Unveiling the shadow economy in emerging markets

Abstract

This study examines the direct role of the shadow economy in economic growth and its indirect roles through interaction with tax burden, institutional environment, foreign direct investment, trade openness, government consumption, and population growth. Although shadow economy has been comprehensively studied in the literature, both joint and environment-specific effects for emerging economies are not well documented. This research fills this void by integrating several dimensions of structure into one Bayesian MCMC model. The Bayesian approach is used because it is powerful in capturing parameter uncertainty and interaction that is challenging to model under limited data. Empirical evidence from a balanced panel of developing countries indicates that the shadow economy reduces per capita GDP, but such adverse impacts are dampened under strong institutions quality, higher foreign direct investment, and higher trade openness. Conversely, higher population growth and over government consumption reinforce its adverse impacts. The findings present a new, interaction-oriented account of shadow economy and contend that institutional change and good fiscal policy are essential in diminishing informality and promoting inclusive and sustainable growth.