Shadow economy and unemployment rate in USA: is there a structural relationship? An empirical analysis

Abstract

This article aims to estimate the size of the US shadow economy (SE) using a structural equation approach and to evaluate if a structural relationship exists between the SE and the unemployment rate (UR) in the United States. The size of the SE is estimated to be decreasing over the last two decades. We corroborate the existence of a structural relationship between the SE and the UR by using a simple theoretical model. Furthermore, we extend the Okun's law to estimate the structural relationship between growth rate of official GDP, SE and UR. Our results indicate a significant positive relationship between the SE and the UR.

Acknowledgements

We thank an anonymous referee and Trevor Breusch for valuable comments.

Notes

¹The 1993 SNA states explicitly that illegal activities should be included in the SNA, noting that ‘despite the obvious practical difficulties in obtaining data on illegal production, it is included within the production boundary of the system’ (1993, SNA 6.30), and that: ‘All illegal actions that fit the characteristics of transactions – notably the characteristic that there is mutual agreement between the parties – are treated the same way as legal actions’ (1993, SNA 3.54). The 1993 SNA suggests that illegal actions for which there is no mutual agreement can be construed as an extreme form of externality for which, in general, no values are imputed in the national accounts. So it is absence of consent rather than illegality that is actually the criterion for exclusion from the production boundary. OECD (2002, p. 38).

²Individuals choose to exit the formal sector to work or operate business in the SE rather than choosing to vote against the government in an election.

³A detailed analysis of the Spanish shadow economy is presented in Ahn and De La Rica (1997), Alañón and Gómez-Antonio (2005).

⁴For an analysis of Italian shadow economy and its causes, see Dell’Anno and Schneider (2003).

⁵ For an overview on the relationship between official and unofficial economy see also Dell’Anno (2003, 2007), Giles et al . (2002).

⁶ The index of real GDP is equal to (Real GDP _t )/(Real GDP₁₉₉₀).

⁷As the variables are all differenced to same degree, to calculate the levels of the latent variable multiplying the structural coefficients for raw (unfiltered) data, it is equivalent to compute the changes in the index by multiplying coefficients for the differenced causes and then to integrate them. The Equation 8 can be rearranged also as: . This form is inadequate for empirical application, since the estimated absolute values of SE are rarely reported among the outputs of applied studies.

⁸In literature the association between changes in the unemployment rate and output growth can become less reliable for a variety of reasons, however, the predominant factor that has tended to undermine specific representations of Okun's law has changes in productivity. See among others: Dixon and Thomson (2000), Kaufman (1988), Sögner and Stiassny (2002).

⁹ It is only ‘partially unobserved’ because shadow activities create an extra value added that can be spent in the official economy.

¹⁰ For instance, Schneider and Enste (2000), state that at least two-thirds of the income earned in SE is immediately spent in the official economy.

¹¹ The authors use a structural VAR model to show a structural relationship between the unemployment rate and the shadow economy in the long-run.

¹² The Kernel function was chosen according to Bartlett's criteria and the Newey–West method is used for bandwidths.

¹³ As the ADF and KPSS tests are adversely sensitive to the presence of breaks in the data, by showing critical values it is possible to check these values with Kurozumi's (2002, Table 3, p. 86) critical values. Kurozumi's (2002) modified KPSS test allows to use consider the distortion in the statistical test distribution caused by a structural break.