The Impact of the Shadow Economy on Indirect Tax Revenues

This paper examines empirically the impact of the shadow economy on indirect tax revenues in an unbalanced panel of 125 countries for the period 1990–2011. The same analysis is conducted excluding at first and then including international trade tax revenues in (total) indirect tax revenues, as a way to disentangle any impact of trade liberalization. In both cases, the results suggest that the size of the shadow economy increases the ratio of indirect tax revenues to GDP, as long as informality does not exceed a cutoff value. When the size of the shadow economy exceeds that level, any further increase affects indirect taxation negatively. The findings are robust to a number of sensitivity tests and when addressing the problem of potential endogeneity. The empirical evidence is in line with the predictions provided by the theoretical framework of the paper.