An Economist's View of the Informal Economy: Interview with Friedrich Schneider

An Economist's View of the Informal Economy: Interview with Friedrich Schneider

. 5 min read

Friedrich Schneider is a Professor of Economics at Johannes Kepler University in Linz, Austria and a Research Fellow at the Institute of Labor Economics in Bonn, Germany.

First off, how can we define the informal economy? What sort of academic debates have gone on regarding the definition of the informal economy?

The informal economy is also called the shadow economy or the gray economy, there are lots of names for it. To be brief, the informal economy consists of goods and services which are produced in the shadow, avoiding taxes and government regulations, but are legal. Legality is important. If I repair a car off the books, it’s running afterwards, and it’s a legal activity, which is different from illegal activities such as drug dealing or burglary or other classical criminal activity.

What are the methods of measuring the shadow economy, statistically or econometrically?

Measuring the shadow economy is quite difficult, and it is a challenging task. There are various ways. There are three main approaches: direct approaches, indirect approaches, and statistical methods. Using statistical methods is quite tricky because to estimate such a function, to fulfill ceteris paribus, and to fulfill all other econometric conditions is quite a challenging task.

From these, the most commonly used one is the currency demand approach. This is a simple idea. Normally, shadow economy activities are paid in cash, because cash doesn't leave a trace. A bank check is microfilmed or computerized and does leave a trace. The idea here is if you are able to isolate the amount of money which is used for shadow economy transactions, you can multiply it by the velocity of money, and you have a value added figure. That's the most common method.

The last approach is the MIMIC procedure. MIMIC means multiple indicators, multiple causes. In this model, the shadow economy is a latent variable which is influenced by certain causes like a tax burden or unemployment, and it's reflected in certain indicators like cash, like a lower official employment rate.

What are some of the economic drivers of activities within the shadow economy?

There are three indicators and ten causes. Well, the main cause of a shadow economy is informal employment. There are some other causes as well: high tax and social security contributions, intensity of regulation, unemployment, and the size of the agricultural sector all increase the shadow economy. A high official income, high tax morale, a high quality of public institutions, and a federal system as in your country all reduce the shadow economy. The three indicators are official GDP, cash, and official employment.

What economic policies have done the most and the least for reducing the size of the shadow economy?

In order to tackle the shadow economy, governments should use incentive-oriented policy measures. I'm very skeptical about punishment. Punishment is difficult to employ, and the effect is rather minor. It's the same debate, as with the tax evasion literature, where we all know punishment does not have a big effect in reducing tax evasion.

Now for policy measures in order to fight the shadow economy, decreasing unemployment is number one. If fewer people are unemployed, they have a lower possibility to work in the shadow economy and a smaller incentive because they earn good money in the official job.

You could also create incentives for self-employment. If people are self-employed and want to make a business, they have a little incentive to do it underground because it's much more difficult.

Then of course, what is very effective, but difficult to achieve, is to decrease the tax burden. The lower taxes I pay, the lower effect there is on my labor burden with taxes and social security payments, there is less incentive to work in a shadow economy. Another measure is to reduce the administrative burden. If you have to fill out a lot of forms, if you have to obey a lot of regulations, then the incentive to work in the shadow economy is great. And if you liberalize this, the incentive is less.

Then of course, you should have good and high quality public institutions, less corruption. If there is corruption, people can get a public contract, and you don't have to work hard in the official economy. Where there is little possibility of corruption, there is also much less possibility to work in the shadow economy. Another thing is that you could give an incentive so people don't use cash. Cash is not a cause of the shadow economy, I underlie, but it's an inefficient means. If there is no cash, the shadow economy will by no means disappear, but it's a bit more difficult.

These were the most important measures in order to reduce the shadow economy. Of course, you can include punishment, with prison or with fines if one works in the shadow economy.

What's the relationship between the shadow economy and the formal economy, and vice versa?

That's a difficult question because it's like marriage. It's a very difficult relationship. In highly developed countries, like in the United States or in most other OECD countries, we have a positive or a complementary relationship: The shadow economy increases total welfare, especially in your country. In the United States, without shadow economy workers, the whole tourism and agricultural sectors will break down in your country. You rely on unofficial workers to pick fruit or do room service, for instance. Over the last three, four years, you had this huge debate under Trump about their role, but you need these people, these unofficial workers. In all, the shadow economy in the United States is very small, but it adds up.

In a lot of developing countries, we have the opposite. We have a substitutive relationship. The higher the shadow economy, the lower the official economy. When you have a shadow economy with the size of 40 or 50 percent [of total GDP], it’s so large that the tax base erodes and the state is not able to fulfill and to parent proper and functioning infrastructure. Here, the higher the shadow economy is, the lower the official economy.

Which is true depends from country to country. Some countries switch from the substitutive to the complementarity relationship. When they fall back to a lower development stage, they come back to the substitute relationship. For most OECD countries, we have complementary relations, so the higher the shadow economy, the higher the total welfare.

How has the COVID-19 pandemic affected the shadow economy?

Well, the pandemic is a totally different story. In the pandemic, the shadow economy is zero. That's obvious, because if you lock people in their houses like we do it in Europe, people can’t conduct economic activity. But if you have a severe recession, the shadow economy starts to get very lively because everybody wants to earn some extra money since they lost a lot during the pandemic and the recession.

Alright, I'll ask one final question. What are the next directions for research in this field?

I am working more on micro data because I wanted to model individual decisions as to why people do or do not work in the shadow economy. At the macro level, we often choose to only model the obvious reason, a high tax burden, which secures a cut and dry result. But what happens if people know that other people work in a shadow economy, do we then have a multiplier effect? “Because the neighbors are doing it, should I do it? If I don’t do it, I pay taxes, and I am the fool; the others don't pay taxes.”

Also, how strong is people's belief as to how good or bad a government is? In the Scandinavian countries, people have very high trust in their government, and they are willing to pay much, much higher taxes, but on the other side, the goods and services they get from the government are tremendously good.

This is currently my type of research on the micro side, but I will always continue to do the macro estimates. This is an offensive word where I work, but I am thankful that we have actual figures for almost all countries across the world.

Cover photo: Domestic workers in Hong Kong take their break in front of the Salvatore Ferragamo store. Photo by istolethetv, CC-BY-2.0, accessed via Wikimedia Commons.

Kendrick Foster

Kendrick is an Executive Editor at the HIR, where he mainly works with the Interviews and Perspectives section. He mainly writes on Latin American diplomatic and environmental issues.