Do fiscal decentralization and income inequality affect the size of the shadow economy? A panel data analysis for OECD countries

ABSTRACT

In this article, we study fiscal decentralization and inequality as driving forces of the shadow economy in advanced economies. Our empirical analysis suggests that a reduction in income inequality will contain the shadow economy, whereas expenditure and tax decentralization do not significantly impact it. As decentralization is generally believed to increase government efficiency, this result is indicative of already highly efficient public administrations. Our results further indicate that redistributive policies positively affect the size of the shadow economy, whereas the tax burden does not have any discernible effect on the shadow economy in our sample.

KEYWORDS:

• Shadow economy
• fiscal decentralization
• income inequality
• OECD countries
• panel data

JEL CLASSIFICATION:

• O17
• H71
• H72
• O15

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ The countries (whose inclusion in the sample is largely dictated by data availability issues) are the following: Australia, Canada, Finland, France, Germany, Iceland, Italy, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, the UK and the USA.

² Note that data availability issues prevent us to re-run the model using the alternative shadow economy series to measure the dependent variable, as the number of observations would drop significantly.

³ Their second and third lags (and the rest of the right-hand side variables included in the model) are used as instruments.

⁴ It should be borne in mind though that the fiscal decentralization measures report local public expenditure and tax revenue and not the government level on which the decision about local expenditure or taxes are actually made.