Empirical Economics

https://doi.org/10.1007/s00181-019-01700-w

Fiscal policy and shadow economy in Asian developing

countries: does corruption matter?

Cong Minh Huynh1 · Tan Loi Nguyen1

Received: 11 October 2018 / Accepted: 25 April 2019

© Springer-Verlag GmbH Germany, part of Springer Nature 2019

Abstract
This article empirically studies how fiscal policy affects the shadow economy through
the two tools of taxation and government expenditure, and how this effect depends on
the presence of corruption. By using a panel data for 24 developing Asian countries
over the period of 2002–2015, we find that the shadow economy is negatively affected
by expansionary fiscal policies and positively affected by contractionary fiscal policies,
extending the Voluntarist school of thought on shadow economy; and corruption and
shadow economy are complements. Specifically, the tax burden from both direct and
indirect taxes increases the shadow economy and the increase in corruption intensifies
this effect. Furthermore, the government expenditure reduces the size of the shadow
economy and the increase in corruption attenuates this effect. In addition, we find a
stronger impact of indirect taxes, compared to direct taxes; a stronger effect of gov-
ernment expenditure, in comparison with direct and indirect taxes; and a dominating
impact of corruption on the shadow economy in developing countries. The findings
indicate that governments can utilize expansionary fiscal policies through appropriate
combination of direct taxes, indirect taxes and government expenditure to reduce the
shadow economy, provided that corruption is controlled.

Keywords Corruption · Fiscal policy · Shadow economy

JEL Classification E62 · D73 · H26 · O17

Electronic supplementary material The online version of this article (https://doi.org/10.1007/s00181-

019-01700-w) contains supplementary material, which is available to authorized users.

B Cong Minh Huynh

minh.huynh@eiu.edu.vn
Tan Loi Nguyen
loi.nguyen@eiu.edu.vn

1 Becamex Business School, Eastern International University, 1 Nam Ky Khoi Nghia St, Thu Dau Mot
City, Binh Duong Province, Vietnam

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 C. M. Huynh, T. L. Nguyen

1 Introduction

The shadow economy has attracted a great attention from policy-makers and scholars
because its presence distorts the allocation of resources, alters income distribution and
reduces governments’ tax revenue (Alm and Embaye 2013). Moreover, it is biased to
evaluate the outcome of various economic policies without considering the shadow
economy since national accounts fail to capture economic activities in the shadow
economy. Thus, governments—especially in developing countries—are always try-
ing to control the size of shadow economy. According to the Voluntarism school of
thought on shadow economy, the rising burden of taxes is one of the main causes
for the increase of shadow economy. The higher taxes make the after-tax earnings
smaller, leading to stronger incentives for people to work underground to reduce the
tax wedge (Feige 1989; Tanzi 1982, 1999; Giles 1999; Schneider 2007, 2010). There-
fore, fiscal policies with the two tools of taxation and government expenditure can
contribute not only to economic growth but also to the control of the shadow econ-
omy. Although taxation is examined as a determinant of the shadow economy, the
impact of government expenditure on the shadow economy is still largely ignored in
the literature. In addition, the effectiveness of fiscal policies is affected by the level
of corruption (Gauthier and Goyette 2016) while corruption is also a determinant of
shadow economy (Johnson et al. 1997; Hindriks et al. 1999). The implications are how
fiscal policies affect the shadow economy and how this effect depends on the presence
of corruption.
Developing Asian countries provide a fruitful context to study the above problems
for their rising thorny features such as the large shadow economy size and the high
corruption level. The estimated average size of shadow economy in 24 selected Asian
countries over the period of 2002–2015 is 33.88% of official gross domestic products
(GDP), and this period experiences an increase of 11.24% in the shadow economy size
(Medina and Schneider 2018). The lowest and the highest sizes are 30.77% and 37.50%
in 2006 and 2013, respectively. Meanwhile, the average index for control of corruption
in 24 Asian countries over the period 2002–2015 fluctuates around − 0.7 and − 0.5
per year (Worldwide Governance Indicators, 2017). The control of corruption index
is scaled from − 2.5 (the most corruption level) to + 2.5 (the least corruption level).
As a result, Asian countries face challenges of various degrees of fiscal policy imple-
mentation to deal with the large shadow economy size amid the high corruption level.
This paper examines the impact of fiscal policies on the shadow economy through
the two tools of taxation and government expenditure, taking corruption into consid-
eration, in 24 developing Asian countries over the period of 2002–2015. For the first
time in the literature, we investigate how government expenditure and the interaction
between corruption and the government behavior influence the shadow economy. The
results from estimation by Feasible Generalized Least Squares (FGLS) and two-step
Generalized Method of Moments (SGMM) contribute to the literature in two aspects.
First, we extend the Voluntarist school of thought on shadow economy by using the
fiscal policy approach: the shadow economy is affected not only by taxation but also
by government expenditure. We argue that government expenditure can reduce the
shadow economy because of its contribution to the growth of the official economy,
the poverty reduction and public goods improvement. In addition, we found a stronger

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 Fiscal policy and shadow economy in Asian developing…

impact of indirect taxes, compared to direct taxes, on the shadow economy in devel-
oping countries, contributing to the Voluntarism in terms of tax structure impact on
the shadow economy. Second, the presence of corruption attenuates the impact of
fiscal policy on shadow economy for two reasons: (i) tax collectors may get bribes
from taxpayers in exchange for ignoring underground production activities and (ii)
the effectiveness of government spending is dampened by corruption through public
projects, diminishing the indirect effect of government expenditure on shadow econ-
omy through channels of economic growth and public services. These findings imply
that government can utilize expansionary fiscal policies (to cut taxation or/and to
increase government spending) to reduce the shadow economy as long as corruption
is controlled.
The remainder of this study is organized as follows. Section 2 reviews the literature.
Section 3 describes models, data and methodology. Empirical results and discussion
are provided in Sect. 4. Section 5 concludes and offers main policy implications.

2 Literature review and hypotheses

2.1 Shadow economy

2.1.1 Definitions

The “shadow economy” named by Schneider and Dominik (2000) has been known
with various labels such as the underground economy (Simon and Witte 1982; Feige
1989), the informal economy (Smith 1985) and the unofficial economy (Johnson et al.
1998).
It is an integral part of the official economy. There is not any adequate and coherent
definition on the shadow economy in the literature. However, most scholars agree that
the shadow economy consists of “all market-based goods and services that escape
inclusion in official accounts” (Alm and Embaye 2013). Schneider (2007, 2010)
defines the shadow economy as including “all market-based legal production of goods
and services that are deliberately concealed from public authorities to avoid payment
of income, value-added or other taxes; to avoid payment of social security contribu-
tions; to avoid having to meet certain legal labour market standards, such as minimum
wages, maximum working hours, safety standards, etc.; and to avoid complying with
certain administrative procedures, such as completing statistical questionnaires or
other administrative forms”. This definition of the shadow economy is also used in
this research due to its specific features.

2.1.2 Measurements

On measurement, there are three major approaches widely used to assess the size and
development of the shadow economy: (i) direct methods that are based on microeco-
nomic theories to employ well-designed surveys or tax auditing methods (Isachsen
and Strom 1985; Mogensen and Pedersen 1995; Haigner et al. 2013); (ii) indirect
methods that are based on macroeconomic indicators such as the currency demand

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 C. M. Huynh, T. L. Nguyen

(Tanzi 1983, 1999; Alm and Embaye 2013), the discrepancy between national income
and expenditure statistics (Thomas 1999), the discrepancy between the official and
actual labor force (Contini 1981); and (iii) the model methods (known as the MIMIC
approach—Multiple Indicators Multiple Causes) in which the shadow economy can
be measured through a set of causes and indicators of the shadow economy (Giles
and Tedds 2002; Bajada and Schneider 2005; Buehn and Schneider 2012; Vo and
Pham 2014; Schneider and Buehn 2017; Medina and Schneider 2018). Many causes
of the shadow economy distinguished in these studies include tax and social contri-
bution burdens, self-employment, institutional quality and tax morality. The size of
the shadow economy is reflected in various indicators such as the official economic
growth, currency/cash outside banks and labor force participation rate. In this research,
we use data on shadow economies from Medina and Schneider (2018), in which the
MIMIC approach was used for shadow economy estimation.

2.2 The impact of fiscal policy and corruption on shadow economy

2.2.1 Fiscal policy and shadow economy

According to Keynesian theory, the government can use fiscal policy by changing
levels of taxation or/and government expenditure to stabilize the economy through
affecting the aggregate demand and economic activity levels (O’Sullivan and Steven
2003). Meanwhile, Voluntarists contend that tax burden is one of the main causes
of shadow economy. People and businesses have stronger incentives to work in the
shadow economy as a choice to avoid paying high taxes (Feige 1989; Tanzi 1982, 1999;
Giles 1999; Schneider 2007, 2010). Thus, an expansionary fiscal policy conducted by
cutting taxes—the first tool of fiscal policy—will expectedly reduce the size of shadow
economy. However, the impacts of different taxes on the shadow economy still receive
little investigation. In this study, we categorize taxes into two groups: direct tax and
indirect tax, and examine their impacts on the shadow economy separately. On average,
the direct to indirect tax ratio is 0.745 in 24 Asian countries over the period 2002–2015
(our calculations based on data from WDI, WB). It seems easier for governments in
developing countries to increase their revenues through indirect taxes than through
direct taxes, since indirect taxes have much wider coverage as compared to direct
taxes in which the rich and large corporations have tools to hide their incomes and
profits. However, this taxation policy can possibly obtain equality but not equity for
the so-called regressive nature of indirect taxes when the rich and the poor share the
same burden for indirect taxes (such as VAT, customs duty…). Indirect taxes may
also lead to market distortions since governments can impose on certain industries but
not others. Moreover, the trend of basing on indirect taxes to generate public revenue
may create conditions for the growth of the shadow economy through corruption and
indirect tax evasion by the rich and multinational corporations.
The second tool of fiscal policy is government spending. Nevertheless, the linkage
between government spending and shadow economy is largely ignored in the liter-
ature except some hints. We argue that government spending can reduce the size of
shadow economy for three possible reasons. First, the government expenditure real-

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 Fiscal policy and shadow economy in Asian developing…

locates scarce resources to the official economy, reducing resources in the unofficial
sector. Second, the government expenditure boosts economic growth through aggre-
gate demand (Kolluri et al. 2000; Bose et al. 2007; Wu et al. 2010), and the growth
in the official economy reduces the shadow economy since Dualists view the shadow
economy as a residual or a by-product of the official economy and economic growth is
the cure for the shadow economy (La Porta and Shleifer 2008, 2014; Williams 2008).
Third, government spending may improve the quality of public services which in turn
discourages people from working in the shadow economy because, according to the
Legalist school of thought, the high quality of public services reduces transaction costs
and increases benefits of being in the official economy (Johnson et al. 1998; Friedman
et al. 2000; Dreher and Schneider 2010).
In other words, we hypothesize that:

Hypothesis 1 The shadow economy size is negatively affected by expansionary fiscal

policy and positively affected by contractionary fiscal policy, ceteris paribus.

2.2.2 Corruption and shadow economy

Most researchers such as Johnson et al. (1997), Hindriks et al. (1999), Hibbs and
Piculescu (2005) and Dreher and Schneider (2010) have a common conclusion from
their empirical studies that corruption and the shadow economy are complements. To
these scholars, corruption increases the size of shadow economy because: (i) corruption
is viewed as a particular form of regulations and institutional quality which are drivers
of shadow economy (Johnson et al. 1997), (ii) inspectors collude with taxpayers for
getting bribes in exchange of underreporting the tax liability of the taxpayers (Hindriks
et al. 1999), and (iii) businesses bribe dishonest bureaucrats for ignoring their unofficial
production activities (Hibbs and Piculescu 2005). Thus, we predict that:

Hypothesis 2 Corruption has a positive impact on the shadow economy, ceteris

paribus.

2.2.3 The effect of fiscal policy on shadow economy in the presence of corruption

Corruption can attenuate the impact of fiscal policy on shadow economy in two ways as
follows. First, tax collectors get bribes in exchange for underreporting the tax obliga-
tions of taxpayers or ignoring their unofficial production activities, and this collusion
unexpectedly weakens the effect of fiscal policy on the shadow economy. For exam-
ple, the government carries out an expansionary fiscal policy by tax cuts to reduce
the shadow economy. However, firms and people still pay bribes if the bribe amounts
are smaller than their tax liability plus the red tape cost or if benefits of working
underground are higher than bribe amounts. As a result, they continue operating unof-
ficially and the shadow economy cannot be reduced. Second, corruption drains the
government’s purse through public projects and reduces the effectiveness of govern-
ment spending, diminishing the indirect effect of government expenditure on shadow
economy through channels of economic growth and public services improvement.
Therefore, we postulate that:

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 C. M. Huynh, T. L. Nguyen

Hypothesis 3 Corruption intensifies the impact of direct and indirect taxes on increas-
ing the shadow economy and attenuates the impact of government expenditure on
reducing the shadow economy, ceteris paribus.

3 Models, data and methodology

3.1 Models

Based on the Voluntarism school of thought on shadow economy, previous studies and
the above arguments, we examine the impact of fiscal policy on the shadow economy,
taking the presence of corruption into consideration by proposing the model as follows:

SHADOWit  a0 + a1 X it + a2 CORit + a3 X it ∗ CORit + Z it a j + εit (1)

where t: time; i: country; a1 , a2 , a3 , and aj : respective coefficients; and ε: error terms.

The dependent variable is the size of the shadow economy (SHADOW), measured
by the percentage of gross domestic product (GDP). The regressors are fiscal policy
(X) and corruption (COR). X*COR is the interaction of fiscal policy and corruption.
Z is a vector of control variables. Since we measure fiscal policy by two tools that
are taxation (both direct and indirect taxes) and government expenditure, model 1 is
estimated in the form of two equations below:

SHADOWit  α0 + α1 TAX_DIit + α2 TAX_INDIit + α3 CORit + α4 TAX_DIit

∗ CORit + α5 TAX_INDIit ∗ CORit + Z it α j + u it (2)

SHADOWit  β0 + β1 EXPit + β2 CORit + β3 EXPit ∗ CORit + Z it β j + vit (3)

where α, β: respective coefficients; u, v: error terms.

In Eq. (2), fiscal policy is represented by the tool of taxation in which we consider
both direct taxes (TAX_DI) and indirect taxes (TAX_INDI). Both of them are measured
by revenue as the percentage of GDP. In Eq. (3), government expenditure per GDP
(EXP) is employed to measure fiscal policy.
The interaction terms between direct tax revenue and corruption (TAX_DI*COR)
as well as between indirect tax revenue and corruption (TAX_INDI*COR) measure
the extent to which direct and indirect tax revenues affect the shadow economy with
the presence of corruption. By taking turns to make a partial derivative of TAX_DI or
TAX_INDI in Eq. (2), we get the total effects of TAX_DI or TAX_INDI on shadow
economy at the margin, respectively:

∂(SHADOWit )
 α1 + α4 CORit (4)
∂(TAX_DIit )
∂(SHADOWit )
 α2 + α5 CORit (5)
∂(TAX_INDIit )

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 Fiscal policy and shadow economy in Asian developing…

Similarly, we get the total impact of EXP on shadow economy at the margin by
making a partial derivative of EXP in Eq. (3):

∂(SHADOWit )
 β1 + β3 CORit (6)
∂(EXPit )

The coefficient pairs of interest are α 1 and α 4 , α 2 and α 5 , as well as β 1 and β 3

in Eqs. (4), (5) and (6), respectively. Because we hypothesize that direct and indirect
taxes can increase the shadow economy, and the increase in corruption intensifies
this impact, we expect that α 1 , α 2 , α 4 and α 3 are all significantly positive. With the
hypothesis that government expenditure reduces shadow economy and the increase in
corruption attenuates this effect, we anticipate that β 1 is significantly negative and β 3
positive.
Control variables (Z) consist of the burden of government regulations (BURDEN),
GDP growth (GDPG), retirement (RETIRE), unemployment (U_RATE) and urban-
ization (URBAN). The selection of these control variables is based on previous studies
and arguments as follows.
The burden of government regulations Legalists debate that burdens of regulations
and procedures induce the rise of shadow economy. For example, over-regulations on
labor market (minimum wages, limited official working hours) or trade barriers (import
quotas) increase labor costs and structural unemployment and reduce individuals’
choice in the official economy. This leads to higher motivation to work underground.
The conclusion that heavily regulated burden causes larger shadow economy is found
from various studies including those by Loayza (1997), Friedman et al. (2000) and
Schneider et al. (2010).
GDP growth The effect of official economy on informal sector is ambiguous
(Schneider and Bajada 2003; Schneider and Dominik 2013; Vo and Pham 2014).
According to the Dualist approach, the economic growth negatively affects shadow
economy because dualists view the shadow economy as a residual or a by-product
of the official economy and economic growth is the cure for the shadow economy
(La Porta and Shleifer 2008, 2014; Williams 2008). Nevertheless, Greenfield (1993)
sees the development of the informal and formal sectors in a parallel way, with the
notion that the direct and indirect demand for goods and services produced in the
informal sector will increase its size as the formal economy expands. Elgin and Oztu-
nali (2014) explore that higher GDP per capita is correlated with the larger informal
sector in countries with low institutional quality.
Retirement: When people retire, they cannot work officially but they may participate
in the shadow economy. Therefore, the shadow economy growth is attributed to the
increase of retirement (Dell’Anno et al. 2007; Williams et al. 2016).
Unemployment: Most schools of thought on informal economy presume that unem-
ployment has a positive impact on the shadow economy because high unemployment
gives individuals more incentive to work unofficially to earn a living. This significant
positive relationship is confirmed by Boeri and Garibaldi (2002) and Dell’Anno and
Solomon (2008).
Urbanization According to the Dualists, urbanization is positively related to the
shadow economy as the shadow economy appears in the process of industrialization

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 C. M. Huynh, T. L. Nguyen

and urbanization when migrants move from rural sector to urban sector (Safa 1986).
However, Elgin and Oyvat (2013) argue that there is an inverted-U relationship between
the level of urbanization and the share of shadow economy. In their interpretation, the
share of the shadow economy rises in the early phase of urbanization due to several
pull and push factors, but it tends to fall in the latter phase when the impact of these
pull and push factors is reduced as a natural result of rural dwellers getting wealthier.

3.2 Data

All data in Eqs. (1) and (2) are extracted from various sources, including Medina &
Schneider (2018); World Development Indicators (WDI) from World Bank (2017a)
and Worldwide Governance Indicators (WGI) from World Bank (2017b); and Global
Competitiveness Index (GCI) from World Economic Forum (WEF). Especially, we
use the component “Control of Corruption” in WGI as a proxy for corruption because
this is viewed as a particular factor of institutional quality which is the crucial driver
of shadow economy (Johnson et al. 1997). “Control of Corruption” is defined as “the
extent to which public power is exercised for private gain, including both petty and
grand forms of corruption, as well as capture of the state by elites and private interests”
(World Bank 2017b). Besides, the component “Burden of government regulations” in
GCI is employed to measure how burdensome it is “to comply with governmental
administrative requirements” which reflect the possibility that people and businesses
can work underground because of higher costs to be official (Schneider et al. 2010).
We collect the data for 24 Asian developing countries—Bangladesh, Bhutan, Cam-
bodia, China, India, Indonesia, Iran, Jordan, Kazakhstan, Kyrgyzstan, Laos, Lebanon,
Malaysia, Maldives, Mongolia, Myanmar, Nepal, Pakistan, Philippines, Sri Lanka,
Tajikistan, Thailand, Vietnam and Yemen—over the period of 2002–2015. Measure-
ments, expected signs and sources of all variables are described in Table 1.
Table 2 provides the summary statistics for the variables.
The selection of 24 Asian countries is owed to two reasons. First, all of these
countries are middle income countries (lower middle income with GNI per capita
between US$1006 and US$3955; or upper middle income with GNI per capita between
US$3956 and US$12,235), defined by the World Bank (2018). Second, the selection
is also due to data constraints. The data for shadow economy, taxes and corruption
must be sufficient for econometric analysis. Studies based on cross-country analysis
do not eliminate differences in many aspects such as culture, population and corre-
spondingly render the results dubious in nature because of data comparability and
heterogeneity problems (Atkinson and Brandolini 2001). However, the selection of 24
Asian countries is our best choice with data availability and possible minimization of
heterogeneity problems.

3.3 Econometric methodology

To estimate the two models (1) and (2), the Feasible Generalized Least Squares (FGLS)
is conducted for correcting the presence of autocorrelation within panels and het-
eroskedasticity across panels (Greene 2012). Some authors argue that lagged levels of

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 Fiscal policy and shadow economy in Asian developing…

Table 1 Measurements, expected signs and sources of all variables

Variables Measurements Expected signs Sources

Dependent variable
SHADOW shadow Medina and Schneider
economy size (% of (2018)
GDP)
Explanatory and control variables
TAX_DI Direct tax revenue (% of + WDI, WB
GDP)a
TAX_INDI Indirect tax revenue (% of + WDI, WB
GDP)b
EXP General government final − WDI, WB
consumption
expenditure (% of GDP)
COR Control of corruption + WGI, WB
index (estimated
number)c
BURDEN The component Burden of − GCI, WEF
government regulations
in Global
Competitiveness Index
(estimated number: 1 
extremely burdensome;
7  not burdensome at
all)
GDPG GDP growth rate (%) − WDI, WB
RETIRE Population ages 65 and + WDI, WB
above (% of total)
U_RATE Unemployment rate (%) + WDI, WB
URBAN Urban population (% of − WDI, WB
total)
a We compute basing on data from WDI by summing up all direct taxes (including taxes on income, profits
and capital gains—current LCU) then divided by GDP (current LCU)
b Our calculations are based on WDI data by combining taxes on goods and services (including general
sales and turnover or value-added taxes, selective excises on goods, selective excises on goods and selective
taxes on services—current LCU) and taxes on international trade (including import duties and export
duties—current LCU), then divided by GDP (current LCU)
c The sign of scale is changed. The control of corruption index from WGI is scaled from − 2.5 (the highest
corruption level) to + 2.5 (the lowest corruption level). However, the corruption index is rescaled by being
multiplied by − 1 in our study

shadow economy can affect its current value (Berdiev et al. 2015). Thus, the dynamic
forms of models (1) and (2) are also examined, being estimated by two-step General-
ized Method of Moments (SGMM) with robustness check, in which lagged differences
and levels of the dependent variable are used as instrumental variables. SGMM esti-
mates linear dynamic panel-data models and copes with the issues of endogeneity,
heteroskedasticity and autocorrelation (Blundell and Bond 1998). Two types of tests
will be used for the empirical model (Arellano and Bond 1991). First, the Sargan test

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 C. M. Huynh, T. L. Nguyen

Table 2 Summary statistics Variables Mean S.D. Min Max Obs

SHADOW 32.479 12.526 12.313 60.121 336

TAX_DI 4.391 3.193 0.309 13.405 336
TAX_INDI 8.606 3.369 0.948 18.388 336
EXP 11.165 3.786 4.039 23.185 336
COR 0.645 0.527 − 1.275 1.698 336
BURDEN 3.203 0.586 2.041 4.991 336
GDPG 5.952 4.278 − 7.147 19.889 336
RETIRE 5.715 2.037 2.690 10.732 336
U_RATE 6.755 3.911 0.100 17.820 336
URBAN 42.424 19.473 14.263 74.729 336

checks the validity of instruments and specifications. Second, the Arellano and Bond
test examines the hypothesis that the residuals from the estimations are first-order
correlated (AR1) but not second-order correlated (AR2).

4 Results and discussion

The empirical results and associated test statistics for Eq. (2) are provided in Table 3
for FGLS and SGMM, with three specifications. In the specification (1.1), the impacts
of direct tax, indirect tax and corruption on shadow economy are estimated. The
interaction terms between taxation (both direct and indirect taxes) and corruption are
added in the specification (1.2). The specification (1.3) includes control variables.
Similarly, the empirical results for Eq. (3) are presented in Table 4 with three spec-
ifications. The impact of government expenditure and corruption on shadow economy
is examined in the specification (2.1). The specification (2.2) includes the interaction
term between government expenditure and corruption. Then, control variables are
added in the specification (2.3).
After SGMM estimation, two types of tests are used (Arellano and Bond 1991).
First, the Sargan tests with high P values for all specifications fail to reject the null
hypothesis of the validity of the over-identifying restriction, indicating that instru-
ments are appropriate and specifications are well determined. Second, the results from
Arellano-Bond tests show that the null hypothesis of no first-order serial correlation in
the residuals (AR1) is rejected and that the null hypothesis of no second-order serial
correlation in the residuals (AR2) is not rejected at 1% level of significance for all
specifications.
The results in Tables 3 and 4 show interesting findings as follows:
First, the shadow economy is positively affected by direct and indirect taxes and
negatively affected by government expenditure, confirming the first hypothesis that
an expansionary fiscal policy can reduce the shadow economy but a contractionary
fiscal policy increases it. Direct and indirect taxes have positive impact on the shadow
economy in all specifications of Eq. (2) by both estimations of FGLS and SGMM,

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 Fiscal policy and shadow economy in Asian developing…

Table 3 Regression results for Eq. (2)

Regressors (1.1) (1.2) (1.3)

FGLS SGMM FGLS SGMM FGLS SGMM

Dependent variables: SHADOW

SHADOW(- 0.807*** 0.779*** 0.659***
1) (10.08) (10.16) (6.84)
TAX_DI 0.160*** 0.360*** 0.158** 0.377** 0.177* 0.223*
(3.28) (4.56) (2.24) (2.17) (1.67) (1.97)
TAX_INDI 0.356*** 0.406*** 0.287** 0.405** 0.517** 0.503**
(3.15) (3.94) (2.32) (2.23) (2.45) (2.14)
COR 1.918*** 0.668*** 3.127** 0.398** 3.701** 1.482**
(2.86) (2.96) (2.25) (2.24) (2.31) (2.03)
TAX_DI*COR 0.237** 0.912*** 0.418** 0.518*
(2.44) (4.71) (2.46) (1.93)
TAX_INDI*COR 0.553*** 1.291*** 0.863** 1.22**
(2.85) (5.03) (2.37) (2.14)
BURDEN − 1.105* − 0.966**
(− 1.94) (− 2.17)
GDPG − 0.103*** − 0.146***
(− 3.24) (− 3.79)
RETIRE 0.845*** 0.522*
(3.41) (1.88)
U_RATE 0.219** 0.436***
(2.17) (2.65)
URBAN − 0.239*** − 0.174**
(− 4.17) (− 2.06)
Constant 15.864*** 5.389*** 12.226*** 5.123*** 13.214*** 15.650***
Observations 336 312 336 312 336 312
AR(1)-P 0.001 0.001 0.002
AR(2)-P 0.962 0.809 0.717
Sargan 0.546 0.602 0.792
test-P
T -statistics appear in parentheses; ***, ** and * indicate significance at 1%, 5% and 10%, respectively;
AR(1)-p is the p value for an AR(1) autocorrelation test; Sargan test-P is the p value for the Sargan test

and there is a stronger impact of indirect taxes, compared to direct taxes, on the
shadow economy in developing countries. When the ratio of direct taxes in GDP
increases by 1%, the shadow economy measured as the percentage of GDP increases
by 0.158–0.377%, while 1% increase in indirect taxes to GDP ratio leads to the rise in
the shadow economy by 0.287–0.517%. This finding supports the conventional view
that tax burden is one of the main causes of shadow economy (Feige 1989; Tanzi 1982,
1999; Giles 1999; Schneider 2007, 2010), and it is in line with the prediction that the
trend of basing on indirect taxes to generate public revenue may create conditions for
the shadow economy growth through corruptions and through indirect tax evasion by
the rich and multi-corporations in developing countries.

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 C. M. Huynh, T. L. Nguyen

Table 4 Regression results for Eq. (3)

Regressors (2.1) (2.2) (2.3)

FGLS SGMM FGLS SGMM FGLS SGMM

Dependent variables: SHADOW

SHADOW(- 0.748*** 0.772*** 0.501***
1) (7.37) (8.47) (5.75)
EXP − 0.479*** − 0.475*** − 0.496*** − 0.434** − 0.232** − 0.292**
(− 3.53) (− 6.21) (− 3.59) (− 2.32) (− 2.01) (− 2.12)
COR 1.787*** 0.470*** 2.043** 1.27** 3.142*** 1.812***
(3.63) (2.78) (2.13) (2.08) (5.26) (2.03)
EXP*COR 0.472** 0.487** 0.198** 0.534***
(1.89) (1.97) (4.75) (3.37)
BURDEN − 1.595** − 1.986**
(− 1.99) (− 1.98)
GDPG − 0.156*** − 0.158***
(− 2.95) (− 3.46)
RETIRE 1.561*** 1.287***
(5.08) (2.85)
U_RATE 0.112* 0.235***
(1.88) (3.87)
URBAN − 0.185*** − 0.091**
(− 5.68) (− 2.01)
Constant 14.830*** 13.633*** 15.388*** 5.715*** 8.836*** 5.695***
Observations 336 312 336 312 336 312
AR(1)-P 0.001 0.001 0.004
AR(2)-P 0.920 0.921 0.318
Sargan 0.873 0.792 0.852
test-P
T -statistics appear in parentheses; ***, ** and * indicate significance at 1%, 5% and 10%, respectively;
AR(1)-p is the p value for an AR(1) autocorrelation test; Sargan test-P is the p value for the Sargan test

On the other hand, government expenditure negatively affects the shadow economy
in all specifications of Eq. (3), by both FGLS and SGMM. Apparently, 1% rise in
government expenditure leads to a fall in shadow economy by around 0.232–0.496%.
This finding fills the gap on the linkage between government spending and shadow
economy in the literature. The finding that government spending is a tool to reduce
the shadow economy can be supported by three possible reasons: (i) the government
expenditure reallocates scarce resources to the official economy, reducing resources
in the unofficial sector, (ii) the government spending reduces the shadow economy
through boosting economic growth; and (iii) the government expenditure may improve
the quality of public services and this improvement in turn discourages people from
working in the shadow economy.
Second, corruption has a positive effect on shadow economy in all specifications
of Eqs. (2) and (3), failing to reject the second hypothesis. In comparison with direct
and indirect taxes and government expenditure, corruption has the strongest impact

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 Fiscal policy and shadow economy in Asian developing…

on the shadow economy. In particular, one unit rise in corruption increases the shadow
economy by 0.470–3.701%. This confirms the postulation that corruption and the
shadow economy are complements in the literature (Johnson et al. 1997; Hindriks
et al. 1999; Hibbs and Piculescu 2005; Dreher and Schneider 2010).
Third, the third hypothesis that corruption intensifies the positive impact of direct
and indirect taxes on the shadow economy and attenuates the negative impact of
government expenditure on the shadow economy is affirmed.
On the one hand, the interaction effects of direct taxes and corruption (α 4 ) as
well as of indirect taxes and corruption (α 5 ) on the shadow economy are significantly
positive, specifying that the tax burden increases the shadow economy and the increase
in corruption intensifies this effect. The total effect of direct taxes on shadow economy,
as shown in Eq. (4), is derived from: (i) the direct effect on shadow economy (α 1 ) and
(ii) the indirect effect on shadow economy in the presence of corruption (α 4 *COR).
Similarly, the total effect of indirect taxes on shadow economy, as displayed in Eq. (5),
is the sum of α 2 and (α 5 *COR). Thus, when corruption is taken into account, the
impacts of direct and indirect taxes on shadow economy are strengthened.
On the other hand, the positive interaction effect of government expenditure and
corruption on shadow economy (β 3 ) shows that government expenditure reduces the
shadow economy size and the increase in corruption attenuates this effect. The total
impact of government expenditure on the shadow economy, as illustrated in Eq. (6), is
the sum of its direct impact on the shadow economy (β 1 ) and its indirect impact in the
presence of corruption (β 3 *COR). By this way, in the presence of corruption, when
the ratio of government expenditure in GDP rises by 1%, the shadow economy just
declines by 0.104–0.192%, compared with 0.232–0.496% of its direct impact on the
shadow economy without the interaction with corruption. This finding demonstrates
that corruption reduces the negative effect of expenditure on shadow economy.
In the presence of interaction with corruption (COR), the total impacts of direct
taxes (α 1 + α 4 *COR), indirect taxes (α 2 + α 5 *COR) and government expenditure
(β 1 + β 3 *COR) on shadow economy in 24 Asian countries are presented in Table 5
(see in Appendix, as additional online material). It can be seen that in countries with
low levels of corruption (such as Bhutan, Jordan and Malaysia), the total impact of
taxes in increasing the shadow economy is weak, but the total impact of government
expenditure in reducing the shadow economy is strong. Conversely, countries with
high corruption levels (such as Cambodia, Kyrgyz Republic, Myanmar, Tajikistan and
Yemen) endure the strong total impact of taxes in increasing the shadow economy, but
the weak total impact of government expenditure in reducing the shadow economy.
Fourth, determinants that have positive impacts on the shadow economy size consist
of the burden of government regulations, retirement and unemployment as asserted
in previous studies. However, the official economy and urbanization are negatively
associated with the shadow economy in Asian developing countries. These are advo-
cated by Dualism with the postulation that official economy and shadow economy are
substitutes, and by Elgin and Oyvat (2013) in the sense that there is an inverted-U rela-
tionship between the level of urbanization and the share of shadow economy, and Asia
is currently in the latter phase of urbanization when the critical value of urbanization
is exceeded.

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 C. M. Huynh, T. L. Nguyen

4.1 Robustness checks

To overcome identification problems of using tax, government burden and unemploy-

ment as regressors for the shadow economy estimated by MIMIC approach (Medina
and Schneider 2018), we use the shadow economy estimated by a two-sector (official
and the shadow economies) dynamic general equilibrium model (Elgin and Oztunali
2012) for regression in Eqs. 2 and 3, and we obtain consistent results. The robust
estimation results are provided in Appendix as additional online material (Tables 6
and 7). In addition, to minimize the heterogeneity in the type of countries, if we drop
some countries in civil war (such as Lebanon and Yemen) and some centrally planned
economies (China, Laos and Mongolia), the estimation results remain stable.1

5 Conclusion

Controlling the size of shadow economy is one of the main concerns for policy-makers,
especially those in developing Asian countries, which experience high levels of shadow
economy and corruption. This paper empirically examines how fiscal policy affects
the shadow economy through the two tools of taxation and government expenditure,
and how this effect depends on the presence of corruption.
By using a panel data for 24 developing Asian countries over the period of
2002–2015, we find that the shadow economy is negatively affected by expansionary
fiscal policies and positively affected by contractionary fiscal policies; and corrup-
tion and shadow economy are complements. In particular, the tax burden from both
direct and indirect taxes increases the shadow economy and the increase in corruption
intensifies this effect. Furthermore, the government expenditure reduces the shadow
economy size and the increase in corruption attenuates this effect. Besides, there is
evidence for a stronger impact of indirect taxes, compared to direct taxes; a stronger
effect of government expenditure, in comparison with direct and indirect taxes; and
a dominating impact of corruption on the shadow economy in developing countries.
Other determinants of shadow economy in developing Asian countries are also found
such as the burden of government regulations, economic growth, retirement, unem-
ployment and urbanization.
The main findings from the study indicate that governments can utilize expansionary
fiscal policies to reduce the shadow economy, provided that corruption is controlled.
Since the impact of government expenditure on the shadow economy is stronger than
that of taxes on the shadow economy, as found in this paper, governments should give
priority on public expenditure rather than taxes when they aim to reduce the shadow
economy by implementing fiscal policies. Moreover, the finding of a stronger impact
of indirect taxes—compared to direct taxes—on the shadow economy suggests that
governments in developing countries should consider appropriate weight of direct and
indirect taxes in their tax revenue to help reduce the shadow economy more effec-
tively. However, corruption control is definitely not to be missed because of its direct

1 The results are not reported here to save space, but they are available upon request to the corresponding
author.

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 Fiscal policy and shadow economy in Asian developing…

dominating impact on the shadow economy and indirect impact on the shadow econ-
omy through fiscal policy tools including direct taxes, indirect taxes and government
expenditure. This also implies that corruption control is one of the key conditions
that international financial organizations such as the World Bank, the International
Monetary Fund and the Asian Development Bank should consider for their funding
agreements. Besides, other supporting policies to reduce the shadow economy should
focus on lessening the burden of government regulations, and unemployment as well
as enhancing economic growth and urbanization.

Compliance with ethical standards

Conflict of interest The authors declare that they have no conflict of interest.

References
Alm J, Embaye A (2013) Using dynamic panel methods to estimate shadow economies around the world,
1984–2006. Public Finance Rev 41(5):510–543
Arellano M, Bond S (1991) Some tests of specification for panel data: Monte Carlo evidence and an
application to employment equations. Rev Econ Stud 58:277–297
Atkinson A, Brandolini A (2001) Promise and pitfalls in the use of “secondary” data-sets: income inequality
in OECD countries as a case study. J Econ Lit 39(3):771–799
Bajada C, Schneider F (2005) The shadow economies of the Asia-Pacific. Pac Econ Rev 10(3):379–401
Berdiev A, Pasquesi-Hill C, Saunoris J (2015) Exploring the dynamics of the shadow economy across US
states. Appl Econ 47(56):6136–6147
Blundell R, Bond S (1998) Initial conditions and moment restrictions in dynamic panel data models. J Econ
87:115–143
Boeri T, Garibaldi P (2002) Shadow activity and unemployment in a depressed labor Market. CEPR dis-
cussion papers 3433, C.E.P.R. discussion papers
Bose N, Haque ME, Osborn DR (2007) Public expenditure and economic growth: a disaggregated analysis
for developing countries. Manch Sch 75(5):533–556
Buehn A, Schneider F (2012) Shadow economies around the world: novel insights, accepted knowledge,
and new estimates. Int Tax Public Finance 19:139–171
Contini B (1981) Labor market segmentation and the development of the parallel economy—the Italian
experience. Oxf Econ Pap 33(4):401–412
Dell’Anno R, Solomon OH (2008) Shadow economy and unemployment rate in USA: is there a structural
relationship? An empirical analysis. Appl Econ 40:2537–2555
Dell’Anno R, Gomez-Antonio M, Pardo A (2007) The shadow economy in three Mediterranean countries:
France, Spain and Greece. A MIMIC approach. Empir Econ 33:51–84
Dreher A, Schneider F (2010) Corruption and the shadow economy: an empirical analysis. Public Choice
144(1):215–238
Elgin C, Oztunali O (2012) Shadow economies around the world: model based estimates. Working papers
2012/05, Bogazici University, Department of Economics
Elgin C, Oyvat C (2013) Lurking in the cities: urbanization and the informal economy. Struct Change Econ
Dyn 27:36–47
Elgin C, Oztunali O (2014) Institutions, informal economy and economic development. Emerg Mark Finance
Trade 50(4):145–162
Feige EL (1989) The underground economies. Tax evasion and information distortion. Cambridge University
Press, Cambridge
Friedman E, Johnson F, Kaufmann D, Zoido-Labton P (2000) Dodging the grabbing hand: the determinants
of unofficial activity in 69 countries. J Public Econ 76(4):459–493
Gauthier B, Goyette J (2016) Fiscal policy and corruption. Soc Choice Welf 46:57–79

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 C. M. Huynh, T. L. Nguyen

Giles DE (1999) Measuring the hidden economy: implications for econometric modelling. Econ J
109:370–380
Giles D, Tedds L (2002) Taxes and the Canadian underground economy. Canadian Tax Foundation, Toronto
Greene W (2012) Econometric analysis, 7th edn. Prentice Hall, Upper Saddle River
Greenfield HI (1993) Invisible, outlawed, and untaxed: America’s underground economy. Praeger Publish-
ers, London
Haigner S, Jenewein S, Schneider F, Wakolbinger F (2013) Driving forces of informal labour supply and
demand in Germany. Int Labour Rev 152(3–4):507–524
Hibbs DA, Piculescu V (2005) Institutions, corruption and tax evasion in the unofficial economy. Public
Economics 0508003, University Library of Munich, Germany
Hindriks J, Muthoo A, Keen M (1999) Corruption, extortion and evasion. J Econ 74:395–430
Isachsen AJ, Strom S (1985) The size and growth of the hidden economy in Norway. Rev Income Wealth
31(1):21–38
Johnson S, Kaufman D, Shleifer A (1997) The unofficial economy in transition. Brook Pap Econ Act
2:159–221
Johnson S, Kaufmann D, Zoido-Lobaton P (1998) Regulatory discretion and the unofficial economy. Am
Econ Rev 88(2):387–392
Kolluri BR, Panik MJ, Wahab MS (2000) Government expenditure and economic growth: evidence from
G7 countries. Appl Econ 32(8):1059–1068
La Porta R, Shleifer A (2008) The unofficial economy and economic development. Brook Pap Econ Act
47(1):123–135
La Porta R, Shleifer A (2014) Informality and development. J Econ Perspect 28:109–126
Loayza NV (1997) The economics of the informal sector: a simple model and some empirical evidence
from Latin America. Carnegie-Rochester Conf Ser Public Policy 45:129–162
Medina L, Schneider F (2018) Shadow economies around the world: what did we learn over the last 20
years? IMF working paper WP/18/17. International Monetary Fund
Mogensen GV, Pedersen S (1995) The shadow economy in Denmark 1994: measurement and results.
Rockwool Foundation Research Unit, Copenhagen
O’Sullivan A, Steven MS (2003) Economics: principles in action. Prentice Hall, Upper Saddle River
Safa HI (1986) Urbanization, the informal economy and state policy in Latin America. Urban Anthropol
Stud Cult Syst World Econ Dev 15(1/2):135–163
Schneider F (2007) Shadow economies and corruption all over the world: new estimates for 145 countries.
economics—the open-access, open-assessment. E-J Kiel Inst World Econ (IfW) 1:1–66
Schneider F (2010) The influence of public institutions on the shadow economy: an empirical investigation
for OECD countries. Rev Law Econ 6(3):441–468
Schneider F, Bajada C (2003) The size and development of the shadow economies in the Asia-Pacific.
Economics working papers 2003-01, Department of Economics, Johannes Kepler University Linz,
Austria
Schneider F, Buehn A (2017) Shadow economy: estimation methods, problems, results and open questions.
Open Econ 1:1–29
Schneider F, Dominik HE (2000) Shadow economies: size, causes, and consequences. J Econ Lit 38:77–114
Schneider F, Dominik HE (2013) The shadow economy: an international survey. Cambridge University
Press, New York
Schneider F, Buehn A, Montenegro CE (2010) New estimates for the shadow economies all over the world.
Int Econ J 24(4):443–461
Simon C, Witte A (1982) Beating the system: the underground economy. Auburn House Publishing Com-
pany, Boston
Smith JD (1985) Market motives in the informal economy. In: Gaertner W, Wenig A (eds) The economics
of the shadow economy. Studies in contemporary economics, vol 15. Springer, Berlin, pp 161–177
Tanzi V (1982) The underground economy in the United States and abroad. Lexington Books, Lanham
Tanzi V (1999) Uses and abuses of estimates of the underground economy. Econ J 109(456):338–340
Thomas J (1999) Quantifying the black economy: “measurement without theory” yet again? Econ J
109:381–389
Vo DH, Pham TM (2014) Any link between unofficial economy and official economy? An empirical evidence
from the ASEAN. Int J Econ Finance 6(11):139–148
Williams C (2008) A critical evaluation of competing representations of the relationship between formal
and informal work. Community, Work Fam 11(1):105–124

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
 Fiscal policy and shadow economy in Asian developing…

Williams C, Horodnic IA, Windebank J (2016) Chapter 4: The participation of the self-employed in the
shadow economy in the European Union. In: Sauka A, Schneider F, Williams CC (eds) Entrepreneur-
ship and the shadow economy. Edward Elgar Publishing, Cheltenham
World Bank (2017a) World development indicators. World Bank Group, Washington
World Bank (2017b) Worldwide governance indicators. World Bank Group, Washington
World Bank (2018) World bank country and lending groups
Wu S, Tang J, Lin E (2010) The impact of government expenditure on economic growth: how sensitive to
the level of development? J Policy Model 32(6):804–817

Publisher’s Note Springer Nature remains neutral with regard to jurisdictional claims in published maps
and institutional affiliations

123
Content courtesy of Springer Nature, terms of use apply. Rights reserved.
Terms and Conditions
Springer Nature journal content, brought to you courtesy of Springer Nature Customer Service Center
GmbH (“Springer Nature”).
Springer Nature supports a reasonable amount of sharing of research papers by authors, subscribers
and authorised users (“Users”), for small-scale personal, non-commercial use provided that all
copyright, trade and service marks and other proprietary notices are maintained. By accessing,
sharing, receiving or otherwise using the Springer Nature journal content you agree to these terms of
use (“Terms”). For these purposes, Springer Nature considers academic use (by researchers and
students) to be non-commercial.
These Terms are supplementary and will apply in addition to any applicable website terms and
conditions, a relevant site licence or a personal subscription. These Terms will prevail over any
conflict or ambiguity with regards to the relevant terms, a site licence or a personal subscription (to
the extent of the conflict or ambiguity only). For Creative Commons-licensed articles, the terms of
the Creative Commons license used will apply.
We collect and use personal data to provide access to the Springer Nature journal content. We may
also use these personal data internally within ResearchGate and Springer Nature and as agreed share
it, in an anonymised way, for purposes of tracking, analysis and reporting. We will not otherwise
disclose your personal data outside the ResearchGate or the Springer Nature group of companies
unless we have your permission as detailed in the Privacy Policy.
While Users may use the Springer Nature journal content for small scale, personal non-commercial
use, it is important to note that Users may not:

1. use such content for the purpose of providing other users with access on a regular or large scale
basis or as a means to circumvent access control;
2. use such content where to do so would be considered a criminal or statutory offence in any
jurisdiction, or gives rise to civil liability, or is otherwise unlawful;
3. falsely or misleadingly imply or suggest endorsement, approval , sponsorship, or association
unless explicitly agreed to by Springer Nature in writing;
4. use bots or other automated methods to access the content or redirect messages
5. override any security feature or exclusionary protocol; or
6. share the content in order to create substitute for Springer Nature products or services or a
systematic database of Springer Nature journal content.
In line with the restriction against commercial use, Springer Nature does not permit the creation of a
product or service that creates revenue, royalties, rent or income from our content or its inclusion as
part of a paid for service or for other commercial gain. Springer Nature journal content cannot be
used for inter-library loans and librarians may not upload Springer Nature journal content on a large
scale into their, or any other, institutional repository.
These terms of use are reviewed regularly and may be amended at any time. Springer Nature is not
obligated to publish any information or content on this website and may remove it or features or
functionality at our sole discretion, at any time with or without notice. Springer Nature may revoke
this licence to you at any time and remove access to any copies of the Springer Nature journal content
which have been saved.
To the fullest extent permitted by law, Springer Nature makes no warranties, representations or
guarantees to Users, either express or implied with respect to the Springer nature journal content and
all parties disclaim and waive any implied warranties or warranties imposed by law, including
merchantability or fitness for any particular purpose.
Please note that these rights do not automatically extend to content, data or other material published
by Springer Nature that may be licensed from third parties.
If you would like to use or distribute our Springer Nature journal content to a wider audience or on a
regular basis or in any other manner not expressly permitted by these Terms, please contact Springer
Nature at

onlineservice@springernature.com