This paper describes all activities considered a part of the shadow economy in state. It also examines the positive and negative impacts of shadow economy on state. Moreover, it explores all factors which cause entrepreneurs escape from the formal economy to the informal. After reading this paper readers will come to know that being involved in various illegal activities, huge corporations are considered a part of the legitimate economy. Conversely, entrepreneurs who avoid paying bribes to corrupt officials are called part of illegal or shadow economy.

Table of Contents



Factors of the shadow economy:

Shadow Economy and Corruption as Complement and Substitute:

Positive Impacts of Shadow Economy on the State:

Negative Impacts of the Shadow Economy:

The so Called “Legitimate” Economy:


“Works Sited”.





According to Schneider, “All currently unregistered economic activities that contribute to the officially calculated or observed Gross National Products are considered shadow economy (04).” None of the authors agree on a specific definition for the term, “shadow economy”. For example, Fleming, Roman, and Farrell define shadow economy as “economic activity that falls outside the purview of government accounting is known by various names: shadow, informal, hidden, underground, and black (387).” However, all writers agree that the shadow economy includes unregulated, unregistered or unrecorded activities.

Fleming, Roman and Farrell wrote that observing the written pieces, lectures and other articles on the shadow economy gives one the idea that the shadow economy is unattractive and undesirable. Even the words shadow, hidden, and informal themselves sound negative. Most often, people stigmatize an activity by naming it illegal. However, all shadow economic activities should not be dishonored because they have tremendously positive effects on the formal economy and peoples’ lives in developing countries (Fleming, Roman, and Farrell 395, 396). These countries have never had legal and political institutions, sufficient for well-organized formal market activities (Choi, Thum 817). Choi and Thum believe that the potential and importance of the informal or shadow economy is supported in developing countries and transitional economies, though it is strictly restricted in developed countries.

Fleming, Roman and Graham argue that not all, but in most developing countries, shadow economic activities are a major employment source. The International Labor Organization (ILO) reports that 80% of new Latin American jobs between1990-94 were in the informal sector. Moreover, 61% of the African labor force is from the informal sector, and is expected to provide 93% of new additional jobs in the 1990s. Finally, 40 to 50% of the pre-crisis Asian labor force is from the informal sectors (Fleming, Roman, and Farrell 406).

Factors of the shadow economy:


Various factors cause shadow economies to exist and upsurge at different times. One factor of the shadow economy, according to Choi and Thum, is corruption.  They argue that every time government officials use the public sector as their personal source of income, entrepreneurs, frequently with no other options, melt into the informal sector. For example, Choi and Thum utilize an argument put forth by Shleifer and Vishny: when an entrepreneur wants to open a shop in the formal economy; he has two options; either to pay corrupt officials to get the license for the shop or to open the shop without license. Consequently, most of the time people choose the second option (Choi, Thum 818)


Another factor of the shadow economy, according to Fleming, Roman and Farrell, is the tax burden: unnecessary increase of the tax burden and complication of rules and regulations may lead merchants from the formal economy to the informal economy. They, for instance, cite Loayza who argues that high entry costs to legalize a business including license fee and other regulation requirements, including high taxes, red tape, and labor regulations cause businessmen to enter the shadow economy. An expectation of good government is the provision of efficient laws, the protection of people’s rights, and labor and environmental regulation that are directly funded by taxes. However, businessmen, operating in the shadow economy, avoid paying these tax revenues. Consequently, the quality of goods and services that the government provides people with gets worse and, as a result, the government increases the tax percentage which causes more people to escape into shadow economy (Fleming, Roman, and Farrell 394, 395).

Furthermore, Schneider wrote, “The increase of intensity of regulations (often measured in the numbers of laws and regulations, like license requirements) is another important factor, which reduces the freedom (of choice) for individuals engaged in the official economy (07).”  In much the same manner, Fleming, Roman and Farrell quote Feige and Loayza who argue that rules where a primarily formal economy flourishes pay a different set of transaction costs than those in the informal economy. Moreover, formal and informal economies are two different economies in a legal environment, however, one is regulated and the other is not. As a result, the informal economy makes the formal economy more unattractive to the people (Fleming, Roman, and Farrell 390).

The third factor, Schneider believes, is the legal labor market standards. In order to get rid of such standards like the minimum wage, maximum working hours and safety standards that exist in the legal markets, entrepreneurs prefer the shadow economy. For example, Schneider argues, “More regulation is correlated with a larger shadow economy. A one point increase in an index of regulation (ranging from 1-5) is associated with 10% increase in the shadow economy for 76 developing, transition and developed countries (08).”

Table 1: Main causes of the increase of the shadow economy

Factors Influencing the Shadow Economy
The most important driving forces are: Influence on the shadow economy (in %)
Increase of the Tax Burden 35-38% 45-52%
Intensity of State regulations 8-10% 10-15%
Specific Labor Market Regulations 5-7% 5-8%
Source: (Friedrich Schneider, September 2006, p. 14)

Shadow Economy and Corruption as Complement and Substitute:

Friedrich and Axel believe that corruption and shadow economies can either be complements or substitutes to each other. According to them, the relationship between shadow economies and corruption varies in developed and developing countries. To illustrate, in developed countries only small businesses can operate in the shadow economy, however, all big businesses are likely to operate in the formal sector because they are provided with their essential needs including the rule of law, enforcement of contracts, and police protection. In this case corrupt officials cannot demand bribes from the people operating these businesses because they may be brought in front of the court by individuals or corporations. Therefore, strengthened institutional quality in developed countries decreases the percentage of corruption. Moreover, corruption in high-income countries is used as a tool of achieving huge benefits, such as winning a contract from the government, getting a license or may be converting land into “construction ready” land. In short, businessmen bribe formal officials to be a part of the formal sector. Consequently, the shadow economy and the corruption in developed countries are substitute (Schneider and Dreher 217,218).

They, conversely, argue that in developing countries businesses like restaurants, bars, haircutters or even bigger enterprises are completely engaged in the shadow economy. One reason for this is that the quality of the public goods, provided by the public sectors, is less efficient. In these low income countries corruption takes place in order to operate in the shadow economy. Furthermore, they expand, “Here, the shadow economy and corruption are likely to reinforce each other, as corruption is needed to expand shadow economy activities and- at the same time- underground activities require bribes and corruption.” As a result, we conclude that in developing countries the shadow economy and corruption are complements (Schneider and Dreher 217,218).

Positive Impacts of Shadow Economy on the State:


Fleming, Roman and Farrell discuss, “An active shadow economy might imply the presence of inefficient economic policies. As such, activity which overcomes inefficiencies in the existing system is conceivably a good thing.” Furthermore, they quote Schneider who finds that shadow economic activities inspiringly affect the formal economy, as at least two-thirds of the money from the informal economy is promptly transferred to the formal economy. The informal economy in the developing and transition countries replaces the formal economy as it assures the availability of essential goods and services to the public to which it is actually the duty of the formal sector (Fleming, Graham and Farrell 395, 396)






Not only the legal sector of the shadow economy assists the formal economy, but the criminal sector also backs up the formal economy. For instance, Fleming, Roman and Farrell quote Maurer who discusses that the drug business and other illegal businesses in the illegal sector indirectly benefit the formal sector by creating hundreds of other employment opportunities in legal sectors. Moreover, “Capital goods, such as agricultural equipment, chemicals as well as consumer goods and services (banking, legal advice) are offered increasingly in the remote coca cultivation areas. This ‘trickling down’ also represents a distribution of the drug profits (Fleming, Roman and Farrell 395, 396).”

As mentioned before, the formal sector limits people’s choices. Anil Gupta gives the example of Indian poor in his TED presentation where he states that the formal sector cannot provide thousands of poor laborers and artisans with any kind of job except breaking stones and digging the earth. However, in the informal sector people are not restricted. Therefore, their needs make them think creatively to find solutions for their needs that actually sometimes pave the way to various innovations. Gupta calls these people economically poor, not mentally. He, for instance, gives the example of millions of people from India and other parts of the world that are creative in terms of education, culture, institutions, and technology. Tens of these poor people are introduced through his “Honey Bee” network program.



Figure 8: Anil Gupta Presentation

Figure 9: Anil Gupta Presentation

Figure 10: Anil Gupta Presentation


Figure 11: Anil Gupta Presentation

According to Gupta, all innovations, such as the invention of a real affordable coffee maker by Rojadeen, living in Motihari, Champaran, and the invention of a flour-grinding machine by Sheikh Jahangir that provides people with opportunity to grind such a small amount of flour, meet the needs of those poor in terms of cost and energy.







Figure 12: Anil Gupta Presentation



Figure 13: Anil Gupta Presentation

Another benefit of these innovations is that most of the things that they make are energetic, safer and of a better quality. For instance, Gupta, in his presentation, compare a tawa-hot plate made of clay-with any other non-stick pan. He illustrates that when someone eats from a non-stick pan, he actually eats surface non-stick material of the pan itself that is very dangerous for health. However, eating from the tawa does not have any side effects. It can be conclude that just because people are involved in

Figure 14: Anil Gupta Presentation

informal activities, they are free to think creatively and satisfy their needs with innovating new solutions.

Negative Impacts of the Shadow Economy:

We should not forget that if the informal economic activities have tremendously assisted the formal economy, in many cases, it has also confronted states with serious consequences. For example, Mathews, Roman and Farrell quote Glinkina who notes, “The effective management of the economy by the state is undermined. The taxation and foreign exchange base that any state needs to manage its economy is eroded by the rapid flight from the official to the underground economy. Macroeconomic stability is thus harder to attain and sustain. Further, the legitimacy of the overall legal and regulatory system is challenged. Similarly, they quote Ott who provides a clear assessment: because transition countries have a weak institutional structure to support market economic activities, the informal economy pose a mass danger by assuring the undermining of the rule of law that is for sure one of the very essential elements of successful transition (Fleming, Roman and Farrell 397, 398).

Moreover, Schneider states that an increase in the shadow economy reduces state revenue and, as a result, publically provided goods and services will suffer both qualitatively and quantitatively. Consequently, the tax rates go higher and the possibility of participation of the entrepreneurs in the shadow economy increases (Friedrich 08). Also, an increase in the shadow economy leads to higher rates of crime because the state revenue will not be quite enough to provide people with police, military and counter-drug units to prevent criminal activities (Fleming, Roman and Farrell 397).

The so Called “Legitimate” Economy:

As said before, when someone wants to legitimize his/her business, they have to pay to a corrupt official, using his/her post as a source of personal income, and bare other regulatory expenses including license fee. However, when they avoid bribing those officials and start their business informally, their business is named as illegitimate.

On the other hand, huge corporations and businesses that are so called “legitimate” are legitimized in order to easily deceive the government and people. That legitimacy becomes a kind of curtain for them under which they continue every kind of illegal activities. For instance, Dexter Filkins in his article The Afghan Bank Heist wrote about the bankruptcy case of Afghan Kabul Bank. He wrote that a huge amount of money about nine hundred million dollars are missing from the bank. The investigation proved that “Farnood, one of the executives, had spent tens of millions of dollars in depositors’ money to buy more than a dozen luxury villas on or near Palm Jumeirah, an exclusive man-made island.” Furthermore, he describes that a small amount of this money is used by the top executives of the bank, Khalil Ferozi, Sher Khan Farnood and Mahmood Karzai to bribe Afghan officials during the election campaign for Hamid Karzai. These people are involved in dozens of other similar illegal activities, but no one can bring them to justice. Their money and status convert all their illegal activities into legal actions and provide them with a shelter.

Another example of this scenario is the fraud of Wall Street executives. Their misconducts faced thousands of investors with a horrible financial crisis. These investors were really optimistic that the Security and Exchange Commission (the SEC) and the Department of Justice (the DOJ), responsible for the capital markets issues, could bring those executives to justice. However, despite of significant evidence of international misconduct, the SEC and DOJ failed to bring a single executive, responsible for the financial meltdown, to justice.

According to the Harvard Law School Forum, the SEC does reached to settlements with some of the companies, but those settlements were of worth nothing. It was criticized by everyone including federal judges and many journalists. For instance, the SEC settled the case of the Bank of America for only 33 million dollars in August 2009 and submitted for approval, but it was rejected by the federal judge Jed Rakoff to approve because of its inadequacy. It explores, “when the SEC latter submitted a revised 150 million dollars settlement for approval, judge Rakoff reluctantly approved the agreement while shaking his head explaining that it was paltry in nature and while better than nothing was half-baked justice at best.”

Similarly, SEC’s another settlement of 75 million dollars with the Citigroup, concealing 40 billion dollars of subprime exposure from investors, was rejected by Judge Ellen Huvelle. This agreement included two executives of the Citigroup, Gray Crittenden and Arthur Tildesley, who were jointly fined 180000 dollars, whereas only Crittenden had pocketed 19.4 million dollars. Finally, Angelo Mozilo, the Chief Executive Officer of the Countrywide Financials, with its 140 million dollars revenue was fined just 22.5 million dollars. (The Harvard Law School Forum on Corporate Governance and Financial Regulation,” June 25, 2011)

In addition, Shinemay Chen described, how some retailers avoid paying tax to the government. He wrote that many of the retailers in the West and Taiwan make their auctions online that help them easily to escape tax. Moreover, they do not pay rents and other arrangement expenses that bring their business cost lower (Chen 23).

All these cases, including Afghan Kabul Bank, Wall Street and the online auctions, suggest that most of huge corporations are involved in different kinds of corruption including tax evasion and frauds. Moreover, the more a corporation gets bigger the more it becomes harder to control it, as a result, government does not rule these corporations, but corporations govern the government. In short, small businesses, avoiding any kind of corruptions by denying bribing corrupt officials while getting license, are called illegal. However, huge corporations that are involved in corruption and fraud are considered legal or legitimate.



Figure 15: Anil Gupta Presentation

The size and importance of the shadow economy varies between different developed and developing countries. It earned much potential and importance in the developing and transition countries than the developed countries. Though it has some cons for the state, it is highly essential that if not all, most of the informal economic activities have to be present, and included in the formal economy especially in developing countries where public sectors are unable to provide people with enough jobs.

It is what Gupta suggests, in his presentation, about the people with innovations who are a part of the informal sector, but need to get deserved appreciation for their work. If any company tries to manufacture cheap things for these poor, they have to hire labors with a low price that once again will create a huge poor class of people. Therefore, it is better to have informal sector where poor create things for other poor that is affordable and based on their needs.


Figure 16: Anil Gupta Presentation

Gupta says, “If we can create a market for these artists, we will not have to employ them for digging earth and breaking stones. They will be paid for what they are good at, not what they are bad at.” Giving these people an opportunity will benefit hundreds and thousands of others. Gupta quotes SRISTI during his presentation, saying, “Give me a place to stand, and I will move the world.”

Beside informal sector, formal sector is also essential for a country because all big enterprises pay the taxes. These taxes contribute in the infrastructure of the country, and help government to provide its public with better rule of law and public services.




“Works Sited”

Axel, Dreher, Schneider Friedrich, “Corruption and the Shadow Economy: an empirical analysis” dx.dio.org, July 01, 2010, 6th March, 2012


Chen, Shinemay. “Tax Evasion and Fraud Detection: A Theoretical Evaluation of

Taiwan’s Business Tax Policy for Internet Auctions” ebscohost.com, December 2010, 9th May, 2012,


Filkins, Dexter. “The Afghan Bank Heist” newyorker.com, February 14, 2011, 9th May, 2012


Fleming, Matthew H., John Roman, and Graham Farrell. “The Shadow Economy.” Journal Of International Affairs 53.2 (2000): 387. Academic Search Complete. Web. 06th March. 2012.


Gupta, Anil. “India’s Hidden Hotbeds of Inventions.” Ted Talks, Mysore India, 2009, Presentation.


Jay Pil, Choi, and Marcel Thum. “Corruption And The Shadow Economy.” International Economic Review 46.3 (2005): 817-836. Business Source Complete. Web. 5 Mar. 2012.

Schneider, Friedrich, “SHADOW ECONOMIES AND CORRUPTION ALL OVER THE WORLD” papers.ssrn.com, September 2006, 6th March, 2012


The Harvard Law School Forum on Corporate Governance and Financial Regulation,” Too Big to Fail or Too Big to Change.” blogs.law.harvard.edu, June 25, 2011, 6th May 2012.