Fiscal Reform in Support of Trade Liberalization Fiscal Policy Reform: Principles and Trends

"Sizing" the Problem of the Hard-To-Tax

James Alm, Jorge Martinez-Vazquez, and Friedrich Schneider

AYSPS Conference: The Hard-to-Tax, An International Perspective (2003)

SIZING THE PROBLEM OF THE HARD-TO-TAX

James Alm*, Jorge Martinez-Vazquez**, and Friedrich Schneider***

January 2004

* Department of Economics, Andrew Young School of Policy Studies, Georgia State University, Atlanta, Georgia, USA ** Department of Economics, Andrew Young School of Policy Studies, Georgia State University, Atlanta, Georgia, USA *** Department of Economics, Johannes Kepler University of Linz, Austria

We are grateful to Laura Sour and other participants at the conference on The Hard-to-tax: An International Perspective for helpful comments and discussions. We are also grateful to Francisco Javier Arze and Edward Sennoga for their able assistance.

1. Introduction It is well accepted that most people do not like to pay taxes, and, because of this fundamental reason, it is hard for tax administrations to levy and collect taxes anywhere and any time. However, taxing certain kinds of activities, sectors, or individuals the so-called hard-totax (HTT) is an additional challenge for tax administrations in both developing and developed countries. In recent years, the policy emphasis in tax enforcement around the world has been on large taxpayers and also, but perhaps less so, on the rest of the formal sector. This approach has made sense because scarce resources for tax enforcement can be much more productive in the development of large taxpayer units. Although they represent a very small percentage of all taxpayers, large taxpayers typically account for two-thirds and upwards of all tax revenues. However, there has been growing policy interest in the hard-to-tax. Even aside from the collection of additional tax revenues from taxing the HTT, there are other important tangible effects that arise from taxing this group, such as an improvement in horizontal and vertical equity and an increase in economic efficiency. There are also significant intangible effects, including higher overall tax morale in the country. If there is a growing sense of the inability or unwillingness of tax authorities to catch tax evaders, the resulting unfairness of relative tax burdens could potentially lead over time to much lower tax yields than the lower tax yields due directly to the HTT. Although developed countries like France and Spain have recently been phasing out special tax regimes that had quite successfully been applied to the HTT, tax administrations in developing and transitional countries have started to give increasing scrutiny to the HTT, often out of an urgent need to increase overall revenues. There are clearly many unresolved issues surrounding the HTT, and it seems unlikely that the problems associated with the HTT are going to disappear any time soon. Indeed, with the steady advance of such processes as globalization,
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internet commerce, and capital mobility, it seems likely that the issues in taxing the hard-to-tax will become even more pressing. In this paper we analyze the hard-to-tax, asking the basic question: Why should the HTT matter to policy makers? In particular, we identify several areas in which we believe that the existence of the HTT may have significant economic effects, and we attempt to provide various informed, if only suggestive, estimates of the size of these impacts; that is, we focus on sizing the problem of the HTT. We begin in section 2 by attempting to identify both the HTT and the main parameters of the problem; included in this section is a discussion of how we measure the size of the HTT via estimates of the shadow economy. In section 3 we examine some of the fiscal impacts of the hard-to-tax, looking both at revenue collections and at the structure of tax systems. We explore in section 4 the impact of the HTT on the allocation of resources in the economy and on the process of economic development, and in section 5 we look at the impact of the HTT on equity and on the distribution of income. We conclude the paper with some implications for the design of tax policy design and for the administration and enforcement of tax policy.

2. Identifying the Hard-to-tax 2.1. Who Are the Hard-to-tax? All taxpayers are hard to tax in one way or another. However, there is a group of taxpayers that it is considerably more difficult to tax than the rest. Who are they and how do we identify them? No precise and widely accepted definition exists of the hard-to-tax., but there are various notions. As noted by Terkper (2003), these are taxpayers who often fail to register voluntarily. Even when they do register, they generally fail to keep appropriate records of their earnings and

costs, they often do not promptly file their tax returns, and they frequently tend to be tax delinquent. Das-Gupta (1994) attempts to develop a theory of the HTT groups based on the number of transactions involved in the derivation of income. Thus, while salaried employees derive income from a single transaction with their employers and find it hard to hide their income, professionals derive their income from multiple transactions with clients and find it easier to hide their incomes. In the context of the Allingham and Sandmo (1972) model of tax evasion, DasGupta (1994) argues that the penalties and taxes due decrease as the number of incomegenerating transactions increases. However, this approach fails to have general appeal because it is easy to find counterexamples of economic agents deriving income in multiple transactions (e.g., hotels, restaurants) that do not fall into the category of the HTT. Independently of the right definition or model, there is considerable consensus in the tax literature regarding the identity of the HTT. Musgrave (1990) identifies the HTT with smalland-medium-sized firms, professionals, and farmers.1 Similarly, Tanzi and Casanegra (1989) identify the HTT mainly with individual proprietorships, farmers, and professionals. There appears to be consensus also that the more sophisticated hard-to-tax activities, such as electronic commerce or multinational corporations with highly mobile capital and sophisticated transfer pricing activities, should not be considered part of the HTT. More recently, the HTT are often identified with small and medium-size taxpayers or firms, although quite clearly these are the same taxpayers traditionally identified as the HTT.2 What is interesting is that the HTT include taxpayers in both the informal and the formal sectors of the economy. In the informal sector, the hard-to-tax may include unregistered merchants and professionals who are involved in cash transactions or even barter. As Terkper
1

The term hard-to-tax appears at least as far back as the Musgrave Report for Colombia of 1971. We thank Victor Thuronyi for bringing this to our attention. 2 See Terkper (2003) and Engelschalk (2003). 4

(2003) points out, these individuals may have genuine difficulty in keeping even simple accounts, and may not be familiar with banking and other financial transactions. In the formal sector, the HTT may include professionals with college educations, as well as small manufacturing firms and commercial farms who are capable of keeping accounts and who often do so for purposes other than paying taxes. Thus both types of the HTT may or may not operate in a cash economy, and they may or may not be capable, but are always unwilling, to provide the tax authorities with relevant information that the tax authorities have a hard time extracting from them (Bird and Oldman, 1990). The idea of the HTT is related to several other important concepts, including the shadow economy and tax evasion. These two sets of issues have separately received considerable attention, and more is known about them than about the hard-to-tax. It seems evident that the entire problem of tax evasion is a much larger problem than the hard-to-tax. Many forms and types of tax evasion fall outside the purview of the HTT, such as evasion by large corporations and even by ordinary common taxpayers.3 However, in terms of their economic base, individuals in the hard-to-tax sector are likely to be similar to those who operate in the shadow economy. As defined by Schneider and Enste (2000), the shadow economy includes income unreported to the tax authorities that is generated from the production of legal goods and services, often by means of clandestine labor, involving monetary or barter transactions by agents that are not registered or do not pay taxes.4 This definition does not precisely match a strict definition of the HTT. For example, the HTT include individuals who eventually pay taxes either as a presumptive tax or by other means; such individuals generally
We do not discuss here other possible relationships and distinctions among these concepts. See Feinstein (1999) and Lippert and Walker (1997) for discussions of the relationship between tax evasion and the shadow economy. Lippert and Walker (1997), for example, argue that tax evasion more often involves financial transactions with the objective of concealing income, while the shadow economy more often involves the production of goods and services with labor and other inputs. 4 The boundary between the shadow economy and criminal activities is that in the latter both production and output are illegal while in the former only production is illegal (Thomas, 1992). The hard-to-tax excludes criminal activities. 5
3

will not be included in the measurement of the shadow economy. Also, there may be some forms of tax evasion that are included in the various measures of the shadow economy but that are not truly part of the hard-to-tax, though examples are not easy to find. Nevertheless, these various notions are clearly related, and we will exploit the overlap between the HTT and the shadow economy in much of what follows. It seems a plausible notion that there is a high correlation between the shadow economy and the HTT. If one accepts this notion, then we can try to quantify some of the impacts of the hard-to-tax on the economy. The proxy measure that we use for the size of the HTT sector are estimates of the shadow economy in different countries around the world, generated from the work of Schneider (2002) and Schneider and Enste (2002). The next subsection discusses our definition and presents these estimates.

2.2. Defining and Estimating the Shadow Economy Most authors trying to measure the shadow economy face the difficulty of how to define it. One commonly used working definition is all currently unregistered economic activities that contribute to the officially calculated and observed Gross National (or Domestic) Product.5 Smith (1994) defines it as market-based production of goods and services, whether legal or illegal that escapes detection in the official estimates of GDP. As these definitions still leave open a lot of questions, Table 1 is helpful for developing a better feel for what could be a reasonable consensus definition of the legal economy and the illegal underground (or shadow) economy. From Table 1, it becomes clear that the shadow economy includes unreported income from the production of legal goods and services, either from monetary or barter transactions, and so includes all economic activities that would generally be taxable were they reported to the state (tax) authorities. A more precise general definition seems quite difficult, if not impossible, as the
5

This definition is used, for example, by Frey and Pommerehne (1984), Feige (1989), and Schneider (1994). 6

shadow economy evolves over time, adjusting to taxes, enforcement changes, and general societal attitudes. Table 1: A Taxonomy of Types of Underground Economic Activities
Type of Activity Illegal Activities Monetary Transactions Trade with stolen goods; drug dealing and manufacturing; prostitution; gambling; smuggling and fraud Tax Evasion Tax Avoidance Employee Unreported income discounts, fringe from selfemployment. Wages, benefits salaries, and assets from unreported work related to legal services and goods Non Monetary Transactions Barter of drugs, stolen goods, smuggling, etc. Produce or grow drugs for own use. Theft for own use. Tax Evasion Tax Avoidance Barter of Do-it-yourself work legal services and neighbor help and goods

Legal Activities

Source: Lippert and Walker (1997), with additional remarks. Schneider (2002) and Schneider and Enste (2002) have used various methods and time periods to estimate the size of the shadow economy for single countries and groups of countries. These estimates are presented in Figures 1 to 5, and Table 2 summarizes the country estimates. A brief overview of the basic methods is given in Appendix A.6

Table 2. The Relative Size of the Shadow Economy, 1999/2000

Country Albania Algeria Argentina Armenia Australia Austria Azerbaijan Bangladesh Belarus Belgium Benin Bolivia Bosnia-Herzegovina
6

Shadow Economy as Percent of GNP 1999/2000 33.4 34.1 25.4 46.3 14.3 10.2 60.6 35.6 48.1 23.2 45.2 67.1 34.1

Country Guatemala Honduras Hong Kong, China Hungary India Indonesia Iran Ireland Israel Italy Jamaica Japan Jordan

Shadow Economy as Percent of GNP 1999/2000 51.5 49.6 16.6 25.1 23.1 19.4 18.9 15.8 21.9 27 36.4 11.3 19.4

See Schneider (2002) and Schneider and Enste (2002) for a detailed discussion of these methods and estimates. 7

Botswana Brazil Bulgaria Burkina Faso Cameroon Canada Chile China Colombia Costa Rica Cote d'Ivoire Croatia Czech Republic Denmark Dominican Republic Ecuador Egypt Ethiopia Finland France Georgia Germany Ghana Greece Panama Peru Philippines Poland Portugal Romania Russian Federation Saudi Arabia Senegal Singapore Slovak Republic Slovenia South Africa Spain Sri Lanka Sweden

33.4 39.8 36.9 38.4 32.8 16 19.8 13.1 39.1 26.2 39.9 33.4 19.1 18.2 32.1 34.4 35.1 40.3 18.3 15.3 67.3 16.3 38.4 28.6 64.1 59.9 43.4 27.6 22.6 34.4 46.1 18.4 43.2 13.1 18.9 27.1 28.4 22.6 44.6 19.1

Kazakhstan Kenya Republic of Korea Kyrgyz Republic Latvia Lebanon Lithuania Madagascar Malawi Malaysia Mali Mexico Moldova Mongolia Morocco Mozambique Nepal Netherlands New Zealand Nicaragua Niger Nigeria Norway Pakistan Taiwan, China Tanzania Thailand Tunisia Turkey Uganda Ukraine United Arab Emirates United Kingdom United States Uruguay Uzbekistan Venezuela Vietnam Yemen Yugoslavia

43.2 34.3 27.5 39.8 39.9 34.1 30.3 39.6 40.3 31.1 41 30.1 45.1 18.4 36.4 40.3 38.4 13 12.8 45.2 41.9 57.9 19.1 36.8 19.6 58.3 52.6 38.4 32.1 43.1 52.2 26.4 12.6 8.7 51.1 34.1 33.6 15.6 27.4 29.1

Switzerland Syria

8.8 19.3

Zambia Zimbabwe

48.9 59.4

Sources: Schneider (2002) and Schneider and Enste (2002). The physical input (electricity) method, the currency method, and the model (DYMIMIC) approach are used for the developing countries in Africa, Asia, and South America; the information is taken from Tables 2, 3, and 4 of Schneider (2002). The size of the shadow economy in transition countries is estimated using similar methods, and the information is taken from Table 5 of Schneider (2002). For all OECD countries except New Zealand, the size of the shadow economy is calculated using the currency demand method and taken from Table 8 of Schneider (2002); for New Zealand, the shadow economy is estimated using both the MIMIC-method and the currency demand approach.

The physical input (electricity) method, the currency demand, and the model (or DYMIMIC) approach are used for developing countries. The results are grouped for Africa, Asia, and Latin and South America, and are shown in Figures 1, 2, and 3. On average, the size of the shadow economy in Africa (Figure 1) was 41 percent of GNP for the year 1999/2000. Zimbabwe, Tanzania, and Nigeria (with 59.4, 58.3, and 57.9 percent, respectively) have by far the largest shadow economies; in the middle are Mozambique, Cote dIvoire, and Madagascar with 40.3, 39.9, and 39.6 percent; at the lower end are Botswana with 33.4 percent, Cameroon with 32.8 percent, and South Africa with 28.4 percent. The sizes of the shadow economies in Africa are typically quite large. The results for Asia are shown in Figure 2, recognizing that it is somewhat difficult to treat all Asian countries equally because Japan, Singapore and Hong Kong are highly developed states and the others are more or less developing countries. Thailand has by far the largest shadow economy in the year 1999/2000 with an estimated shadow economy of 52.6 percent of official GNP; Thailand is followed by Sri Lanka (44.6 percent) and the Philippines (43.4 percent). In the middle range are India with an estimated shadow economy of 23.1 percent of GNP, Israel with 21.9 percent, and Taiwan and China with 19.6 percent. At the lower end are Singapore (13.1 percent) and Japan (11.3 percent). On average Asian developing countries have a size of the shadow economy of 26 percent of official GNP for the year 1999/2000.

Figure 3 shows the results for 17 South and Latin America countries for 1999/2000. The average size of shadow economy of these 17 countries is 41.0 percent of official GNP. The largest shadow economy is in Bolivia with 67.1 percent, followed by Panama (64.1 percent), and Peru (59.9 percent); the smallest shadow economies are in Chile (19.8 percent) and Argentina (25.4 percent). Overall, the average sizes of the shadow economies of South and Latin America and of Africa are generally similar, and somewhat larger than in Asia. The shadow economies of transition countries have been estimated using the currency demand, the physical input, and the DYMIMIC approaches, and are shown in Figure 4. The average size of the shadow economy relative to official GNP is 38.0 percent for the year 1999/2000. Georgia has by far the largest shadow economy at 67.3 percent of GNP, followed by Azerbaijan with 60.6 percent and Ukraine with 52.2 percent. At the lower end are Hungary (25.1 percent), the Czech Republic (19.1 percent), and the Slovak Republic (18.9 percent). OECD countries typically have a smaller shadow economy than the other country groupings. European OECD countries are shown in Figure 5, and the remaining OECD countries (Australia, Canada, New Zealand, and the United States) are given in Figure 6. The average size of the 16 European OECD countries is 18.0 percent, while the average size for the remaining OECD countries is 13.5 percent. Table 3 gives some additional results for the evolution of the shadow economy over an extended time period (from 1989 to 2002) for these OECD countries. Aside from this information on OECD countries in Table 3, we have little information on how the problem of the hard-to-tax has evolved through time in any particular country. Schneider and Enste (2000) review several reasons to expect growth over time of the shadow economy, including the increasing burden of taxes and social security contributions and

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the increasing complexity of the tax systems and government regulations.7 All of these can also be seen as good reasons to expect growth in the HTT sector. The size of the HTT may also be expected to grow as economies evolve toward a higher relative importance of services (e,g., small business and individual entrepreneurs and professionals) and a lower relative importance of manufacturing with large businesses and employers. Of course, these are also good reasons for expecting further growth in the shadow economy.

This process can be more pronounced in some developing countries caught in a bad equilibrium (Johnson , Kaufman, and Zoido-Lobaton, 1998): high taxes and high regulatory burdens lead to increases in the shadow economy, which may lead to still higher taxes and higher regulations, and so on. 11

in % of GNP

Zi m
10.0 20.0 30.0 40.0 50.0 60.0 70.0 0.0 59.4 58.3 57.9 48.9 45.2 43.2 43.1 41.9

e Ta nz an ia N ig er ia Za m bi a Be ni n Se ne g al U

ba bw

12
N ig er M al i Et hi op ia M al aw M i oz am bi qu C e ot e d' Iv oi re M ad ag as Bu ca r rk in a Fa so G ha na Tu ni sia M Eg or oc yp co t, A ra b R ep . K en ya A lg er ia Bo ts w an a C am er oo So n ut h A fr ic a A V ER A G E

ga nd a

41.0 40.3 40.3 40.3 39.9 39.6 38.4 38.4 38.4 36.4 35.1 34.3 34.1 33.4 32.8 28.4 41

Figure 1. Africa - Shadow Economy as Perce nt of GNP, 1999/2000

in % of GNP 10.0 20.0 30.0 40.0 50.0 60.0 0.0 52.6 44.6 43.4 38.4 36.8 35.6 34.1 32.1 31.1 27.5 27.4 26.4 23.1 21.9 19.6 19.4 19.4

13
Ir an M o Sa ngo li u H o n di A a g ra K bi on a g, C hi na V ie tn am C hi n Si ng a ap or e Ja pa A V ER n A G E
11.3

Th ai la nd Sr iL a Ph nka ili pp in es N ep al Pa ki Ba sta n ng la de s Le h ba no n Tu rk ey M al ay K sia or ea ,R U ni ep te . d Y A e ra m b e Em n ir at es In di a Ta Is r iw an ael ,C hi na In do ne sia Jo rd an Sy ri a

19.3 18.9 18.4 18.4 16.6 15.6 13.1 13.1

Figure 2. Asia - Shadow Economy as Percent of GNP, 1999/2000

26

in % of GNP 10.0 67.1 20.0 30.0 40.0 50.0 60.0 70.0 80.0 0.0 64.1 59.9 51.5

Bo liv ia Pa na m a Pe

Figure 3. South America - Shadow Economy as Percent of GNP, 1999/2000

14

51.1

ru G ua te m al a U ru gu ay H on du ra s N ic ar ag ua
49.6 45.2

Br az il ol om bi a

39.8

Ja m

39.1

ai ca

36.4

34.4

Ec ua do V en r ez D u el om a, in R ic B an R ep ub lic M C os ta A rg e ex ic R nt C A

33.6

32.1

o
30.1

ic a
26.2

in a
25.4

V ER A

hi le G E

19.8

41

in % of GNP

10.0 67.3 60.6 52.2 48.1 46.3 46.1 45.1 43.2 39.9 39.8 36.9 34.4 34.1 34.1 33.4 33.4 30.3 29.1 27.6 27.1 25.1 19.1 18.9 38

20.0

30.0

40.0

50.0

60.0

70.0

80.0

0.0

Figure 4. Transition Countries - Shadow Economy as Percent of GNP, 1999/2000

15

G eo rg A ia ze rb ai ja n U kr ai ne Be la ru R s A us rm sia en n Fe ia de ra tio n M ol do K va az ak hs ta n K La yr gy t z R via ep ub li Bu c lg ar Bo ia R sn om ia -H an ia er ze go vi na U zb ek i st an A lb an ia C ro at ia Li th ua ni Y a ug os la vi a Po la nd Sl ov en ia H un C ze ga ch ry R Sl ep ov ub ak lic R ep ub A lic V ER A G E

in % of GNP 10.0 15.0 20.0 25.0 30.0 35.0 0.0 5.0

G re ec e
28.6

It al y
27.0

Be lg i um
23.2

Po rt u ga l

22.6

Sp ai n

Figure 5. OECD/West European Countries - Shadow Economy as Percent of GNP, 1999/2000

16
N or w ay Sw ed en Fi nl an d D en m G ar k er m an Ir y el an d N Fr an ce et he rl an U ds ni te d K in gd om A us tr ia Sw itz er la nd A V ER A G E

22.6

19.1

19.1

18.3

18.2

16.3

15.8

15.3

13.0

12.6

10.2

8.8

18

Figure 6. Other OECD Countries - Shadow Economy as Percent of GNP, 1999/2000 18.0 16.4 16.0 14.0 12.7 12.0 in % of GNP 10.0 8.0 6.0 4.0 2.0 0.0 Canada Australia New Zealand United States AVERAGE 15.3 13

8.8

17

Table 3. The Size of the Shadow Economy and its Evolution in OECD Countries Shadow Economy as Percent of GNP (Currency Demand Method) OECD Countries Average 1989/90 10.1 19.3 12.8 10.8 11.8 13.4 9.0 22.6 9.6 11.0 22.8 8.8 11.9 9.2 14.8 6.9 15.9 15.8 6.7 16.1 6.7 13.2 Average 1991/92 13.0 20.8 13.5 15.0 12.5 16.1 13.8 24.9 11.2 14.2 24.0 9.5 12.7 9.0 16.7 7.1 17.2 17.0 6.9 17.3 8.2 14.3 Average 1994/95 13.5 21.5 14.8 17.8 13.5 18.2 14.5 28.6 12.5 15.4 26.0 10.6 13.7 11.3 18.2 8.6 22.1 19.5 7.8 22.4 8.8 15.7 Average 1997/98 14.0 22.5 16.2 18.3 14.9 18.9 14.9 29.0 13.0 16.2 27.3 11.1 13.5 11.9 19.6 9.0 23.1 19.9 8.1 23.1 8.9 16.7 Average 1999/2000 14.3 22.2 16.0 18.0 16.0 18.1 15.2 28.7 12.7 15.9 27.1 11.2 13.1 12.8 19.1 9.8 22.7 19.2 8.6 22.7 8.7 16.8 Average 2001/2002 (Preliminary) 14.1 22.0 15.8 17.9 16.3 18.0 15.0 28.5 12.5 15.7 27.0 11.1 13.0 12.6 19.0 10.6 22.5 19.1 9.4 22.5 8.7 16.7

Australia Belgium Canada Denmark Germany Finland France Greece Great Britain Ireland Italy Japan Netherlands New Zealanda Norway Austria Portugal Sweden Switzerland Spainb United States Unweighted Average

Sources: Schneider and Enste (2002), Giles (1999), and Mauleon (1998). a The figures are calculated using the MIMIC-method and Currency Demand Approach (see Giles,1999). b The figures have been calculated for 1989/90, 1990/93, and 1994/95 from Mauleon (1998) and for 1997/98.

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2.3. Some Simple Correlations8 These estimates of the shadow economy are used in the rest of the paper as a proxy measure of the HTT, in order to size various aspects of the HTT. The relative importance of the HTT is likely to vary across countries and over time, and to vary according to some obvious determinants. A priori, the hard-to-tax should be expected to have a larger relative presence when there are more taxpayers unprepared to keep books of accounts and where the tax administration lack the means to help and also to audit those other taxpayers who can keep their accounts but refuse to keep them of disclose them to the authorities. Thus, the problem of the HTT is likely to decrease in importance with the level of economic development. This hypothesis receives some support from the simple correlation coefficient between our proxy for the hard-to-tax and gross domestic product (GDP) per capita in Table 4. The problem of the hard-to-tax could also be seen as becoming more serious when the public sector is trying to raise more taxes, exercising a higher tax effort. Perhaps surprisingly, however, this hypothesis is not supported by the correlation coefficient between the size of the HTT sector and tax effort in Table 4, although this result may reflect that the fact that tax effort is highly correlated with GDP per capita. For the same level of general economic development, as measured by GDP per capita, we would expect the size of the HTT sector to increase with the relative share of agriculture in GDP and decrease with the share in GDP of manufacturing.9 Although we are not controlling for the level of development, the positive correlation coefficient for the share of agriculture in Table 4 supports the notion of higher incidence of the hard-to-tax with a larger relative presence of agriculture. We would also expect the problem of the HTT to become more acute in societies with higher levels of corruption. We measure the latter through the CPI score from Amnesty International (see the data appendix), which relates to
Descriptive statistics for the data used to compute these correlations are given in Appendix B. Of course, we do not know precisely the relative predominance of the self-employed in developing and developed economies. Interestingly, the self-employed seem to be increasing in importance in mature economies.
9 8

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perceptions of the degree of corruption as seen by business people, risk analysts and the general public, and ranges between 10 (highly clean) and 0 (highly corrupt). This hypothesis is supported by the correlation coefficient in Table 4. Thus, the hard-to-tax and the shadow economy are highly complementary with corruption: a corrupt economy tends to be an economy with a larger HTT sector.

Table 4. Simple Correlation Coefficients between the Shadow Economy and Selected Variables Tax Manufacturing GDP per Agriculture/ Corruption Revenue/ Value Added/ Capita GDP Index GDP GDP Shadow Economy/GNP -0.50 -0.26 0.02 0.45 -0.60 Source: Calculations by authors.

3. The Impact of the Hard-to-tax on Revenues and Tax Structure The most immediate effect of the hard-to-tax is to reduce the revenue potential of any given tax structure. In addition, however, we argue in this section that it is likely that the presence of the HTT affects not only the level of tax effort and the effectiveness of tax administration but also the choice of tax structure. To our knowledge, there exists very limited direct information on the revenue losses implied by the HTT. For the United States, Kenadjian (1982) reports on the findings of a 1979 IRS study that estimated total unreported legal sector income of $74.9 billion in 1976, of which self-employment income was $33 billion; a considerable share of unreported self-employment income could be considered as belonging to the hard-to-tax group.10 Also, Terkper (2003) states that developing countries lose tax revenue in proportionally greater amounts than developed countries from the informal sector because small and medium traders (e.g., the hard-to-tax) tend to thrive in underground economies. He estimates that the tax losses could constitute as much as
10

In fact, the IRS definition of self-employment bears a significant resemblance to an operational definition of the hard-to-tax: self-employment income covers net earnings of farm and non-farm proprietorships and partnerships (at times referred to as unincorporated business income) as well as net earnings of self-employed individuals working outside the context of regularly established businesses in the legal sector (Kenadjian, 1982).

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35 to 55 percent of GDP. As discussed below, our calculations lend some credence to Terkpers (2003) conjectures. There are at least two possible ways that we can examine the impact of the HTT on tax revenues. First, we can explore how the presence of the HTT affects the overall tax effort in any country. There is a quite extensive literature on the determination of tax effort, as well as its limitations (Bahl, 1971; Bird, 1980). Despite these limitations, our hypothesis is that a greater presence of the HTT will reduce the tax effort in any country. The regressions in Table 5 explore the effects of the relative size of the HTT on tax effort, defined as total tax revenues in 2000 divided by gross national produce (GNP) for the same year. We follow the literature on tax effort in our specification of different models. We include as one control variable GDP per capita, and we interact the relative size of the HTT with GDP per capita to allow for a decreasing impact of the hard-to-tax as the level of development increases. In Model 1, we also introduce a group of variables that account for the existence of particular tax handles or that represent features of the economy that may facilitate tax collections (e.g., the share of mining in GDP) or impede tax collections (e.g., the share of agriculture in GDP). Because of the lack of data on these two variables, the number of usable observations becomes quite small. Therefore, we run another equation (Model 2) without some of the control variables but with more observations. The estimation results are reported in Table 5, and are, of course, only suggestive. The impact of the HTT on tax effort in Table 5 is consistent across both models. As conjectured, the intensity of the HTT reduces overall tax effort for a sample of developed and developing countries in 2000. However, the impact of the hard-to-tax on effort gets dampened with increases in the level of economic development. Table 5. Determinants of Tax Effort a Independent Variable GDP per Capita 21

Model 1 -0.02

Model 2 -0.01

Shadow Economy/GNP (Shadow Economy/GNP) X GDP per Capita Taxes on Internal Trade/GDP Agriculture/GDP Mining/GDP Constant Observations R-squared
a

(-3.58) -0.40 (-2.06) .0001 (3.53) -2E-05 (-0.55) -0.001 (-0.72) 0.003 (2.02) 0.32 (4.37) 15 0.83

(-2.69) -0.23 (-2.59) 9.17E-05 (3.42) -1.1E-05 (-0.46) ----0.24 (5.94) 41 0.34

The dependent variable is total tax revenue divided by GNP in year 2000. White corrected tstatistics are in parentheses. The equations are estimated by OLS methods. Source: Calculations by authors.

The second approach to examining the impact of the hard-to-tax on tax revenues is to estimate directly the revenue losses induced by this group. To do this, we continue to make use of the assumption that the tax base of the HTT can be approximated by the size of the shadow economy, and we also assume that the effective average tax rate in the formal (non-shadow) economy is also the effective average tax rate that would apply to the hard-to-tax. Both assumptions are open to question, and so our approach is only suggestive. Indeed, our estimates of the revenue loss from the HTT seem likely to be upper-boundary estimates, for several reasons. First, the actual size of the hard-to-tax may be smaller than the underground economy. Second, the effective average tax rate that would apply to the HTT is likely to be lower than that of the regular formal economy. Table 6 shows the summary statistics for the losses in revenues from the hard-to-tax for two groups of developing and developed countries, with the losses in revenues expressed as a percentage of potential tax revenues (calculated as actual tax revenues plus losses in revenues). Revenue losses from the HTT tend to be considerably higher (in relative terms) in developing countries than in developed countries; they also tend to show higher dispersion in developing 22

countries. The estimates of losses can represent up to 40 percent of total potential revenues in developing countries.

Table 6. Ratio of Revenue Loss from the Hard-to-tax to Potential Tax Revenue Sample Observations Developing 57 Industrialized 19 Whole World 76
Source: Calculations by authors.

Mean 0.25 0.15 0.22

Standard Deviation 0.07 0.05 0.07

Minimum 0.11 0.08 0.08

Maximum 0.40 0.22 0.40

Figures 7 and 8 show the plots of the estimates of relative revenue losses versus GDP per capita, for developing countries (Figure 7) and for developed countries (Figure 8). Although there is a high level of dispersion, clearly there is a tendency in both developing and industrialized countries for relative revenue losses to become smaller with the level of development. This result tends to support the perception that the HTT problem is more serious in developing than in developed economies.

Figure 7

23

Developing Countries
("Developing Countries" corresponds to High Income classification of World Bank indicators (2002), with per capita GDP of $9,265 or less) 0.45

0.40

Ratio Loss Revenue to Tax Revenue

0.35 0.30 0.25 0.20 0.15 0.10 0.05 0.00

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

GDP per Capita

(Constant 1995 US$)

Figure 8
Industrialized Countries
("Industrialized Countries" correponds to High Income classification of World Bank indicators (2002), with per capita GDP $9,266 or more)

0.25

Ratio Loss Revenue to Tax Revenue

0.20

0.15

0.10

0.05

0.00

10,000

20,000

30,000

40,000

50,000

GDP per Capita

(Constant 1995 US$)

24

Consider now the impact the hard-to-tax on the structure of the tax system itself. Shoup (1990), among others, points out the constraints imposed by economic structure, administrative capabilities, and taxpayer voluntary compliance on the choice of tax structure. Clearly, a higher presence of the HTT in developing countries and also in developed countries may constrain the optimal choice of the tax mix. A heavy presence of the HTT leaves less room for sophisticated taxes requiring more reporting by taxpayers and more complex auditing by tax administrators. Thus, we hypothesize that a larger hard-to-tax sector should be associated with more reliance on indirect taxes (especially excises), on taxes on international trade, and on natural resource extraction.11 Before we examine some preliminary evidence on this hypothesis, it is important to note that we might also expect to find a reverse causality between the impact of the tax mix on the hard-to-tax and the shadow economy in general. For example, Brou and Collins (2001) study the impact of the tax mix on the informal economy in a general equilibrium model, and they conclude that direct taxation is a better instrument to raise revenues when government is concerned with controlling the growth of the informal sector.12 They also blame recent policy changes favoring indirect taxation for the rapid growth internationally of the informal economy. We look here at some preliminary evidence on the hypothesis that a more significant presence of the hard-to-tax leads countries to rely more heavily on indirect and simplified methods of taxation. Empirically, we find no evidence of simultaneity between the hard-to-tax and tax structure. We can approximate the tax mix in a variety of ways. Five possible measures, or dependent variables, are:

See Boadway et al. (1994) for an analysis of the impact of tax evasion on the direct-indirect tax mix. They show that a tax mix is favorable to other methods of taxation when individuals are able to evade certain taxes. 12 With direct taxation, Brou and Collins (2001) argue that lower taxes on labor than on capital will help shrink the labor-intensive informal sector.

11

25

Ratio of Direct Taxes to Indirect Taxes: Taxes on Income, Profit, and Capital Gains Dependent 1 = (Domestic Taxes on Goods and Services + Taxes on International Trade) Ratio of Direct Taxes to Indirect Domestic Taxes: Taxes on Income, Profit, and Capital Gains Dependent 2 = Domestic Taxes on Goods and Services Ratio of Special Taxes to Total Tax Revenue: (Excises + Taxes on International Trade) Dependent 3 = Total Tax Revenue Ratio of Direct Taxes to Total Tax Revenue: Taxes on Income, Profit, and Capital Gains Dependent 4 = Total Tax Revenue Ratio of Domestic Taxes on Goods and Services to Total Tax Revenue: Domestic Taxes on Goods and Services Dependent 5 = Total Tax Revenue

Table 7 shows the results of simple OLS regressions explaining the variation across the sample of countries in tax mix, measured in the above five possible ways; independent variables include the relative size of the HTT sector (measured by the share of the shadow economy in GDP), as well as several control variables, including GDP per capita, the share of the manufacturing sector in GDP, and the openness of the economy. The results in Table 7 are generally supportive of the hypothesis that, after controlling for the level of economic development and other factors, a larger HTT sector leads to a heavier reliance on indirect taxation. As expected, the coefficient for the shadow economy is negative and statistically significant for dependent variables 1, 2, and 4, and positive and significant for variable 5. Note that the shadow economy coefficient for dependent variable 3 is negative, opposite of what was expected, but it is not statistically significant. The HTT and, more generally, the shadow economy should be much harder to reach through direct taxation, with the personal identification of taxpayers and so on, than trough indirect taxation. Not surprisingly,

26

the openness of the economy also leads to a heavier reliance on indirect taxation. It is, however, surprising that higher levels of GDP per capita seem to lead to greater reliance on indirect taxation. To test for the potential simultaneity of the HTT sector and tax structure we run a Hausman Chi-square test with corruption as an instrument for the HTT, and fail to detect any presence of simultaneity.
Table 7. Shadow Economy Effects on Tax Composition (2000)a
Explanatory Variable Dependent 1 Dependent 2 Dependent 3 Dependent 4 Dependent 5 0.21 -0.02 -0.02 0.001 0.005 GDP per Capita (0.92) (-1.55 (2.36) (0.29) (3.08) Shadow Economy -1.48 -2.71 -0.04 -0.34 0.41 /GNP (-2.34) (-1.85) (-0.24) (-2.15) (2.94) Manufacturing Valued -0.01 -0.05 -0.002 -0.001 -0.005 Added/GDP (-0.51) (-0.81) (-0.56) (-0.30) (-1.17) -0.004 -0.006 -0.001 -0.002 0.001 Openness (-2.04) (-1.62) (-1.56) (-2.41) (1.55) 1.72 3.38 0.44 0.52 0.29 Constant (2.03) (1.70) (3.46) (3.96) (2.61) Observations 41 42 38 43 42 R-squared 0.11 0.10 0.24 0.21 0.19 a White corrected t-statistics for the OLS regressions are in parentheses. Source: Calculations by authors.

4. The Impact of the Hard-to-tax on the Efficiency of Resource Allocation 4.1. The Nature of the Efficiency Effects of the Hard-to-Tax

The presence of the hard-to-tax is likely to distort the allocation of economic resources in the economy. It is also quite likely that a wider presence of the HTT may impede development. Das-Gupta (1994) identifies several types of inefficiencies associated with the HTT. First, the use of cash, barter, and other less efficient means of payments among the HTT should lead to excess burdens. Second, there may be losses in economies of scale if the hard-to-tax utilize many smaller transactions as opposed to larger ones in order to avoid detection. Third,

27

there may be a larger-than-optimal allocation of labor and other resources in the hard-to-tax sectors due to the differential tax burdens.13 This last type of inefficiency is similar to that identified by Alm (1986) in the context of the shadow economy. The existence of a sector to which resources may move in order to evade taxation means that taxes drive a wedge between the returns to factors in different sectors. For example, if factors of production are mobile between taxed and untaxed activities, then they will move between these sectors until the net-of-tax return in the taxed sector equals the return in the untaxed sector. However, the gross-of-tax return to a factor measures the social productivity of the factor, and the gross-of-tax return will be higher in the taxed sector by the amount of the tax. Consequently, a tax on a factor in only some of its uses encourages overallocation of factors to untaxed activities and so generates an excess burden. A similar source of potential inefficiency is discussed by Palda (1998), also in the context of the shadow economy. In the presence of different abilities to enter the shadow economy (or the HTT sector in our case), markets will tend to select producers for both their ability to evade and their ability to have low costs of production. An excess burden arises when efficient firms are crowded out by inefficient firms with greater ability to evade taxes. There are also other possible sources of inefficiencies that arise from the existence of tax evasion (Martinez-Vazquez, 1996) and that might also be relevant in the presence of the hard-totax. One might be termed the anxiety costs of tax evasion, or the loss in utility suffered by risk-averse individuals engaged in tax evasion activities (Yitzhaki, 1987). There are also out-ofpocket costs that often accompany tax evasion. These include such costs as the expenses incurred by taxpayers to cover their evasion (including payments to tax professionals and bribes

13

Das-Gupta raises the important point that there will be this type of inefficiency only if decisions on the allocation of resources are affected by tax evasion opportunities. For example, Marelli (1984) and Yaniv (1988) show that in the presence of certain tax and enforcement regimes, risk-averse firms do not change their resource allocation decisions when there is a possibility of evading taxes, provided that it is optimal for the firms to pay some tax.

28

to tax officials), the costs borne by the tax agency in its enforcement activities, and costs imposed on other taxpayers who must comply with stricter information and disclosure requirements. If tax evasion and the accompanying revenue loss prompt the government to increase tax rates on other taxes to offset the revenue loss, then these rate increases generate additional excess burdens; on the other hand, if the government responds by reducing government services, then there is a welfare loss from the diversion of resources from the public sector. Finally, there may well be a cost that arises because cheating imposes a negative externality on others in the form of unhappiness that some are not paying their fair share of taxes. This externality can exist independently of any loss of tax revenues from tax evasion. Of course, there can also be efficiency gains, and there are plausible reasons to expect the various inefficiencies to be dampened and even reversed. For example, Schneider and Enste (2000) note that in the shadow economy the small scale of services and manufacturing may contribute to more dynamic entrepreneurship, more competition, and greater limits on government encroachment and regulations. All these factors can be growth enhancing. Bahl and Martinez-Vazquez (1992) make a similar argument for tax evasion. With highly inefficient and corrupt governments, the presence of tax evasion may lead to higher growth and development by leaving more funds in a potentially more efficient private sector. Put differently, the presence of a hard-to-tax sector suggests that there are what might be considered static excess burdens as resources are misallocated at a point in time, as well as dynamic effects on efficiency due to the accumulation of these static effects over time. It is therefore useful to focus our analysis on these static and dynamic effects. In the next subsection, we estimate one component of the static misallocations of the HTT for a stylized economy, and in the following subsection we present preliminary evidence on the dynamic impact of the HTT on economic growth.

29

4.2. Measuring the Static Excess Burden of the Hard-to-tax

One component of the excess burden of the HTT the misallocation of factors between sectors because of differential taxation can be measured using an extension of the general equilibrium model of tax incidence pioneered by Harberger (1962). This model can also be used to measure some aspects of the incidence of the HTT, as discussed in Section Five below. Let a typical stylized economy be divided into three sectors: a fully taxed sector that produces output X, a sector Y that is legally exempt from taxation, and a hard-to-tax sector Z that is legally subject to taxation but that escapes taxation because activities there are hard-to-tax. Demand for each output is a function of relative prices, and all agents (including government) are assumed for simplicity to have the same average and marginal propensity to consume each commodity. Each good is produced under competitive conditions with a linearly homogeneous production function that depends upon the amount of capital (K) and labor (L). Capital and labor are assumed to be fixed in supply; they are also assumed to be perfectly mobile among sectors. Because of perfect mobility, net factor returns must be equalized across sectors, where factor returns are assumed to be adjusted for the presence of any risk premia that may exist in the untaxed sectors. All physical units are chosen such that initial prices are unity. Since capital and labor in sectors Y and Z are assumed to be untaxed, there are only two taxes: a tax on capital (TK) and a tax on labor (TL) in the taxed sector X.14 As discussed above, the taxation of capital and labor in only some its uses creates an incentive for resources to flow from the taxed sector (X) to the untaxed sectors (Y and Z). This movement has both allocative and distributional effects. The allocative effects are the focus here; the distributional effects are discussed in section 5. The full set of equations for this stylized economy is in Appendix C.

The only other tax that might be imposed is a tax on consumption of X (or TX), and this tax is equivalent to an equal-rate tax on capital and labor in X.

14

30

Measuring the excess burden of taxation then requires knowledge of the responses of KX and LX to the various taxes. This information is contained in the reduced form solutions for these variables. To illustrate, consider the tax on capital in sector X, or TK. In the absence of the tax, factor mobility will assure that the equilibrium price of capital will be the same in both sectors. In the presence of the tax, however, capital will move from sector X until the gross-of-tax price of capital in X exceeds the price of capital in Y and in Z by the amount of the tax. Capital thus moves from higher productivity uses in the formal sector to lower valued uses in the informal sector. The excess burden of this single tax on capital in sector X is measured by the usual welfare "triangle" of (-1/2 TKKX). When there are also taxes on labor in X, the combined excess burden becomes (-1/2TKKX - 1/2TLLX ). Here, KX and LX represent the changes in factors that result from both taxes simultaneously. Estimation of the excess burden therefore requires knowledge of these total factor responses. Assuming that the relevant derivatives are constant, it is straightforward to show that the excess burden EB is measured by: EB = -1/2 TK [(MKX/MTK)TK + (MKX/MTL)TL] -1/2 TL [(MLX/MTK)TK + (MLX/MTL)TL], where, for example, MKX/MTK is the partial derivative of KX with respect to TK. These partial derivatives allow for all general equilibrium adjustments in production and in demand, and so may be viewed as "reduced form" coefficients that show the equilibrium responses of capital and labor in the taxed sector to changes in the taxes. Because the solution of the system of equations ^ ^ gives KX and LX as a function of the two taxes (and the other parameters of the system), these partial derivatives can be directly calculated, given estimates of the amounts and the shares of capital and labor in the three sectors, the taxes on the factors in the taxed sector, and the various elasticities of demand and of substitution. These estimates are based upon a highly stylized version of a developing country.

31

Using dollars as the unit of currency for purposes of discussion, the size of sector X is assumed to equal $75, and this also equals the sum of the gross-of-tax income of capital and labor in the sector. Similarly, sector Y is assumed to equal $25; the legally untaxed sector Y is therefore 1/3 the size of the taxed sector. The amounts paid gross-of-tax to K and L in the taxed sector are assumed to equal $20 and $55, respectively, so that the shares of capital and labor in sector X (denoted fK and fL ) are assumed to equal fK =0.2667 and fL =0.7333. The amounts paid to K and L in sector Y are assumed to equal $5 and $20, respectively. The factors shares in sector Y (gK, gL) are therefore gK =0.2 and gL =0.8. Recall that units are chosen so that one unit of a factor is the amount that earns $1 net of taxes. Because capital and labor in sector Y are not taxed, there are 5 units of capital and 20 units of labor in the sector. For sector X, the number of units depends on the burden of taxation. We assume that total taxes equal 25 percent of output in sectors X and Y, with $8 of taxes coming from capital in sector X and $17 coming from labor in X. Because units of capital and labor are chosen so that one unit of a factor is the amount that earns $1 unit net of all taxes, there are 12 (=20-8) units of capital in X and 38 (=55-17) units of labor. This procedure also generates estimates of the tax rate on capital and labor. The tax rate is calculated by dividing the total taxes borne by the factor by its net-of-tax income. The tax rate on capital in sector X is 0.6667 (=$8/($12), while the tax rate on labor is 0.4474 (=$17/$38). Capital and labor in sector Y are untaxed.15 As for the hard-to-tax sector, we make two alternative assumptions about its size. We assume that sector Z equals either 25 percent of formal sector (X+Y) output, or $25, or that it equals 50 percent ($50) of formal sector output. In either case, we assume that this sector is highly labor-intensive, with factor shares for labor (hL) and capital (hK) of hL =0.9 and hK =0.1, respectively; the amounts of labor and capital therefore equal (22.5, 2.5) and (45, 5) in the two
15

See Harberger (1962) or Alm (1986) for more discussion of this procedure.

32

alternative scenarios. As discussed below, sensitivity analysis indicates that the excess burden estimates do not vary substantially with variations in the size of the sector. We assume various combinations of the elasticities of substitution between capital and labor (or si, i=X,Y,Z), from 0 to -1/2 to -1. As for the compensated elasticities of demand, we assume that the own-elasticities (EXX, EYY, EZZ) are equal to each other, and that the crosselasticities of demand of Y and Z with respect to the price of the taxed good X are equal to one another. Together with the requirement of symmetry in compensated responses, these assumptions imply that choosing a value for EXX determines the values of the other elasticities. We assume that EXX equals -1/2 or -1. As discussed below, variations in the elasticities of demand and of substitution have a more significant impact on the welfare cost estimates. Table 7 presents some estimates of the excess burden in this stylized economy, under a variety of alternative assumptions. The excess burden is expressed as a percent of tax revenues and as a percent of formal sector output. In all cases, the existence of a hard-to-tax sector, in combination with a legally untaxed sector, generates a large excess burden, somewhere between 11 and 27 percent of taxes and between 3 and 7 percent of formal sectors output. These estimates are especially sensitive to the compensated elasticity of demand (EXX). They are also somewhat sensitive to the various elasticities of substitution in production. They do not depend significantly on the assumption regarding the size of the HTT sector.

Table 8. Estimates of Static Excess Burden from the Hard-to-tax Hard-to-tax Sector Excess Burden Equals 25% of Formal Sectors As Percent of As Percent of Formal Taxes Sector Output sX sY sZ EXX -1/2 0 0 -1/2 11.1% 2.8% -1/2 0 0 -1 22.5 5.6 -1 0 0 -1/2 11.9 3.0 -1 0 0 -1 23.7 5.9 -1/2 -1/2 -1/2 -1/2 11.5 2.9 -1/2 -1/2 -1/2 -1 22.8 5.7 -1 -1/2 -1/2 -1/2 12.3 3.1

33

-1 -1/2 -1/2 -1 -1

-1/2 -1 -1 -1 -1

-1/2 -1 -1 -1 -1

-1 -1/2 -1 -1/2 -1

24.7 11.8 23.2 13.3 26.1

6.2 3.0 5.8 3.3 6.5

sX -1/2 -1/2 -1 -1 -1/2 -1/2 -1 -1 -1/2 -1/2 -1 -1

Hard-to-tax sector Equals 50% of Formal Sectors sY sZ EXX 0 0 -1/2 0 0 -1 0 0 -1/2 0 0 -1 -1/2 -1/2 -1/2 -1/2 -1/2 -1 -1/2 -1/2 -1/2 -1/2 -1/2 -1 -1 -1 -1/2 -1 -1 -1 -1 -1 -1/2 -1 -1 -1

Excess Burden As Percent of As Percent of Formal Taxes Sector Output 11.5% 2.9% 22.9 5.7 12.3 3.1 24.2 6.1 11.9 3.0 23.4 5.9 12.8 3.2 25.3 6.3 12.4 3.1 23.9 6.0 13.8 3.5 26.9 6.7

Source: Calculations by authors.

It should also be remembered that there are many other sources of inefficiencies, as well as possible efficiencies, from the HTT sector. The overall effects of the HTT on dynamic efficiency, as measured by economic growth, are discussed next.

4.3. Estimating the Dynamic Impact of the Hard-to-tax on Economic Growth

There are a several channels by which the existence of the hard-to-tax may affect positively or negatively economic growth. Generally, the view prevails that the informal sector/the shadow economy influences the tax system and its structure, the efficiency of resource allocation between sectors, and the official economy as a whole in a dynamic sense. In order to study the effects of the shadow economy on the official one, several studies integrate underground economies into theoretical or empirical macroeconomic models.16 For example,

See also Schneider, Hofreither, and Neck (1989), Neck, Hofreither, and Schneider (1989), Quirk (1996), and Giles (1999).

16

34

Houston (1987) develops a theoretical business cycle model in which there are tax and monetary policy linkages with the shadow economy, and concludes that the existence of a shadow economy could lead to an overstatement of the inflationary effects of fiscal or monetary stimulus. In an empirical study for Belgium, Adam and Ginsburgh (1985) focus on the implications of the shadow economy on official growth, and find a positive relationship between the growth of the shadow economy and the official economy under certain assumptions (e.g., very low entry costs into the shadow economy due to a low probability of enforcement). They conclude that an expansionary fiscal policy is a positive stimulus for both the formal and informal economies. Another hypothesis is that a substantial reduction of the shadow economy leads to a significant increase in tax revenues and therefore to a greater quantity and quality of public goods and services, which ultimately can stimulate economic growth. Some authors found evidence for this hypothesis. Loayza (1996) presents a simple macroeconomic endogenous growth model in which the production technology depends on congestable public services and in which excessive taxes and regulations are imposed by governments unable to enforce fully compliance. He concludes that an increase in the relative size of the informal economy reduces economic growth in economies where the statutory tax burden is larger than the optimal tax burden and where the enforcement is weak. Loayza (1996) also finds empirical evidence for Latin America countries that an increase in the shadow economy by one percentage point (of GDP) reduces the growth rate of official real GDP per capita by 1.22 percentage points. However, this negative impact of informal sector activities on economic growth is not broadly accepted (Asea, 1996). For example, the Loayza (1996) model is based on the assumptions that the production technology depends on tax-financed public services that are subject to congestion and that the informal sector does not pay taxes but must pay penalties that are not used to finance public services. The negative correlation between the size of the informal 35

sector and economic growth is therefore not very surprising. Further, in the neoclassical view the underground economy is optimal in the sense that it responds to the economic environment's demand for urban services and small-scale manufacturing. From this point of view the informal sector provides the economy with a dynamic and entrepreneurial spirit, and can lead to more competition, higher efficiency, and stronger boundaries and limits for government activities. Put differently, the informal sector may help create markets, increase financial resources, enhance entrepreneurship, and transform the legal, social, and economic institutions necessary for accumulation (Asea, 1996). The voluntary self-selection between the formal and informal sectors may provide a higher potential for economic growth and hence a positive correlation between the informal sector and economic growth. The effects of an increase of the shadow economy on economic growth therefore remain ambiguous. Accordingly, we test empirically the impact of the size of the shadow economy upon economic growth. We construct a panel data set for 109 developing, transition, and OECD countries for the time period from 1990 to 2000 to estimate the possible effects of the shadow economy on the official one. Our panel dataset consists of variables that growth theory suggests are relevant for economic growth (Barro et al., 1995; Breton, 2001). The data set includes such explanatory variables as the size of the shadow economy (as a percent of GNP), capital accumulation, labor force and population growth rates, the inflation rate, openness, foreign direct investment, the corruption index, government expenditures, and GDP per capita, in order to estimate the relationship between economic growth, the shadow economy, and other possible factors. We estimate a basic equation for the entire sample of 109 developing and developed countries and variants on this basic equation for the two separate subsamples of 21 OECD countries and 75 developing and transition countries.17 In all regressions, the dependent variable

17

Note that our basic model unavoidably excludes some variables included in the growth literature, such as research and development expenditures, patent information, or school enrollment information. Some variables were not

36

is the average annual growth rate in per capita GDP over the 1990 to 2000 period. Appendix D contains a description of the countries and our variables. Putting all possible variables for all possible countries into the estimating equation did not deliver satisfying results, since many conventionally important variables were insignificant. For example, the labor force growth rate has no influence on the GNP growth rate despite the fact that theory suggests a positive relationship between labor force growth and economic growth (Breton, 2001); similarly, neither the corruption index nor foreign direct investment had a statistically significant impact on annual GNP growth. Accordingly, we followed a testing down procedure to address possible misspecification.18 Tables 9, 10, and 11 present our final specifications and results for the different samples of countries. The results for entire sample of 109 developing, transition, and industrialized countries are given in Table 9. This regression clearly shows a highly interesting and statistically significant negative relationship between the shadow economy of developing countries and the official rate of economic growth, and a statistically significant positive relationship between the shadow economy in industrialized countries and economic growth. If the shadow economy in industrialized countries increases by 1 percentage point of GDP (e.g., the shadow economy increases from 10 to 11 percent of official GDP), then official growth increases by 7.7 percent; in contrast, for developing countries an increase in the shadow economy by 1 percentage point of official GDP is associated with a decrease in the official growth rate of GDP by 4.9 percent. Also, all other variables (except the inflation rate in other countries) have a statistically significant influence on growth. For example, the more open a country the higher is official growth. If the inflation rate in developing countries increases by 1 percent, then official growth

available at all, but many variables were available only for a small number of countries. Consequently, many observations would have been lost if we had tried to include all relevant explanatory variables. 18 The testing down procedure means that step-by-step insignificant variables are dropped from the equation after carrying out F-tests on joint significance. See Wooldridge (2000, pp. 139-150) for additional discussion.

37

decreases by 2.1 percent. Similarly, an increase in the state sector by 1 percent is associated with a decrease in growth by 1.8 percent. On the other hand, an increase in total population by 10 million leads to an increase in official GDP growth by 0.36 percent.

Table 9. Growth Estimation Results 109 Countries Independent Variable

Estimated Coefficient (Standard Error) 0.077 (2.63)** -0.052 (2.37)** 0.012 (2.14)** 0.023 (1.32) -0.021 (4.10)** -0.181 (3.23)** 0.154 (3.06)** 0.000036 (2.07)** 0.019 (1.88)* 0.062 (4.13)** 109

Shadow Economy Industrialized Countries Shadow Economy Developing Countries Openness Inflation Rate Other Countries Inflation Rate Transition Countries Government Consumption Lagged Annual GDP per capita Growth Rate Total Population Capital Accumulation Rate Constant

Number of countries

Overall R-Squared 0.347 Within R-Squared 0.266 Between R-Squared 0.417 Wald-CHI 94.63 (0.000) The regression is a random effects GLS regression, with the dependent variable the annual growth rate in GDP per capita over the period 1990 to 2000. The absolute value of z-statistics is in parentheses, where * denotes significance at 10% and ** denotes significance at 5%. Source: Calculations by authors.

In general these results clearly show a statistically significant negative impact of the shadow economy of developing countries on the growth rate of the official economy and a positive influence of the shadow economy on the growth rate of industrialized countries. Other 38

variables have plausible signs and are generally statistically significant at usual levels. When we focus more narrowly on OECD countries only, we find similar results. The 21 OECD countries are Australia, Belgium, Canada, Denmark, Germany, Finland, France, Greece, Great Britain, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Austria, Portugal, Sweden, Switzerland, Spain, and the U.S. As before, we estimate a time series regression with the official annual growth rate of GDP per capita of the period over the 1990 to 2000 period as the dependent variable. Table 10 presents the estimation results. Again, the shadow economy has a positive and statistically significant influence on the official growth rate of GDP per capita. An increase in the shadow economy by 1 percentage point of official GDP is associated with an increase in the annual growth rate of 7.8 percent. These results also show a negative trend for the growth rate of the OECD countries, reflective of overall economic performance of OECD countries during 1990s. In addition, increases in the capital accumulation rate, in foreign direct investment, and in the annual labor force growth rate are associated with an increase in official economic growth.

Table 10. Growth Estimation Results OECD Countries Independent Variable

Estimated Coefficient (Standard Error) -0.003 (3.36)** 0.078 (2.05)** 0.016 (2.47)** 0.127 (3.47)** 0.004 (2.49)** 0.951 (2.44)** 6.206 (3.36)** 21

Trend Variable Shadow Economy Openness Capital Accumulation Rate Annual FDI Growth Rate Annual Labor Force Growth Rate Constant

Number of countries

39

Overall R-Squared 0.370 Within R-Squared 0.213 Between R-Squared 0.716 Wald-Chi 51.10 (0.000) The regression is a random effects GLS regression, with the dependent variable the annual growth rate in GDP per capita over the period 1990 to 2000. The absolute value of z-statistics is in parentheses, where * denotes significance at 10% and ** denotes significance at 5%. Source: Calculations by authors.

Economic growth of highly industrialized countries may be quite different than that of developing and transition countries, and the explanatory factors that influence the growth rate may also be quite different. Accordingly, we present in Table 11 estimation results with only 75 developing and transition countries. Table 11 reveals a statistically significant positive influence of the shadow economy of transition countries and a statistically significant negative influence of the shadow economy on developing countries. In particular, an increase of 1 percent in the relative size of the shadow economy in transition countries increases official economic growth of transition countries by 9.9 percent, and decreases growth in developing countries by 4.5 percent. As for other variables, the inflation rate in transition countries has a negative and statistically significant influence on per capita GDP growth, as does government consumption. Lagged annual GPD per capita growth has a large positive and statistically significant influence, and total population also has a positive (though small) positive impact on growth. Capital accumulation and foreign direct investment (lagged) are not statistically significant.

Table 11. Growth Estimation Results 75 Developing and Transition Countries Independent Variable Estimated Coefficient (Standard Error) Shadow Economy Transition Countries Shadow Economy Developing Countries 0.099** (3.80) -0.045** (-2.36)

40

FDI (lagged) Inflation Rate Other Countries Inflation Rate Transition Countries Government Consumption Annual GDP per capita Growth Rate (lagged) Total Population Capital Accumulation Rate Constant

0.00049 (0.05) 0.0263 (1.28) -0.021** (-3.69) -0.184** (3.25) 0.154** (3.06) 0.000036* (1.80) 0.015 (1.42) 0.067** (5.00) 75

Number of countries

Overall R-Squared 0.3211 Within R-Squared 0.263 Between R-Squared 0.443 Wald-CHI 73.89 (0.000) The regression is a random effects GLS regression, with the dependent variable the annual growth rate in GDP per capita over the period 1990 to 2000. The absolute value of z-statistics is in parentheses, where * denotes significance at 10% and ** denotes significance at 5%. Source: Calculations by authors.

In summary, all three sets of regressions clearly indicate that the shadow economy has a statistically significant influence on official growth. For transition countries and highly industrialized (OECD) countries, this influence is positive, while for developing countries the shadow economy has a negative influence on official growth. These results at least partially confirm our earlier discussion of theoretical considerations.

5. Equity and Income Distribution: What is the Incidence of the Hard-to-tax?

Analyzing the impact of the hard-to-tax on the distribution of income is an enormously difficult undertaking, given the range of issues that must be considered. In this section, we

41

identify some of the more important of these issues, and we present some initial and suggestive results on the distributional effects. One issue relates to the impact on vertical equity of the traditional HTT (e.g., street vendors, small farmers). The failure to tax such groups is likely to have a negligible impact on vertical equity. Since these groups are likely to be lower income, their presence in the HTT sector may even improve vertical equity to some degree by increasing the effective progressivity of tax systems. However, the impact on vertical equity is likely to be quite different when we expand our definition of the hard-to-tax to include higher income groups like professionals, doctors, and lawyers, all of whom fall into higher income groups. On the other hand, it would appear that horizontal equity will suffer as the result of the HTT. Lower income groups subject to taxation in the formal sector may do less well than those at the same income level in the informal sector who do not pay taxes. In fact, wage earners in developing countries generally feel that they are overtaxed in relation to those of the same level of income that are self-employed. Bird and Oldman (1990) mention three types of remedies often used to level the field between these groups. One approach is to use different taxes as in a schedular income tax. A second approach is to create compensating tax allowances and credits for wage earners. A third possible remedy is to increase the burden on the self-employed by using some kind of minimum tax or presumptive tax. Another issue is that the existence of a HTT sector may limit the governments ability to
redistribute income, given the erosion of the tax base from the HTT. However, this erosion

may also reduce the scope for public sector rent-seeking, with uncertain effects on the distribution of income. Ultimately, reaching any conclusion on the distributional impact of the hard-to-tax requires some understanding of the tax incidence that accompanies the HTT activities. However,

42

it is far from clear what the actual incidence of a hard-to-tax sector really is; that is, who actually benefits form the lower tax burden that falls on HTT activities? In this regard, it should be emphasized that the standard conclusion about the incidence of the hard-to-tax is that the beneficiaries of a hard-to-tax sector are those who directly participate in the HTT sector themselves. However, this conclusion is certainly incomplete and, indeed, is likely to be incorrect. Those who actually benefit from the existence of a HTT sector are not necessarily the individuals participating in that sector; indeed, these participants may not benefit at all. Using an analogy from the incidence of tax evasion (Martinez-Vazquez, 1996), the standard conclusion ignores the fact that in many situations tax evasion is similar to a tax advantage generated by the tax laws. If there is any advantage at all, we would expect replication and competition (if possible) to work toward the elimination of this advantage; that is, a general equilibrium process of adjustment should occur through changes in the relative prices of both commodities and factors of production, and these changes should tend to eliminate (or at least reduce) the tax advantage of the HTT.19 A complete analysis of the incidence of the HTT therefore requires the consideration of these general equilibrium effects. In such an analysis, whether the advantages associated with the HTT are eroded will depend on the degree of competition or free entry that exists wherever the HTT is present. At one extreme, with no entry or competition, those participating in the hard-to-tax sector are the final beneficiaries, as the standard conclusion would predict. However, at the other extreme, with perfect competition and absolute free entry, the HTT participants may hardly benefit at all as any initial benefit from the absence of taxation is eroded via entry and competition. The failure to consider these adjustments can lead to a variety of mistakes. As one example, Skinner and Slemrod (1985) argue that, if labor income is more likely to be generated

19

Any advantage from tax evasion may also be dissipated by direct means, such as bribes to corrupt officials (Shaw and Whalley, 1990).

43

in the hard-to-tax sector than capital income, then the existence of the HTT makes the tax system more progressive. However, if the advantages realized by workers get capitalized or competed away by market processes, then this conclusion is incorrect. The failure to tax, say, domestic help may actually benefit higher-income households who hire these services because entry into domestic help means that the households pay lower prices for the domestic services. Similarly, immigrant or undocumented workers working in, say, the garment industry may not benefit from their failure to pay taxes. Instead, with entry it is rather the buyers of garments who benefit from lower prices of the various commodities that are produced. A second example is demonstrated by Persson and Wissen (1984), who analyze the relationship between the actual distribution of income, which income on which no taxes are paid, and the distribution of officially reported income. Given the differences between the two, they conclude that government policies aimed at reducing the inequality in the distribution of reported income could be counterproductive in terms of actual income distributions. However, they implicitly assume that the incidence of the HTT is simple and direct: participants in the hard-totax sector benefit exclusively and fully from their failure to pay taxes. If the incidence of evasion is more indirect and more complicated, then the government could stop redistribution efforts based on the belief that certain groups are already benefiting from tax evasion, when actually they are not. Empirical studies of the distribution, of tax burdens provide a third, and perhaps the most important, example of the use of naive assumptions about the incidence of evasion. It is a traditional exercise in public finance to examine the progressivity or regressivity of a particular tax system, and the study of the overall incidence of new proposals for tax reform is almost always part of the background work accompanying the reform. Frequently, findings of vertical and horizontal incidence are adjusted to take into account the impact of existing evasion, such as in the case of professionals or unskilled workers employed in the informal sector of the economy 44

(Alm, Bahl, and Murray, 1991). These adjustments are made under the assumption that the evading groups benefit exclusively and in full from the assumed tax evasion. Of course, in many cases this assumption is incorrect. What are the basic elements of a model that conceptually captures the main distributional implications of the HTT? First, the model should be able to capture the potential general equilibrium effects of the HTT. The general equilibrium effects induce changes in the relative prices of factors of production and goods and services via market equilibrium forces. If there exists an advantage in terms of (expected) factor incomes or (expected) profits, then (potential) competition and factor mobility will lead to price adjustments until any advantage disappears. In this regard, the general equilibrium model utilized in the previous section to examine the efficiency effects of the hardto-tax has some important uses in the analysis of the distributional effects. Second, the model should allow for different degrees of competition or entry across sectors in the economy. This includes the mobility both of labor (e.g., the movement of labor into the HTT sector), but also of capital (e.g., firm entry into the HTT sector to avoid/evade sales taxes or corporate income taxes). The element of mobility is fundamental to an understanding of how much of the tax advantage may be kept by the initial participants in the HTT sector and how much is shifted via factor and commodity price changes. Third, the model should incorporate any element of uncertainty that may be present in the individual decision to participate in the hard-to-tax sector. This uncertainty may reflect the element of tax evasion present in the HTT; more broadly, it may simply reflect the possibility that the HTT may at some point be subject to taxation. The presence of uncertainty is an essential characteristic, and allows any excess burdens associated with uncertainty to be accounted for.

45

There are several other features that would be desirable in a complete model. For example, it would be desirable to allow for differences in preferences among individuals so that different groups may benefit differently from changes in relative prices. It would also be desirable to incorporate any the externality effects that HTT participants may impose on others. The key phenomenon that any model should explain is to extent to which any advantage of the HTT gets capitalized or competed away via price changes, including the identification of gainers and losers from this process. A complete model of incidence should also allow us to reach a wide variety of conclusions. As noted above, at one extreme we might have the case in which there is no shifting at all (for example, because there is no mobility or no free entry). In this case, those in the HTT sector keep all unpaid taxes in their entirety, and there are no changes in relative prices of factors of production or commodities as a result of the HTT activity itself.20 At the other extreme we might have the case in which the tax advantage gets fully shifted because entry is unrestricted and the supply response is large enough to compete away any residual tax advantage. This could happen if, for example, there is a very elastic supply of potential taxpayers who may have no choice but to work in the HTT sector, such as the presence of unskilled laborers in a developing economy with limited opportunities for employment, or the existence of undocumented workers in a developed economy also with limited opportunities. In these cases, it is unlikely that workers would be able to keep any benefit from working in a hardto-tax sector. Instead, the likely beneficiaries are buyers of the goods and services produced in the HTT sectors.21 Although incomplete according to our model criteria, the general equilibrium model used in section 4 to estimate the static excess burden of the HTT has some of the elements required to
Limits to entry may reflect the fact that buyers prefer to buy from reputable merchants with products under warranty. Limits to entry may also come from risk aversion, higher costs for concealing taxes, fear of stigma, or even the need to show some degree of compliant behavior to conceal other taxes due from the authorities. See Kesselman (1989). 21 A special case here is one in which the commodities are consumed exclusively by higher income groups.
20

46

examine the distributional effects of the HTT. In particular, this model allows us to calculate the impact on relative product and factor prices of the existence of a hard-to-tax sector, in combination with a legally untaxed sector. Recall that the taxed sector was assumed to be capital-intensive and that the tax rate on capital was also assumed to be greater than that on labor. As a result, the taxation of capital in sector X generates general equilibrium adjustments that always reduce the relative price of capital, and that also always increase the relative price of the product of sector X. The ultimate impact on the equity of the tax system then depends upon how one evaluates these changes.

6. Summary and Conclusions

In this paper we have analyzed some reasons why the hard-to-tax should matter to tax policy makers. We find that the HTT can have a significant impact on tax revenues, especially for developing countries. Thus raising taxes needed to provide critical social services and infrastructure in many developing and transition countries will require addressing the problem of the hard-to-tax. A larger HTT sector also leads to a greater reliance in tax structures on indirect taxation; indirect taxation can, of course, have significant effects on the overall incidence of the tax system. We also find that the hard-to-tax may be associated with an array of welfare losses driven by the induced misallocation of resources, and these excess burdens can be quite large. The role of the HTT on long run economic development appears to be diverse; a larger size of the HTT tends to slow down economic growth in developing countries but it accelerates it in industrialized countries. Finally, we find that the impact of the hard-to-tax on equity is complicated by the final incidence of the forms of tax evasion represented by the hard-to-tax. Nevertheless, even though it may often be the case that HTT groups do not benefit directly from evasion because of the final incidence of this form of tax evasion, it seems uncontroversial that 47

having the hard-to-tax pay their fair share of taxes will be improve the overall equity of the tax system. This paper does not deal with the question about what to do about the hard-to-tax. Still, we believe that this issue is more important for a countrys public finances than might appear to be the case. As we point out, in recent years the policy emphasis around the world has been on large taxpayers, and this focus has been well justified from a revenue production perspective; indeed, from this same perspective a strict calculus of costs versus additional revenues it can be argued that tax administrations may be dedicating too many resources to the hard-to-tax. Nevertheless, as Terkper (2003) and others have emphasized, the attention paid to the HTT may well be justified in order to control the negative externalities imposed by the hard-to-tax: reducing tax compliance morale and increasing the risks of generalized non-compliance. Besides, as noted by Tanzi and Casanegra (1989), the presumptive taxation of hard-to-tax groups may not only reduce evasion and increase revenue collections and equity, but it may also lead to significant efficiency gains, given that higher effort and the resulting higher incomes are usually not penalized by presumptive taxes.22

22

There is even scope for increasing revenue under presumptive taxation without necessarily undermining economic stability. See Erbas (1993).

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Appendix A: Methods to Estimate the Size of the Shadow Economy Estimating the size of a shadow economy is a difficult and challenging task. In this Appendix A, we give a short but comprehensive overview on various procedures to estimate the size of a shadow economy. Three different types of methods are most widely used, and each is briefly discussed. Direct Approaches These are micro approaches that employ either well-designed surveys and samples based on voluntary replies or tax auditing and other compliance methods. Sample surveys designed to estimate the shadow economy are widely used in a number of countries.23 The main disadvantage of this method is that it presents the flaws of all surveys. For example, the average precision and results depend greatly on the respondents willingness to cooperate, it is difficult to assess the amount of undeclared work from a direct questionnaire, most interviewees hesitate to confess fraudulent behavior, and responses are of uncertain reliability, which makes difficult to calculate a real estimate of the extent of undeclared work. The main advantage of this method lies in the detailed information about the structure of the shadow economy, but the results from these kinds of surveys are very sensitive to the way the questionnaire is formulated. Estimates of the shadow economy can also be based on the discrepancy between income declared for tax purposes and that measured by selective checks. Fiscal auditing programs have been particularly effective in this regard. Since these programs are designed to measure the amount of undeclared taxable income, they may also be used to calculate the shadow economy.24 However, a number of difficulties beset this approach. First, using tax compliance data are equivalent to using a (possibly biased) sample of the population. In general, the selection of taxpayers for tax audit is not random but is based on properties of submitted (tax) returns that indicate a certain likelihood of (tax) fraud. Consequently, such a sample is not a random one of the whole population, and estimates of the shadow economy based upon a biased sample may not be accurate. Second, estimates based on tax audits reflect only that portion of shadow economy income that the authorities succeed in discovering, and this is likely to be only a fraction of hidden income. A further disadvantage of these two direct methods (surveys and tax auditing) is that they lead only to point estimates. Moreover, it is unlikely that they capture all shadow activities, so they can be seen as providing lower bound estimates. They are unable to provide estimates of the development and growth of the shadow economy over a longer period of time. As already argued, they have, however at least one considerable advantage: they can provide detailed information about shadow economy activities and the structure and composition of those who work in the shadow economy. Indirect Approaches These approaches, which are also called indicator approaches, are mostly macroeconomic ones, and use various economic and other indicators that contain information about the development of the shadow economy over time. Currently there are five indicators that leave some trace of the shadow economy.

23

The direct method of voluntary sample surveys has been extensively used for Norway by Isachsen, Klovland, and Strom (1982). For Denmark this method has been used by Mogensen et al. (1995). See Mogensen et al. (1995) for an extensive discussion of advantages and disadvantages. 24 For the United States, see for example IRS (1979, 1983), Simon and Witte (1982), Witte (1987), Clotfelter (1983), and Feige (1986).

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(1) The Discrepancy between National Expenditure and Income Statistics This approach is based on discrepancies between income and expenditure statistics. In national accounting the income measure of GNP should be equal to the expenditure measure of GNP. Thus, if an independent estimate of the expenditure site of the national accounts is available, the gap between the expenditure measure and the income measure can be used as an indicator of the extent of the black economy.25 Since national accounts statisticians are anxious to minimize this discrepancy, it is the initial discrepancy rather than the published discrepancy that should be employed as an estimate of the shadow economy. If all the components of the expenditure side are measured without error, then this approach would indeed yield a good estimate of the scale of the shadow economy. Unfortunately, however, this is not the case. Instead, the discrepancy reflects all omissions and errors everywhere in the national accounts statistics as well as the shadow economy activity. These estimates may therefore be very crude and of questionable reliability.26 (2) The Discrepancy between the Official and Actual Labor Forces A decline in participation of the labor force in the official economy can be seen as an indication of increased activity in the shadow economy. If total labor force participation is assumed to be constant, then a decreasing official rate of participation can be seen as an indicator of an increase in the activities in the shadow economy.27 One weakness of this method is that differences in the rate of participation may also have other causes. Also, people can work in the shadow economy and have a job in the official economy. Therefore such estimates may be viewed as only weak indicators of the size and development of the shadow economy. (3) The Transactions Approach This approach has been most fully developed by Feige (1996).28 It is based upon the assumption that there is a constant relation over time between the volume of transaction and official GNP, as summarized by the well-known Fisherian quantity equation, or M*V = P*T, where M=Money, V=Velocity, P=Prices, and T=Total Transactions. Assumptions also have to be made about the velocity of money and about the relationships between the value of total transactions (P*T) and total (or official plus unofficial) nominal GNP. Relating total nominal GNP to total transactions, the GNP of the shadow economy can be calculated by subtracting the official GNP from total nominal GNP. However, to derive figures for the shadow economy, one must also assume a base year in which there is no shadow economy and therefore the ratio of P*T to total nominal GNP was normal and would have been constant over time if there had been no shadow economy. This method, too, has several weaknesses, such as the required assumptions of a base year with no shadow economy and of a normal ratio of transactions to nominal GNP. Moreover, to obtain reliable shadow economy estimates, precise figures of the total volume of transactions should be available, and this availability might be especially difficult to achieve for
For example, see Franz (1983) for Austria; MacAfee (1980), OHiggins (1989), and Smith (1985) for Great Britain; Petersen (1982) and Del Boca (1981) for Germany; and Park (1979) for the United States. For a critical survey, see Thomas (1992). 26 A related approach is pursued by Pissarides and Weber (1988), who use micro data from household budget surveys to estimate the extent of income understatement by self-employed. 27 Such studies have been made for Italy (Contini, 1981; Del Boca, 1981) and for the United States (ONeill, 1983). For a critical survey, again see Thomas (1992). 28 For an application to the Netherlands, see Boeschoten and Fase (1984); for Germany, see Langfeldt (1984).
25

50

cash transactions because they depend, among other factors, on the durability of bank notes in terms of the quality of the papers on which they are printed. Also, the assumption is made that all variations in the ratio between the total value of transaction and the officially measured GNP are due to the shadow economy. This means that a considerable data are required in order to eliminate financial transactions from pure cross payments, which are legal and have nothing to do with the shadow economy. In general, although this approach is theoretically attractive, the empirical requirements necessary to obtain reliable estimates are so difficult to fulfill that its application may lead to doubtful results.29
(4) The Currency Demand Approach The currency demand approach was first used by Cagan (1958), who calculated a correlation of the currency demand and the tax pressure as one cause of the shadow economy for the United States over the period 1919 to 1955. Gutmann (1977) also used the same approach but without any formal statistical procedures. This approach was further developed by Tanzi (1980, 1983), who econometrically estimated a currency demand function for the United States for the period 1929 to 1980 in order to calculate the shadow economy. His approach assumes that shadow (or hidden) transactions are undertaken in the form of cash payments, so as to leave no observable traces for the authorities. An increase in the size of the shadow economy will therefore increase the demand for currency. To isolate the resulting excess demand for currency, an equation for currency demand is econometrically estimated over time. All conventional possible factors, such as income, payment habits, interest rates, and so on, are controlled for. Additionally, such variables as the direct and indirect tax burden, government regulation, and the complexity of the tax system, which are assumed to be the major factors causing people to work in the shadow economy, are included in the estimation equation. Any excess increase in currency demand, or the amount unexplained by the explanatory variables, is then attributed to the rising tax burden and the other reasons leading people to work in the shadow economy. The currency demand approach is one of the most commonly used approaches. It has been applied to many OECD countries,30 but has nevertheless been criticized on various grounds.31 The most commonly raised objections to this method are several. First, not all transactions in the shadow economy are paid in cash. Isachsen and Strom (1985) used the survey method to find out that in Norway in 1980 roughly 80 percent of all transactions in the hidden sector were paid in cash. The size of the total shadow economy (including barter) may thus be even larger than previously estimated. Second, most studies consider only one particular factor (e.g., the tax burden) as a cause of the shadow economy, so that many other relevant factors such as the impact of regulation, taxpayers attitudes toward the state, tax morality, and so on are not considered, largely because reliable data for most countries is not available. Third, as discussed by Garcia (1978), Park (1979), and Feige (1996), increases in currency demand deposits are due largely to a slowdown in demand deposits rather than to an increase in currency caused by activities in the shadow economy, at least in the case of the United States.

29

For a detailed discussion of the transaction approach, see Boeschoten and Fase (1984), Frey and Pommerehne (1984), Kirchgaessner (1984), Tanzi (1982, 1986), Dallago (1990), Thomas (1986, 1992, 1999), and Giles (1999a). 30 See Schneider (1997, 1998a), Johnson, Kaufmann and Zoido-Lobatn (1998a), and Williams and Windebank (1995). 31 See Feige (1986), Thomas (1992, 1999), and Pozo (1996).

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Fourth, Blades (1982) and Feige (1986, 1996), criticize Tanzi (1980, 1983) on the grounds that the U.S. dollar is used as an international currency. Instead, he should have considered (and controlled for) the presence of U.S. dollars, which are used as an international currency and held in cash abroad.32 Moreover, Frey and Pommerehne (1984) and Thomas (1986, 1992, 1999) claim that Tanzis parameter estimates are not very stable.33 Fifth, most studies assume the same velocity of money in both types of economies. As argued by Hill and Kabir (1996) for Canada and Klovland (1984) for the Scandinavian countries, there is already considerable uncertainty about the velocity of money in the official economy, and the velocity of money in the hidden sector is even more difficult to estimate. Without knowledge about the velocity of currency in the shadow economy, one has to accept the assumption of an equal money velocity in both sectors. Sixth, the assumption of no shadow economy in a base year is open to criticism. Relaxing this assumption would again imply an upward adjustment of shadow economy size.
(5) The Physical Input (Electricity Consumption) Method In one variant on the physical input method, Kaufmann and Kaliberda (1996) assume that electric-power consumption is regarded as the single best physical indicator of overall (or official plus unofficial) economic activity.34 Now overall economic activity and electricity consumption have been empirically observed throughout the world to move in lockstep, with an electricity to GNP elasticity usually close to one; this means that the growth of total electricity consumption is an indicator for growth of overall (or official plus unofficial) GNP. By having this proxy measurement for the overall economy and then subtracting from this overall measure the estimates of official GNP, Kaufmann and Kaliberda (1996) derive an estimate of unofficial GDP. This method is very simple and appealing. However, it can also be criticized on various grounds. For example, not all shadow economy activities require a considerable amount of electricity (e.g. personal services), and other energy sources can be used (gas, oil, coal, etc.). Only a part of the shadow economy will be captured. Further, over time there has been considerable technical progress, so that both the production and use of electricity are more efficient than in the past, and this will apply to both official and unofficial uses. Finally, there may be considerable differences or changes in the elasticity of electricity/GDP across countries and over time.35 In a related approach, Lack (1996, 1998, 1999, 2000) assumes that a certain part of the shadow economy is associated with the household consumption of electricity. This part comprises the so-called household production, do-it-yourself activities, and other non-registered production and services. She further assumes that in countries where the portion of the shadow economy associated with the household electricity consumption is high, the rest of the hidden economy (or the part that she cannot measure) will also be high. She uses her econometric
In another study by Tanzi (1982), he explicitly deals with this criticism. Rogoff (1998) also undertakes a very careful investigation of the amount of U.S. dollars used abroad and the amounts of U.S. dollars used in the shadow economy (including classical crime activities), who concludes that large denomination bills are major driving force for the growth of the shadow economy and of crime activities due largely to reduced transactions costs. 33 However, in studies for European countries Kirchgaessner (1983, 1984) and Schneider (1986) conclude that the estimation results for Germany, Denmark, Norway, and Sweden are quite robust when using the currency demand method. Hill and Kabir (1996) find for Canada that the rise of the shadow economy varies with respect to the tax variable used. 34 This general approach was used earlier by Lizzeri (1979) and Del Boca and Forte (1982). See Lacko (1998) for a critique. 35 Note that Johnson, Kaufmann, and Shleifer (1997) attempt to adjust for changes in the elasticity of electricity to GDP.
32

52

estimation results to establish an ordering of the countries with respect to electricity use in their respective shadow economies. For the calculation of the actual size (value added) of the shadow economy, Lack further must know how much GDP is produced by one unit of electricity in the shadow economy of each country; since these data are not known, she uses the shadow economy estimates for the United States as the relevant base. Although a refinement on Kaufmann and Kaliberda (1996), Lack's method is also open to criticism: not all shadow economy activities require a considerable amount of electricity and other energy sources can be used, shadow economy activities do not take place only in the household sector, it is doubtful whether the ratio of social welfare expenditures can be used as the explanatory factor for the shadow economy, especially in transition and developing countries, and it is questionable which is the most reliable base value of the shadow economy in order to calculate the size of the shadow economy for all other countries, especially for the transition and developing countries.
The Model Approach36 All methods described so far consider just one indicator that must capture all effects of the shadow economy. However, it is obvious that shadow economy effects show up simultaneously in the production, labor, and money markets. An even more important critique is that the causes that determine the size of the hidden economy are taken into account only in some of the monetary approach studies that usually consider one cause (e.g., the burden of taxation). The model approach explicitly considers multiple causes leading to the existence and growth of the shadow economy, as well as the multiple effects of the shadow economy over time. The empirical method used is quite different from those used so far. It is based on the statistical theory of unobserved variables, which considers multiple causes and multiple indicators of the phenomenon to be measured. For the estimation, a factor-analytic approach is used to measure the hidden economy as an unobserved variable over time. The unknown coefficients are estimated in a set of structural equations within which the unobserved variable cannot be measured directly. The DYMIMIC (or dynamic multiple-indicators multiplecauses) model consists in general of two parts, with the measurement model linking the unobserved variables to observed indicators.37 The structural equation model specifies causal relationships among the unobserved variables. In this case, there is one unobserved variable, or the size of the shadow economy; this is assumed to be influenced by a set of indicators for the shadow economys size, thus capturing the structural dependence of the shadow economy on variables that may be useful in predicting its movement and size in the future. The interaction over time t between the causes Zit (i = 1, 2, ..., k), the size of the shadow economy Xt in time t, and the indicators Yjt (j = 1, 2, ..., p) is shown in Figure A.1.

36

This summary is derived from a longer study by Aigner, Schneider, and Ghosh (1988). The pioneers of this approach are Weck (1983) and Frey and Weck-Hannemann (1984), who applied this approach to cross-section data from the 24 OECD countries for various years. Before turning to this approach, they developed the concept of soft modeling (Frey, Weck, and Pommerehne, 1982; Frey and Weck, 1983a, 1983b), an approach that has been used to provide a ranking of the relative size of the shadow economy in different countries. 37 One of the latest papers dealing extensively with the DYMIMIC approach, its development, and its weaknesses is DellAnno (2003).

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Figure A.1. Development of the shadow economy over time. Causes

Xt-1

Indicators

Z1t Z2t ... Zkt

Development of the shadow economy over time Xt

Y1t Y2t ... Ypt

There is a large body of literature on the possible causes and indicators of the shadow economy. The following three types of causes are distinguished38: (1) The burden of direct and indirect taxation, both actual and perceived. A rising burden of taxation provides a strong incentive to work in the shadow economy. (2) The burden of regulation as proxy for all other state activities. It is assumed that increases in the burden of regulation give a strong incentive to enter the shadow economy. (3) The tax morality (e.g., citizens attitudes toward the state), which describes the readiness of individuals (at least partly) to leave their official occupations and enter the shadow economy: it is assumed that a declining tax morality tends to increase the size of the shadow economy. Similarly, several types of indicators are typically identified: (1) Development of monetary indicators. If activities in the shadow economy rise, then additional monetary transactions are required. (2) Development of the labor market. Increasing participation of workers in the hidden sector results in a decrease in participation in the official economy. Similarly, increased activities in the hidden sector may be expected to be reflected in shorter working hours in the official economy. (3) Development of the production market. An increase in the shadow economy means that inputs (especially labor) move out of the official economy, and this displacement may have a depressing effect on the official growth rate of the economy. The latest use of the model approach has been undertaken by Giles (1999a, 1999b) and by Giles, Linsey and Gupsa (1999), Giles and Tedd (2002), Chatterjee, Chaudhury and Schneider (2002) and Bajada and Schneider (2003). They basically estimate a comprehensive DYMIMIC model to get a time serious index of the hidden/measured output of New Zealand or Canada, and then estimate a separate cash-demand model to obtain a benchmark for converting this index into percentage units. Unlike earlier empirical studies of the hidden economy, they pay proper attention to the non-stationary, and possible co-integration of time serious data in both models. Again, this DYMIMIC model treats hidden output as a latent variable, and uses several (measurable) causal variables and indicator variables. The former include measures of the
38

See Thomas (1992), Schneider (1994a, 1997, 2003b), Pozo (1996), Johnson, Kaufmann, and Zoido-Lobatn (1998a, 1998b), Giles (1999a, 1999b), Giles and Tedds (2002), and DellAnno (2003).

54

average and marginal tax rates, inflation, real income and the degree of regulation in the economy. The latter include changes in the (male) labor force participation rate and in the cash/money supply ratio. In their cash-demand equation they allow for different velocities of currency circulation in the hidden and recorded economies. Their cash-demand equation is not used as an input to determine the variation in the hidden economy over time, but is used only to obtain the long-run average value of hidden/measured output, so that the index for this ratio predicted by the DYMIMIC model can be used to calculate a level and the percentage units of the shadow economy. Overall, this latest combination of the currency demand and DYMIMIC approach clearly shows that some progress in the estimation technique of the shadow economy has been achieved and a number of critical points have been overcome.

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Appendix B. Description of Data in Correlations Table B.1. Descriptive Statistics

Variable Observations Mean Standard Deviation Minimum Maximum Tax Revenue /GDP 46 0.21 0.08 0.09 0.38 Shadow Economy/GDP 110 0.33 0.14 0.09 0.67 GDP per Capita (Constant 1995 US$) 107 7,833 11,781 115 46,736 Tax Revenue (Current Local Currency) 56 387,434 1,510,847 537 11,200,000 Manufacturing Value Added/GDP 79 16.35 7.43 4.05 34.52 Agriculture Value Added/GDP 92 17.49 13.55 0.14 52.33 Corruption Index 79 4.76 2.40 1.20 10.00 Agriculture/GDP (1997) 29 13.63 10.65 0.12 38.77 Mining/GDP (1997) 27 8.72 12.44 0.03 42.47 Economic Growth Rate (1990-2000) 107 4.11 2.62 -4.88 11.50 Openness (1999) 95 73.44 38.42 19.10 261.15 Gross Capital Formation (annual growth) 104 1.28 13.76 -39.21 47.08 Labor force (annual growth) 109 0.02 0.01 -0.01 0.04 Inflation 108 11.65 23.24 -6.57 185.03 Foreign Direct Investment 106 3.91 4.12 -2.97 24.27 If not otherwise indicated, variables are for FY (2000). Sources: World Bank Indicators (2002), Transparency International, and Schneider (2002) for the shadow economy data (see Table A.2).

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Appendix C. Equations of General Equilibrium Model

The full set of equations for the stylized economy can be represented as follows (where ^ denotes the percentage change in the relevant variable): ^ ^ ^ ^ ^ (C1) X = EXX (PX - PZ ) + EXY ( PY - PZ ) ^ ^ ^ ^ ^ (C2) Y = EYX (PX - PZ ) + EYY ( PY - PZ ) ^ ^ ^ (C3) X = fKKX + fLLX ^ ^ ^ (C4) Y = gKKY + gLLY ^ ^ ^ -T ) (C5) K - L = s ( ^ r +T - w (C6) (C7) (C8) (C9) (C10) (C11) (C12) (C13) ^ KY ^ KZ ^ KX ^ LX ^ PX ^ PY ^ PZ ^ PZ
X

^ ^ -^ - LY = sY ( w r ) ^ ^ -^ r ) - LZ = sZ ( w ^ ^ KX + KY KY + KZ KZ = 0 ^ ^ LX + LY LY + LZ LZ = 0 ^ + T ) + f (w ^ + T) = fK(r K L L ^ r +g w =g ^
K L

^ r + hL w = hK^ =0

where Eij is the compensated elasticity of demand for i with respect to a change in the price of good j, defined to be nonpositive (i,j = X,Y); Pi is the price of good i (i = X,Y,Z); r is the price of capital; w is the price of labor; fj is the initial share of factor j in sector X (j=K,L); gj is the initial share of factor j in sector Y (j=K,L); hj is the initial share of factor j in sector Z (j=K,L); si is the elasticity of substitution between capital and labor in sector i, defined to be nonpositive (i=X,Y,Z); and Tj is the tax on factor j in sector X (j=K,L). Equations (C1) and (C2) express the percentage change in compensated demand as a function of the percentage change in the relative product prices of X and Y, respectively. Equations (C3) and (C4) describe the change in output of X that results from changes in factor usage in the sector. Equations (C5), (C6), and (C7) relate the change in factor proportions in the sectors to changes in relative factor prices via the elasticity of substitution in production. Equations (C8) and (C9) follow from the assumption of fixed factor supplies of capital and labor. Equations (C10), (C11), and (C12) show the relationships between changes in factor prices (including taxes where appropriate) and the resulting changes in product prices. Equation (C13) defines the price of good Z as the numeraire. All physical units are chosen such that initial prices are unity. These equations constitute a thirteen-equation, thirteen-unknown system, where the ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ ^ . This system unknowns are X , Y , K , K , K , L , L , L , P , P , P , ^ r , and w
X Y Z X Y Z X Y Z

can be reduced by substitution and then solved for the remaining unknowns by Cramer's Rule.

57

Appendix D: Data Set for Growth Regressions Countries Table D.1 presents the 109 countries in the sample and the two data of most interest: the size of the shadow economy expressed as a percent of GDP for the year 2000, and the annual growth rate in GDP per capita (as a percent) for the year 2000.
Table D. 1. Countries in Data Set, Shadow Economy, and Economic Growth Country Shadow Economy 2000 GDP Growth Rate 2000 Albania 33.4 9.15 Algeria 34.1 5.05 Argentina 25.4 1.77 Armenia 46.3 8.16 Australia 15.3 4.21 Austria 10.2 5.34 Azerbaijan 60.6 20.37 Bangladesh 35.6 8.58 Belarus 48.1 8.30 Belgium 23.2 6.13 Benin 45.2 8.42 Bolivia 67.1 5.04 Bosnia and Herzegovina 34.1 0.00 Botswana 33.4 -2.06 Brazil 39.8 7.68 Bulgaria 36.9 9.30 Burkina Faso 38.4 4.66 Cameroon 32.8 8.45 Canada 16.4 6.17 Chile 19.8 8.51 China 13.1 9.92 Colombia 39.1 1.04 Costa Rica 26.2 -0.37 Cote d'Ivoire 39.9 0.77 Croatia 33.4 5.96 Czech Republic 19.1 5.47 Denmark 18.2 6.34 Dominican Republic 32.1 9.86 Ecuador 34.4 3.98 Egypt, Arab Republic 35.1 7.73 Ethiopia 40.3 8.01 Finland 18.3 7.91 France 15.3 5.32 Georgia 67.3 8.20 Germany 16.3 5.24 Ghana 38.4 7.03 Greece 28.6 7.18 Guatemala 51.5 6.03 Honduras 49.6 6.52 Hong Kong, China 16.6 14.26 Hungary 25.1 7.63

58

India Indonesia Iran, Islamic Republic Ireland Israel Italy Jamaica Japan Jordan Kazakhstan Kenya Korea, Rep. Kyrgyz Republic Latvia Lebanon Lithuania Madagascar Malawi Malaysia Mali Mexico Moldova Mongolia Morocco Mozambique Nepal Netherlands New Zealand Nicaragua Niger Nigeria Norway Pakistan Panama Peru Philippines Poland Portugal Romania Russian Federation Saudi Arabia Senegal Singapore Slovak Republic Slovenia South Africa Spain Sri Lanka Sweden Switzerland

23.1 19.4 18.9 15.8 21.9 27.0 36.4 11.3 19.4 43.2 34.3 27.5 39.8 39.9 34.1 30.3 39.6 40.3 31.1 41.0 30.1 45.1 18.4 36.4 40.3 38.4 13.0 12.7 45.2 41.9 57.9 19.1 36.8 64.1 59.9 43.4 27.6 22.6 34.4 46.1 18.4 43.2 13.1 18.9 27.1 28.4 22.6 44.6 19.1 8.8

6.35 6.96 7.14 15.67 10.64 5.25 4.10 4.78 4.57 16.14 1.82 10.43 7.70 7.87 2.03 5.52 8.06 4.25 14.61 6.86 9.09 1.56 3.88 2.60 4.89 8.62 5.94 4.86 7.25 2.45 6.89 4.45 7.05 2.27 5.31 6.28 6.32 6.00 3.74 8.81 8.86 8.08 13.76 4.90 7.24 5.58 6.30 8.73 6.17 5.37

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Syrian Arab Republic Tanzania Thailand Tunisia Turkey Uganda Ukraine United Arab Emirates United Kingdom United States Uruguay Uzbekistan Venezuela, RB Vietnam Yemen, Rep. Yugoslavia, Fed. Rep. Zambia Zimbabwe

19.3 58.3 52.6 38.4 32.1 43.1 52.2 26.4 12.6 8.7 51.1 34.1 33.6 15.6 27.4 29.1 48.9 59.4

7.52 7.00 5.18 7.42 10.05 5.90 8.48 0.00 5.97 7.44 1.24 7.86 5.06 7.93 12.64 0.00 4.86 -5.58

Definition of the Variables It should be noted that all calculations and estimations are based on the software package Intercooled Stata 8.0. Also, all growth rates or shares as described in the following section are defined as fractions, not percentages, for example, a growth rate of 2 percent is defined as 0.02 instead of 2.0. If observations for important countries for one year are missing, we used the following formula to calculate the average growth rate for these variables:

variablet + n n [D.1] = growth rate variablet Multiplying the value of the variable from year t with the average growth rate gives the value for t+1. Formally: growth rate variablet = variablet +1 [D.2] The label in parentheses is the Stata label for the specific variable.
(1) GDP per Capita on PPP Basis [gdpc] GDP per capita based on purchasing power parity [PPP]. PPP GDP is gross domestic product converted to international dollars using purchasing power parity rates. An international dollar has the same purchasing power over GDP as the U.S. dollar has in the United States. GDP is the sum of gross value added by all resident producers in the economy plus any product taxes and minus any subsidies not included in the value of the products. It is calculated without making deductions for depreciation of fabricated assets or for depletion and degradation of natural resources. Data are in current international dollars. Sources: World Bank, International Comparison Programme database. (2) Annual GDP per Capita Growth Rate [growgdpc] GDP per Capita for the 109 countries over the years 1990 to 2000 is used to calculate Annual GDP per Capita Growth Rate (the dependent variable in the growth regressions), using the formula

60

(GDPpct GDPpct 1 ) [D.3] GDPpct 1 Sources: World Bank, International Comparison Programme database; own calculation by authors. Per Capita Growth =
(3) Shadow Economy [shad] The variable Shadow Economy is defined as the informal sector as a percent of official GDP. The estimations for the size of the shadow economy are undertaken using the DYMIMIC and the currency demand approaches (Schneider et al., 2002; Schneider, 2003a, 2003b). This variable is only available for three points in time, namely the years 1990, 1995, and 2000. Source: Own calculation by authors. (4) Shadow Economy Industrialized Countries [shadind] The variable Shadow Economy Industrialized Countries is defined as the informal sector as a percent of official GDP. It has the value 0 if a country is a developing country and the value of the shadow economy in percent of GDP if a country is an industrialized country or a transition country. Source: Own calculation by authors. (5) Shadow Economy Developing Countries [shaddev] The variable Shadow Economy Developing Countries is defined as the informal sector as a percent of official GDP. It has the value 0 if a country is an industrialized country or a transition country and the value of the shadow economy in percent of GDP if a country is a developing country. Source: Own calculation by authors. (6) Openness [open] Openness is the sum of exports and imports of goods and services measured as a share of gross domestic product. Sources: World Bank national accounts data, and OECD National Accounts data files. (7) Inflation Rate [infl] Inflation as measured by the annual growth rate of the GDP implicit deflator shows the rate of price change in the economy as a whole. The GDP implicit deflator is the ratio of GDP in current local currency to GDP in constant local currency. Sources: World Bank national accounts data, and OECD National Accounts data files. (8) Inflation Rate Other Countries [inflrest] Inflation Rate Other Countries is defined to equal the Inflation Rate but has the value 0 if a country is a transition country and the value of the inflation rate if a country is a non-transition country. Sources: World Bank national accounts data, and OECD National Accounts data files; own calculation by authors. (9) Inflation Rate Transition Countries [infltran] Inflation Rate Transition Countries is defined to equal the Inflation Rate but has the value 0 if a country is a non-transition country and the value of the inflation rate if a country is a transition country.

61

Sources: World Bank national accounts data, and OECD National Accounts data files; own calculation by authors.
(10) Government Consumption [gov] Government Consumption is defined as general government final consumption expenditure (general government consumption), and includes all government current expenditures for purchases of goods and services (including compensation of employees). It also includes most expenditures on national defense and security, but excludes government military expenditures that are part of government capital formation. Sources: World Bank national accounts data, and OECD National Accounts data files. (11) Lagged GDP per capita Growth Rate [lastgrowth] This variable is the Annual GDP per capita Growth Rate lagged for one period. Source: Own calculation by authors. (12) Total Population in millions [pop] Total Population in millions is based on the de facto definition of population, which counts all residents regardless of legal status or citizenship, except for refugees not permanently settled in the country of asylum who are generally considered part of the population of their country of origin. Sources: World Bank staff estimates from various sources including the United Nations Statistics Division's Population and Vital Statistics Report, country statistical offices, and Demographic and Health Surveys from national sources and Macro International. (13) Capital Accumulation Rate [caac] The Capital Accumulation Rate is the annual growth rate of gross capital formation based on constant local currency. Aggregates are based on constant 1995 U.S. dollars. Gross capital formation (formerly gross domestic investment) consists of outlays on additions to the fixed assets of the economy plus net changes in the level of inventories. Fixed assets include land improvements (fences, ditches, drains, and so on); plant, machinery, and equipment purchases; and the construction of roads, railways, and the like, including schools, offices, hospitals, private residential dwellings, and commercial and industrial buildings. Inventories are stocks of goods held by firms to meet temporary or unexpected fluctuations in production or sales, and work in progress. According to the 1993 SNA, net acquisitions of valuables are also considered capital formation. Sources: World Bank national accounts data, and OECD National Accounts data files. (14) Dummy Industrialized Countries [ind] The variable Dummy Industrialized Countries is a binary variable and takes the value 0 if a country is a developing country and 1 if the country is an industrialized country. Developing Country corresponds to high income classification of World Bank Indicators 2002 with per capita income of US $9,265 or less. The same applies to Industrialized Countries, defined as countries with per capita GDP of US $9,266 or more. Source: Own calculation by authors. (15) Dummy Transition countries [tran] The variable Dummy Transition Countries is a binary variable and takes the value 1 if a country is a transition country from a centrally planned economy to a market economy and 0 if the country is not.

62

Source: Own calculation by authors.

(16) Dummy OECD countries [oecd] The variable Dummy OECD countries is a binary variable and takes the value 1 if a country is member of the OECD and 0 if the country is not. Source: Own calculation by authors. (17) Foreign Direct Investment [fdi] Foreign Direct Investment is net inflows of investment to acquire a lasting management interest (10 percent or more of voting stock) in an enterprise operating in an economy other than that of the investor. It is the sum of equity capital, reinvestment of earnings, other long-term capital, and short-term capital as shown in the balance of payments. This series shows net inflows in the reporting economy. Sources: International Monetary Fund, International Financial Statistics and Balance of Payments databases, World Bank, Global Development Finance, and World Bank and OECD GDP estimates. (18) Annual FDI Growth Rate [fdigrowth] Foreign Direct Investment for the observed 109 countries over the years 1990 to 2000 is used to calculate Annual FDI Growth Rate using the formula ( FDI t FDI t 1 ) FDI Growth Rate = [D.4] FDI t 1 Source: International Monetary Fund, International Financial Statistics and Balance of Payments databases, World Bank, Global Development Finance, and World Bank and OECD GDP estimates, own calculation by authors. (19) Labor Force [lab] Total Labor Force comprises people who meet the International Labour Organization definition of the economically active population: all people who supply labor for the production of goods and services during a specified period. It includes both the employed and the unemployed. While national practices vary in the treatment of such groups as the armed forces and seasonal or part-time workers, in general the labor force includes the armed forces, the unemployed, and first-time job-seekers, but excludes homemakers and other unpaid caregivers and workers in the informal sector. Sources: International Labour Organization, using World Bank population estimates. (20) Annual Labor Force Growth Rate [labgrowth] Labor Force values for the observed 109 countries over the years 1990 to 2000 are used to calculate Annual Labour Force Growth Rate using the formula ( LABt LABt 1 ) [D.5] Labour Force Growth Rate = LABt 1 Sources: International Labour Organization, using World Bank population estimates, own calculation by authors.

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