Taxing the unobservable: The impact of the shadow economy on inflation and taxation

Ummad Mazhar () and Pierre-Guillaume Méon

World Development, 2017, vol. 90, issue C, 89-103

Abstract: Because the shadow economy cannot be taxed, it erodes the tax base and reduces tax revenues, forcing governments to resort to other ways to finance their expenditures. Accordingly, a larger shadow economy should give governments an incentive to shift revenue sources from taxes to inflation, in line with the public finance motive of inflation. In this paper, we recall that point in a simple canonical model, then empirically test it in a sample of up to 153 developed and developing countries over the 1999–2007 period. In line with the model’s prediction, we indeed observe a positive relation between inflation and the size of the shadow economy, and a negative relation between the tax burden and the size of the shadow economy. We find that both relations are conditional on central bank independence and on the exchange rate regime, implying that it is the strongest in institutional set-ups that constrain monetary policy the least. Both relations are present in the sub-sample of developed countries as well as the sub-sample of developing countries. Both relations survive several robustness checks, using various sets of control variables including the stock of debt, controlling for endogeneity, using alternative estimates of the shadow economy, and estimating the two relations as a system of equations.

Keywords: shadow economy; informal sector; inflation; taxes; inflation tax (search for similar items in EconPapers)
Date: 2017
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (29)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0305750X1630465X
Full text for ScienceDirect subscribers only

Related works:
Working Paper: Taxing the unobservable: The impact of the shadow economy on inflation and taxation (2012)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:wdevel:v:90:y:2017:i:c:p:89-103

DOI: 10.1016/j.worlddev.2016.08.019

Access Statistics for this article

World Development is currently edited by O. T. Coomes

More articles in World Development from Elsevier
Bibliographic data for series maintained by Catherine Liu ().