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«The Shadow Economy in Portugal: An Analysis Using the MIMIC Model Eduardo Barbosa Samuel Pereira Elísio Brandão FEP-UP, School of Economics and ...»

-- [ Page 1 ] --

n. 514 December 2013

ISSN: 0870-8541

The Shadow Economy in Portugal:

An Analysis Using the MIMIC Model

Eduardo Barbosa

Samuel Pereira

Elísio Brandão

FEP-UP, School of Economics and Management, University of Porto

The Shadow Economy in Portugal:

An Analysis Using the MIMIC Model

Eduardo Augusto Soares Coelho Barbosa*, Samuel Cruz Alves Pereira♠

and Elísio Fernando Moreira Brandão♣

Abstract

The purpose of this working paper is to identify the main factors that are at the origin of the Shadow Economy in Portugal, and to analyze its evolution over the period between 1977 and 2011.

For the econometric analysis we used the Structural Model of Multiple Indicators and Multiple Causes - MIMIC, which was developed by Jöreskog, Karl G. and Arthur S.

Goldberg (1975). The Structural Model of Multiple Indicators and Multiple Causes (MIMIC) is a special case of the models of structural equations (SEM – Structural Equation Models) allowing the specification of statistical relationships between causal variables (observed) and latent variables (non-observed), which in turn affect, in an indirect way, a set of observed indicators.

The conclusion is that, among the selected causal variables in this working paper, the unemployment rate and the subsidies granted to enterprises are the ones that contribute the most to the evolution of the Shadow Economy. It is also concluded that the share of the Shadow Economy in Portugal, during the period under review, had a sharp decrease between 1997 and 2000, from about 52% to 13.4% of the GDP. Since 2001 the Shadow Economy has been rising again, accentuating its growth rate after 2007, and it reached a peak of 24.2% of the GDP in 2011.

Key Words: Shadow Economy, MIMIC Model, Portugal JEL Classification : O17, H26, C39 * Faculdade de Economia, Universidade do Porto, 110487009@fep.up.pt ♠ Faculdade de Economia, Universidade do Porto, ebrandao@fep.up.pt ♣ Faculdade de Economia, Universidade do Porto, Samuel@fep.up.pt

1. INTRODUCTION The Shadow Economy has a huge significance in various aspects of the economy and social life of a country, and thus it has been studied by a wide range of researchers worldwide. There is no consensus on its definition, its causes, its effects and its measurement. Some emphasize its causes, Schneider, Friedrich and Dominik H. Enste (2000), others its consequences, Gonçalves, Nuno (2010), and others its dimension, Schneider, Friedrich (2007).

Common sense points to the fact that the Shadow Economy causes inefficiency in the functioning of the labor market and of the market of goods and services and introduces unfair competition among companies and countries. It attracts workers from the official economy, harming them by depriving them of their rights and guarantees, and produces a vicious circle, since their exodus from the formal economy reduces tax revenues and consequently the state's ability to conduct public expenditure. Moreover, the Shadow Economy favors corruption and the lack of confidence in institutions and feeds resentment among citizens.

However, in the opinion of several authors, the Shadow Economy does not have only

negative effects, and on the contrary can generate positive effects. Among these are:

Schneider, Friedrich and Dominik H. Enste (2000), who state that at least two thirds of the income obtained in the Shadow Economy is immediately spent in the official economy, thus generating a positive net effect.

Smith, Roger S. (2002) points out that the Shadow Economy may allow some individuals to be employed, and otherwise they would be unemployed, it allows other individuals to increase their income by maintaining second jobs and provides services that would not be available. Irregular activities can add a dynamic element to the economy and increase competition in some sectors, and can improve income distribution in society.

Enste, D.H. (2003) affirms that everything depends on circumstances. It may be beneficial to meet the demand for certain urban services and goods produced on a small scale, supplying more dynamism to the economy and more competitiveness and efficiency to the markets.

Neuwirth, Robert (2010) says that as reprehensible as it is, the Shadow Economy has boosted small businesses, ensuring the survival of thousands of people. Its growth allows the opening of the market to those for whom it is traditionally closed, and it even generates entrepreneurial ideas: everything that goes on in the Shadow Economy is the result of intelligence, self-organization and solidarity and will be crucial in the development of the XXI century.

There are not many studies on the Shadow Economy in Portugal. One can cite some that deal with a number of countries, including Portugal. Schneider, Friedrich and Dominik H. Enste (2000); Schneider, Friedrich (2005); Schneider, Friedrich and A. Buehn (2007); Schneider, Friedrich (2007), Schneider, Friedrich, Andreas Buehn and Cláudio E. Montenegro (2010).

Dedicated only to Portugal we can refer: Dell'Anno, Roberto (2007), Afonso, Óscar and Nuno Gonçalves (2009) and Gonçalves, Nuno (2010).

The aim of this working paper is to estimate the size of the Shadow Economy in Portugal in the period from 1977 to 2011, having as benchmark the working paper by Dell'Anno, Roberto (2007), which estimated the Shadow Economy in Portugal until 2004, considering the same causes and the same indicators, thus contributing to a deeper understanding of this issue and updating the existing estimates for Portugal.





For this purpose we use the econometric model named "Structural Model of Multiple Indicators and Multiple Causes" (MIMIC) (1).

This working paper is organized as follows: the second chapter is devoted to defining the Shadow Economy and the third chapter is devoted to the causes and indicators. In the fourth chapter the econometric model is presented and results are introduced in the fifth chapter. Finally the sixth chapter presents the main findings, the study's limitations and prospects for future work.

–  –  –

2. DEFINITION OF SHADOW ECONOMY

The first major difficulty in studying the Shadow Economy is to define it. Therefore, alternative definitions have been adopted depending on the researchers who are studying it.

De Soto, Hernando (1989) defines Shadow Economy as a set of economic units that do not meet the obligations imposed by the state, with regard to taxes and regulation.

Feige, E. (1994) defines it as all activities that contribute to the official or observed calculation of the GDP but that are not properly registered.

Smith, P. (1994) describes it as the production of goods and services based on the market, legal or illegal, which escapes detection of the official estimates of the GDP.

Schneider, Friedrich and Dominik H. Enste (2000) define Shadow Economy as any activity that would generally be taxed if it were reported to tax authorities.

Schneider, Friedrich (2000) defines it as activities in themselves legal, which create added value, but that are not taxed or registered and in which most can be classified as "black" or clandestine work. This means that excludes unpaid work, "pure" household production, non-profit social services and criminal activities.

Blades, Derek and David Roberts (2002) define Shadow Economy as the economic activities that should be included in the GDP, but that, for various reasons, are not covered by the statistical analyses and accounting records through which national accounts are constructed.

They believe there are four reasons for these activities not to be recorded:

• For purposes of tax evasion and non-subjection to labor laws and social security contributions;

• As they are illegal activities (e.g.: drugs and prostitution);

• Production of goods for own use;

• Incomplete statistical analysis and accounting records.

Dell'Anno, Roberto (2003) and Dell'Anno, Robert and Schneider, Friedrich (2004) define Shadow Economy as including the economic activities and income arising from them that circumvent government regulation, taxation and observation.

Schneider, Friedrich (2007) says the Shadow Economy includes all the legal production of goods and services on a market basis that is deliberately concealed from public

authorities for the following reasons:

• To avoid paying taxes on income or value-added tax;

• To avoid payment of social security contributions;

• To avoid having to meet certain standards of the labor market, such as minimum wages, maximum hours of work, security levels, etc.

• To avoid the fulfillment of certain administrative procedures, such as completing statistical questionnaires or other forms.

Therefore, it does not include criminal activities (e.g.: theft, drug traffic, etc) and it also does not include the informal household production. He does not dwell on the analysis of tax evasion or tax compliance either, because tax evasion is another matter.

This working paper adopts the definition of a 2002 OECD report: "Measuring the Nonobserved Economy" (NOE), according to which the non-observed economy includes:

Underground Production (clandestine, hidden, or under-declared): it represents the productive activities that are not observed directly, either for economic reasons, that is, they are performed with the deliberate desire of tax evasion or also to avoid observing the legal provisions about the minimum wage, working hours, job security, etc; or for statistical reasons, since the productive activities are not reported due to failure in completing the statistical forms and/or deficiency in the statistical system.

Illegal Production: it includes activities related to the production of goods and services whose sale, distribution or possession is prohibited by law, such as illegal drugs and practicing medicine without a license.

Informal Production: it is the production of legal goods and services held by entities with a low organizational level and on a small scale, with no division between labor and capital and labor relations based on casual work. This includes street vendors, artisans, agricultural workers, domestic workers and small traders with no recorded activity.

Production for Own Use or Self-Consumption: it represents the production of goods and services that are to be consumed by those who produce them.

The referred OECD report was based on the System of National Accounts (SNA 93) and the European System of National Accounts (ESA 95), whereby the use of the terms ‘underground production, illegal production, informal production’, and ‘production for own use’ is not only a matter of nomenclature. They measure different clusters clearly and therefore require different theoretical and empirical methodologies.

As stated, the definition of Shadow Economy to adopt depends on the purpose of each study. In this working paper, the Shadow Economy is defined as the non-observed economy due to economic reasons (T4, T5) and the unregistered economy (T6), as shown in Figure 1.

Figure 1: Structure of the Non-Observed Economy (NOE)

–  –  –

Source: Dell’Anno, Roberto (2007), adapted by the author

3. CAUSES AND INDICATORS OF THE SHADOW ECONOMY

Causes Weight of the Public Employment in the Labor Force as a Proxy of Economic Freedom (X1) This cause measures the degree of economic freedom and the burden of the public sector in the economy.

According to the Heritage Foundation - Wall Street Journal, which publishes the Annual Index of Economic Freedom, the Shadow Economy is the reaction of citizens to the restrictions on economic freedom.

For Eiras, Ana Isabel (2003), corruption, as well as the Shadow Economy, is a symptom of over-regulation, faults in the rule of law and a large public sector. Countries must drive economic freedom in all possible areas, in particular in the regulation affecting SME, so that corruption and the Shadow Economy progressively decrease. Economic freedom with a strong rule of law will foster a culture of investment, job creation and institutional respect. There is a negative relationship between economic freedom and Shadow Economy, that is, as economic freedom is reduced the Shadow Economy assumes a greater share of the GDP. In repressed countries in their economic freedom the Shadow Economy weighs 40.25% in the GDP, while in countries with high economic freedom the weight drops to 16.37%.

There is no consensus regarding the relationship between the Shadow Economy and regulation. However, the vast majority of researchers in these matters support the

reduction of the public sector's role in the economy for the following reasons:

It causes an over-bureaucratization in the economy. The more an economy is • regulated, the more incentives firms receive to develop their activities in the underground economy, Belev, Boyan (2003).

A high relative size of the public sector implies that bureaucrats have more • decisive power and obviously the level of corruption, bribery and dishonesty of public officials increases (Schneider, Friedrich and Dominik H. Enste, 2002).

A large public sector presence in the market needs to be financed by a complex • tax system. This introduces distortions in the allocation of resources among private businesses, institutions and public enterprises.

Other researchers, a minority, argue that in some industries the state's presence could provide a disincentive for people to adhere to the Shadow Economy, because as the state is formed only by legal activities, this means that economic agents would remain in official activities to benefit from businesses with the state. From this point of view, the stronger the state intervention in the economy is, the greater the intensification of the attack on the irregular economy becomes; consequently, a negative sign in the relationship between the Shadow Economy and the "rule of law" index would be expected.

De Soto, Hernando (1989), in a study for 67 developed and developing countries, state that the increment of one unit in the regulation index, in a 1-5 scale, is directly related with a 10% increase in the informal economy.

A reasonable option to lessen the incentive to the Shadow Economy could be to reduce the regulatory burden associated with its better enforcement. However, governments do precisely the opposite, that is, they opt for greater regulation, bringing the power of bureaucrats to greater employability in the public sector (Schneider, Friedrich and Dominik H. Enste (2000)).

It is assumed that an increase in weight of the public employment in the labor force intensifies the Shadow Economy, whereby a positive sign in the coefficient associated with that variable is expected.

Tax Burden (X2) The Tax Burden is measured by the weight of direct taxes, indirect taxes and social security contributions in the GDP.

It is almost unanimous in the literature on Shadow Economy that the tax burden is one of its main causes.

According to Frey, Bruno and Hannelore Weck-Hannemann (1983), the tax burden encourages tax evasion, since both sellers and buyers have an interest in withholding taxes.

For Schneider, Friedrich and Reinhard Neck (1993), a lower tax burden by itself may not reduce the size of the Shadow Economy if other factors act in the opposite direction, e.g. a lower complexity of the tributary system, a higher tax base, a increase of regulation.

For Tanzi, Vito and Parthasarathi Shome (1993), tax evasion affects the horizontal and vertical equity of a tributary system, as well as its efficiency and that of the market, thus affecting the productivity of the economy.

According to Johnson, Simon, Daniel Kaufman, and Pablo Zoido Lobatón (1998), a greater tax burden may not increase the size of the Shadow Economy. This means that there may even be a negative correlation between the size of the Shadow Economy and the tax burden as long as other factors such as deductions, choice of different tributary systems and other legal ways to avoid taxation are incorporated. The efficiency of administration, the control on politicians and bureaucrats and bribery and corruption can have a greater impact on the Shadow Economy than the actual tax burden.



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