traded commodities may be more expensive in comparison with the normal prices.
This may be attributed to the difficulties in producing, acquiring, dangerous to deal with or else be hardly available through legal means. It is a case common in shadow market for items that are illegal to posses, sell or purchase (Cheung, 2003, pp. 43). For the shadow economy to be proved, some consumer issues must come in, with respect to legality and pricing issues. Even if prices may be low, consumers may prefer buying legal and expensive commodities. This is because it is justified to purchase from legal dealers than illegal dealers because they can be held responsible or be easily contacted in case of product fault.
Again participation in unregulated economic activities may jurisdictionally lead to criminal accusations, since this is transferring a kind of physical risk to the economy and other people in the economic setup, depending on the way the goods are acquired. In other occasions, the government regulations may not hinder legitimate service, encouraging consumers to prefer shadow markets (Schneider, Klinglmair, 2004, pp. 6). In Baltimore, many studies have shown that shadow trade of unlicensed taxicabs is highly practiced, with consumers preferring illegal taxis because they are priced fairly, more convenient and more available.
Shadow economic activities are also preferred by groups that feel they are highly marginalized, such as illegal immigrants. They undertake most of their employment and purchases within the underground economy because they feel effectively exclude from the legal economic setup (Olowu, 2004, pp. 54). Shadow economic activities that are common in the developed world include transport modes, drugs provision, prostitution activities, weaponry, tobacco and alcohol; provisions, media copyrighting and currency manipulation. In the United States and the United Kingdom, several cities use a medallion system to restrict entry to taxicab market.
As a result, consumers composed of urban neighborhoods to rural old order Amish and Black Americans have actively engaged in illegal taxicab operations. At the beginning of 19th and 20th centuries, western nations banned possession of recreational drugs, by imposing and implementing what was called the war on drugs. Despite this law enforcement criterion, the existing high demand for these products give a high profitability initiative to the organized criminal groups who participate in availing and trading of the commodities (Schnieder, Klinglmair, 2004, p. 8).
According to a report by the United Nations, the retail market value of illegal drugs around the world is worth 321. 6 dollars. The report alerts that the war on drugs remains a perpetual cycle because the high and inflexible demand encourage new distributors and therefore limit the effectiveness of law enforcement efforts. To assist in eliminating the vice, many drug legalization activists have arisen all over the world, analyzing the causes, impacts and mitigative measures against the effects.
They are however drawing parallels between the experience of the united states on alcohol prohibition and recent various psychoactive drug bans (Lin, 2002, pp. 17). Prostitution is another element of shadow market that has attracted global attention because of its high manifestation and social disgrace. The continuous supply of sex workers is fueled by the high demand from customers, low skill aspects of the work, high pay and the fact that it is labor intensive. Unite nations report says that prostitution is present in every nation but flourishes in poor countries with many unattached men such as around military bases.
Prostitution is carried out in secrecy, negotiation activities and prices through subtle gestures and codeword. In Netherlands, prostitution is legal but carefully regulated by the government authorities (Jung, 2003, pp. 10). Many nations over the world have many unanimous efforts to restrict or else forbid personal ownership of arms, ranging from cold steel weapons, firearms and explosives. The shadow market is globally recognized in supplying such demands by smuggling from other countries trough stealing or cheap purchases. Other commonly smuggled products are tobacco and alcohol.
Reports have indicated that smuggling a truckload of cigarettes to high tax US jurisdictions from low tax areas earns a profit of $2 million. These low taxed zones are the mass tobacco production cites, which are reluctant in increasing their levels of taxation. The fear that profits from tobacco may be directed to terrorism activities has made US Congress to intervene and thus order for minimum tobacco tax, applicable to all states. The other major area is in media, where street vendors sell extremely discounted copies of video games, computer software, music CDs, and films.
In the field of currency, taxing currency transactions within official and designated points leads unauthorized currency vendors to transact at lower tax level. This can also take place if the government plans to control exchange rate physically (Zartman, 1997, pp. 11). In the last two decades, several studies have been done on the relationship between institutional quality, tax morale and the shadow economy. It has been found that many societies around the world try to control shadow economic activities through prosecution, education, economic growth and punishments.
It has been seen wise to handle objective issues such as rate of public expenditure, tax burden and the density of regulations. It is also necessary to consider subjective perceptions, attitudes, expectations and motivations such as tax morale and institutional quality. Cross country data sets to analyze shadow market activities have of late been provided by institutions such as World Values Surveys, the ISSP and Latinobarometro. It has been noticed that better institutions have stronger incentives towards legal behavior through increasing the coast of illegal activities.
These are activities that promote institutional accountability (Cheung, 2003, pp. 34). Illegal behavior is said to result to high moral costs. This means that the size of shadow economy in any setting not only depend on external factors but also on internal and more so social factors. This brings in the aspect of the role played by social institutions. The perception of tax payers that they are well taken care of in political arena depicts their response towards paying tax. Tax payers also consider the state of the government, whether it is helpful or wasteful, affecting their willingness to participate in taxation obligations.
The kind of perception gathered generally by taxpayers enable them make an option of whether to stick into the official sector or jump over to the shadow market operations. After consideration of the above elements, it has been collectively gathered that at ceteris paribus, the better the social institutions, the lower the activities of shadow economy (Olowu, 2004, pp. 76). In trying to understand why citizens pay taxes, it has been found paramount to go beyond neoclassical approaches. In many countries, deterrence level is too low to explain the high degree of tax compliance.
Results indicate large gaps between required amount to guarantee compliance and the degree of risk aversion. This has recently been proved in United States and Switzerland. To solve this controversy, researchers argue that tax morale can explain the world’s high degree of compliance. Tax morale measures individual attitude and not individual behavior. Tax morale is therefore a moral obligation o pay tax or a belief that motivates societies to pay taxes. It is highly linked to taxpayer ethics. These ethics comprise of behavioral norms that govern citizens’ relationship with the government as taxpayers.
A sustainable tax system is built upon a fair tax system, responsive government and sound connection between supply of goods and tax payments. A uniform generalization has therefore been achieved that, a high degree of tax morale reduces the size of shadow economy in any setting at ceteris paribus (Lin, 2002, pp. 18). Surveys have extended their efforts to investigating whether tax morale differences across countries impact any differences in observed or real behaviors in the same countries. It has been found that tax morale imposes real effects on the size of the shadow economy.
A number of findings have looked at the correlation between the size of shadow economy and tax morale. In Europe and America, there has been found a strong negative correlation, with Pearson correlation coefficient of 0. 460, at 0. 05 level of significance. When expressed in a linear regression relationship, tax morale explains approximately more than 20 percent of the total variance of the size of shadow economy. To support this, a research on 145 countries of the world from 1999 to 2003 indicated that the degree of tax morale affects real behavior (Schneider, Klinglmair, 2004, p. 24).
It can be thus responsible for the size of shadow economy. This means that, if the tax morale is declining, the shadow economy may likely increase. At 0. 01 level of significance, the global statistics indicated a still a strong negative correlation with Pearson correlation coefficient of -0. 551. This may be interpreted to mean that countries with low tax morale are subjected to high level of shadow economy. In a linear regression relationship, if tax morale decrease by a unit, shadow economic activities increase by 20 percent, with variable tax morale explaining more than 30% of total variance of the size of shadow economy (Jung, 2003, pp. 1).
As regards institutional quality, economic activities are not only affected by formal but also informal institutions. For this reason, poor nations need tax more to improve their education and public infrastructure. political systems around the world have intensed their concern on importance and efficiency of institutions, affecting the size of shadow economy. There thus has been a persistent search for the institutions to be modified for better fiscal outcomes and reduce the size of shadow economies.
Surveys indicate that insecurity of property rights and corruption affect the size of shadow economy around the world. If governments had their respective administrations had bigger discretionary in allocating resources, corruption is promoted. If institutions are neither working well nor credible, discretionary power rests on agents like administration staff, legislators and political elite (Lin, 2002, pp. 19). The participation of citizens in the formal economy is highly dependent on institutional stability, transparency and the adherence to rule of law.
Where there exists great numbers of corrupt officials, in the tax administration, crowding out effect of morality may arise. Consequently, citizens feel cheated if corruption is widespread because their tax burden is not well spent and not fully protected by the rule of law. This perception about institutions gives incentive to enter the informal sector. In corruption rampant governments, citizens lose trust in government and fail to cooperate. For adequate tax system, it is an essential precondition to initiate a more legitimate and encompassing state.
Therefore, low institutional quality increase the size of shadow economies at ceteris paribus. In high income countries, it has been observed that shadow economy and corruption are substitutes but complements in low income nations. In analyzing shadow economy around the world, it is necessary to consider the level of government participation in trading activities (Jung, 2003, pp. 12). Many research works use the index of economic freedom provided by heritage as a proxy for government interventions. This measure direct use of resources for own purposes by government and its control over resources by ownership.
To look at the scope of government participation, it is good to focus on consumption of the government as percentage of the economy, ownership of industries and businesses governments revenues share from state owned enterprises, its ownership of property and economic output produced by government. High level of participation and regulation by government in trading activities give an inclination to engage in illegal activities. More government participation therefore promotes shadow market activities (Jung, 2003, pp. 13).
Most of the global estimations and generalizations have been made from the dimensions of the shadow economy, shadow economies of 145 countries all over the world: estimation results over the period 1999 to 2003. Most of the work is credited to Friedrich Schneider. He analyzed shadow economy impact on economic growth and labor market. He watched the effects of shadow economy on variables such as average net monthly salary, unemployment rate and gross domestic product. Ha used econometric modeling, software package EViews 5. 0.
This software package was used to process the data of the 145 nations and assisted in making statistical conclusions (Zartman, 1997, pp. 11). After regression analysis, the standard errors were inferior to the value of coefficient taken as module. This coupled with small value of probability strengthened validity of the estimations. The correlation coefficient was 23. 15%, showing a very strong relationship between the level of gross domestic product and shadow economy size. Changes in GDP include appreciable proportion of changes in shadow economy changes.
Durbin Watson test indicated a value slightly above critical threshold 2. This scenario meant that the two residual variables were not auto correlated. Through analyzing of the results, the impact of the shadow economy to the rate of unemployment was moderate, where an increase of 1% in shadow activities decrease employment rate by 0. 13%. This finding has been validated by the fact that shadow economy serves as an absorber on labor market. Illegal employment created by shadow economy compensates the deficit offer of employment (Cheung, 2003, pp. 4). Still with incorporation of 145 countries, the impact of shadow economies on net monthly salary is moderate, but it is positive. A 1% increase in shadow economic activities increases net average monthly salary by a magnitude of 14. 5%. This gives an implication that, shadow economy creates new places of work, growing up illegal earnings which are in turn revolved through the input. After considering the above findings, Schneider gave a paradoxical conclusion that shadow economy has visible consequences over social life and economic life.
This was supported by the argument that shadow economy had an impact on efficient functioning of economy, which is low but positive. An increase in shadow market activities by 1% increase GDP with 4. 7%. He therefore described shadow economy as a necessary evil because its mechanisms make the legal economic growth of a country more stable (Olowu, 2004, pp. 54). About the impact on inflation rate, when shadow market expands by 1%, decrease inflation rate by 6. 1%. Sustention of shadow economy for the goods offer on real market causes inflationary pressure and thus supplements the legal offer.
It thus complements the legal supply of goods and services. Since these interpretations were based on 145 countries, the validity of the research work is subject to other variables such as the system of governance, innovation and technological advancements. However under all circumstances, ninety percent of the findings are not bound to change, regardless of economic, political and social advancements or drawbacks in any nation. The 145 countries used in this research comprised of 96 developing countries, 28 countries undergoing transition and 21 developed countries (Lin, 2002, pp. 19).
Shadow economy can thus be said to be a product of poor political, institutional and economic policies and frameworks. According to above and other findings, factors that Marjory affect this economy are closely linked to weak macroeconomic stability and high income inequality. These can be propelled by lack of transparency, unfair rule of law application, high income inequality corruption and high tax burden. For ex-communist emerging market economies, small businesses foster shadow market activities. In these kind of economies, most of the production activities are carried out in governed companies and state owned ventures.
Shadow economy therefore has both positive and negative attributes. It is usually upon the authority in power to put in place the necessary mechanisms to balance the effects of the economy, depending on the nature of the economy, level of industrialization and the system of governance. This diversity is because of the variation of legislations provided by different political, economic and social settings. Some systems of governance may promote the economy whereas others may limit them (Jung, 2003, pp. 13).