Tackling the shadow economy through inflation and access to credit

Abstract

How do changes in inflation and financial market development affect the size of the shadow economy? Previous studies show that lowering the tax rate, coupled with increasing the level of tax enforcement through policing and imposing high penalties for tax evasion may reduce the size of the shadow economy. While increasing the level of enforcement may be a viable strategy, most developing countries are unable to effectively enforce their tax laws. Based on empirical observations, we suggest that monetary authority could play an important role in this regard. Using a two-sector dynamic general equilibrium model of a small open economy, we demonstrate how monetary policy can be used to reduce the size of the shadow economy. The results suggest that, conditional on access to credit, a rise in inflation leads to a reduction in the size of the shadow economy. With little or no access to credit, such a policy will be ineffective. We evaluate alternative policy measures to achieve a targeted size of the informal sector.

Keywords:

• Shadow economy
• monetary policy
• inflation
• access to credit

JEL Codes:

• E5
• E6
• F4
• F3
• O1

Acknowledgments

We sincerely thank Matthew Murray, Donald Bruce, Phillip Daves, Scott Gilpatric, Georg Schaur, Rudy Santore, Maria Padilla-Roma, and Luiz Lima for their constructive comments. We accept responsibility for any errors. We are also thankful to the referees and the editor for their various constructive and meaningful comments. The usual disclaimer applies.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Based on advice from the World Bank and policy experts, some developing countries have introduced several policies to deal with informality. These policies include introducing tax tamps, training small-scale business owners in basic accounting and bookkeeping practices, and reducing the cost and the time it takes to register a business. While these policies may help reduce informal sector activity, it is important to note that informality is a multifaceted problem with tax evasion being a major factor.

2 Though it may be possible to export informal goods, the exporting process increases the chance of informality being detected. For instance, informal goods may have to be registered before they can be exported, making them essentially non-tradable.

3 In practice, the informal sector has some access to credit from microfinance institutions and local money lenders. However, the cost of accessing credit from the informal financial market is often very high.

4 In the baseline model, investment spending is not subject to credit and cash constraint.

5 Loayza (1996) documented the costs of participating in the formal and informal sectors. The costs of operating in the formal sector entail paying taxes, meeting regulatory requirements, and surmounting bureaucratic bottlenecks. The costs of participating in the informal sector include paying penalties if informal activity is detected and being unable to fully access public services.

6 An identical production function can be assumed in which case formal and informal goods would be identical. However, this paper considers a situation in which the informal sector does not have full access to the economy's available capital resources due to the clandestine nature of activities in that sector.

7 Medina and Schneider (2018) use Multiple Indictors Multiple Causes (MIMIC) model and calibration procedure to estimate the size of the economy for 158 countries for the period 1991–2015. The MIMIC approach treats the shadow economy as an observed variable for which there are multiples causes and effects.

8 The World Bank (2017a)

9 The World Bank (2017b)

10 The World Bank (2017c), also see Kaufmann, Kraay, and Mastruzzi (2010)

11 Koreshkova (2006) constructs estimates of the shadow economy based on data from Schneider and Enste (2000).

12 Koreshkova (2006) found the average inflation rate for poor and rich countries to be 19.1% and 4.4% respectively for the period 1986–1995.

13 In reality, the informal sector has some access to credit but faces high costs for credit services. One way of modeling the problem is to allow the informal sector to have access to credit and then introduce a credit cost that is high enough to discourage its use. However, to keep the model simple, we assume that the informal sector has no access to credit.

14 $c_{\mu }^F=\frac{(1+\alpha (r_t+{\pi }_t))}{U^{″}}<0,$ $c_{\pi }^F=\frac{\mathrm{\mu \alpha }}{U^{″}}<0$, $c_{\alpha }^F=\frac{\mu (r_t+{\pi }_t)}{U^{″}}<0$, $c_{\mu }^S=\frac{e(1+r_t+{\pi }_t)}{W^{″}}<0$, $c_e^S=\frac{\mu (1+r_t+{\pi }_t)}{W^{″}}<0$, $c_{\pi }^S=\frac{\mathrm{e\mu }}{W^{″}}<0$, $L_{\mathrm{Fe}}=\frac{H_L}{(F_{\mathrm{LL}}+e{H}_{\mathrm{LL}})}<0$, $L_{\mathrm{FK}}=\frac{-F_{\mathrm{LK}}}{(F_{\mathrm{LL}}+e{H}_{\mathrm{LL}})}>0$, and $I_q=\frac{1}{{\mathrm{\Psi }}^{″}}>0.$

15 The characteristic equation of the coefficient matrix can be written as follows: ${\mathrm{\Xi }}^4+{\mathrm{\Xi }}^3(-a_{22}-a_{44})+{\mathrm{\Xi }}^2(a_{22}{a}_{44}-a_{14}{a}_{41}-a_{23}{a}_{32}-a_{24}{a}_{42})+{\mathrm{\Xi }}^1(a_{14}{a}_{22}{a}_{41}+a_{23}{a}_{32}{a}_{44}-a_{24}{a}_{32}{a}_{43})+{\mathrm{\Xi }}^0(-a_{41}{a}_{32}(a_{13}{a}_{24}-a_{14}{a}_{23}))=0.$ The sign of the coefficients of ${\mathrm{\Xi }}^4,{\mathrm{\Xi }}^3,{\mathrm{\Xi }}^2,{\mathrm{\Xi }}^1$ and ${\mathrm{\Xi }}^0$ are +, −,, + , + , respectively. It is clear that the number of sign changes in coefficients in the above polynomial is two. According to Descartes' rule of sign, the number of positive real roots of a polynomial could be at most two (two or zero).

16 To increase access to credit in the short run, monetary authorities can deploy the tools of monetary policy such as lowering the required reserve ratio, reduce the rate at which it lends to commercials banks and the rate at which commercial banks lend among themselves. Policies that could increase access to credit in the long run are linked to policies that promote financial development including stable macroeconomic environment, regulatory quality (Capasso, Ohnsorge, and Yu 2022), and increase in digitalization.