The Shadow Economy in Colombia: Working Paper No January 2007

Transcription

1 DEPARTMENT OF ECONOMICS JOHANNES KEPLER UNIVERSITY OF LINZ The Shadow Economy in Colombia: Size and Effecs on Economic Growh by SCHNEIDER, Friedrich *) and HAMETNER, Beina Working Paper No January 2007 Johannes Kepler Universiy of Linz Deparmen of Economics Alenberger Srasse 69 A-4040 Linz - Auhof, Ausria friedrich.schneider@jku.a phone +43 (0) , (fax)

2 Final Version January 12, 2007 Paper_Colombia_final THE SHADOW ECONOMY IN COLOMBIA: SIZE AND EFFECTS ON ECONOMIC GROWTH by Friedrich Schneider * and Beina Hamener ** Absrac: Using he currency demand approach size and developmen of he Colombian shadow economy are esimaed over he period from 1976 o In he 70s he size flucuaed around 20% of official GDP and rose o 50% in he 90s. The mos imporan facors driving he shadow economy are unemploymen and axaion. Analyzing he ineracion beween shadow and official economy, he shadow economy has a posiive effec on he official one. Average growh rae of real per capia GDP is 1.11% beween 1976 and 2002 and he shadow economy explains on average beween 0.09 and 0.27 of his growh. JEL-Code: 017, 05, D78, H2, H11, H26 Key-words: Colombian shadow economy, currency demand mehod, axaion, unemploymen, ineracion beween he shadow and official economy. * Prof. Dr. Dr.h.c.mul. Friedrich Schneider, Deparmen of Economics, Johannes Kepler Universiy Linz, Alenbergersraße 69, A-4040 Linz-Auhof, AUSTRIA, Phone: , Fax: -8209, friedrich.schneider@jku.a, hp:// ** Beina Hamener, suden a he Deparmen of Economics, Johannes Kepler Universiy Linz, Phone: , beina.hamener@gmx.a page 1 ou of 39

3 1. Inroducion Colombia is a developing counry which unforunaely made he headlines in he media because of her drug crime business which negaively influenced Colombia s image by her large-scale cocain producion and rade especially since he 80s. Our paper, however, does no deal wih drug rafficking or oher illegal (i.e. classical crime) economic aciviies in Colombia, because he focus of our sudy is he esimaion of he size and he developmen of he shadow economy over ime and is influence on he official economic growh of Colombia. To our knowledge hese wo aspecs have no been invesigaed so far, especially he ineracion of he shadow economy wih he official one and here he quesion wheher he shadow economy has a posiive or negaive effec! Our paper is divided in five pars. Afer his shor inroducion, in par 2 some heoreical consideraions abou his opic are given, explaining differen ways of defining a shadow economy, analyzing he main causes ha suppor underground aciviy and discussing ineracions beween formal (official) and informal (shadow) economy. In par 3, he economeric resuls of regression models based on he currency-demand approach (o calculae he size of he shadow economy in Colombia) are presened. Based on hese resuls, in par 4 economeric esimaions are shown which demonsrae he influence of he shadow economy on he official one, here on official economic growh. In par 5, he sudy concludes wih a summary of he main findings and a brief oulook on possible policies o ackle he problem of underground aciviies. 2. Theoreical background 2.1. Defining he shadow economy Researchers aemping o esimae he size of shadow economy face he problem of defining a shadow economy. One commonly used (working) definiion is: All currenly unregisered economic aciviies are couned ha conribue o he officially calculaed (or observed) Gross Naional Produc. 1 Smih (1994, p. 18) uses he definiion markebased producion of goods and services, wheher legal or illegal, ha escapes deecion in he official esimaes of GDP. One of he broades definiions includes hose economic aciviies and he income derived from hem ha circumven or oher wise 1 This definiion is used, for example, by Feige (1989, 1994), Schneider (1994a, 2003b, 2005), and Frey and Pommerehne (1984). Do-i-yourself aciviies are no included. page 2 ou of 39

4 governmen regulaion, axaion or observaion. 2 As hese jus menioned definiions sill leave open a lo of quesions, Table 2.1 summarizes wha could be a reasonable consensus abou he definiion of he underground (or shadow) economy. From Table 2.1, i is clear ha a broad definiion of he shadow economy includes unrepored income from he producion of legal goods and services, eiher from moneary or barer ransacions and so includes all economic aciviies ha would generally be axable were hey repored o he ax auhoriies. Table 2.1: A axonomy of ypes of underground economic aciviies moneary ransacions non-moneary ransacions illegal aciviies rade wih solen goods barer of drugs, solen goods, drug dealing and manufacuring smuggling, ec. prosiuion producing or growing drugs for own gambling use smuggling hef for own use fraud ec. legal aciviies ax evasion ax avoidance ax evasion ax avoidance unrepored income from selfemploymen employee discouns, fringe benefis barer of legal services and goods all do-iyourself work and neighbour wages, salaries help and asses from unrepored work relaed o legal services and goods Source: Srucure of he able is aken from Lipper and Walker (1997, p. 5) wih addiional own remarks. Our paper uses a more narrow definiion of he shadow economy 3 : The shadow economy includes all marke-based legal producion of goods and services ha are deliberaely concealed from public auhoriies for he following reasons: (1) ax evasion or ax avoidance, (2) o avoid paymen of social securiy conribuions, (3) o avoid having o mee cerain legal labor marke sandards, such as minimum wages, maximum working hours, safey sandards, ec., and/or 2 This definiion is aken from Del Anno (2003), Del Anno and Schneider (2004) and Feige (1989). See also Thomas (1999) and Fleming e al. (2000). 3 Compare also he excellen discussion of he definiion of he shadow economy in Pedersen (2003, pp ), who uses a similar definiion. page 3 ou of 39

5 (4) o avoid complying wih cerain adminisraive procedures, such as compleing saisical quesionnaires or oher adminisraive forms. Hence, his paper does no deal wih ypical economic aciviies ha are illegal and fi he characerisics of classical crimes like burglary, robbery, drug dealing, ec. The definiion used also excludes all non-marke based economic aciviies like neighbour help, household and do-i-yourself work Theoreical consideraions abou he main causes for he exisence of he shadow economy (1) Tax and social securiy burdens Numerous sudies demonsrae, ha an increasing burden of axes and social securiy conribuions is one of he main causes for he developmen and increase of shadow economic aciviies. 4 The reason is ha his form of fiscal inervenion has a srong influence on individuals cos-benefi and/or labour-leisure choices because i heavily increases he opporuniy cos for legal economic aciviies and finally reduces he profiabiliy of legal (official) work. The greaer he difference beween oal cos of labour in he official economy and afer-ax earnings from work, he greaer is he incenive o work in he shadow economy. However, even major ax reforms wih major ax rae deducions may no lead o a subsancial decrease of he shadow economy. 5 Such reforms may sabilize he size of he shadow economy and avoid a furher increase. Social neworks and personal relaionships, high profis form irregular aciviies, and associaed invesmens in real and human capial preven people from going back o he official economy. 6 Figure. 2.1: Main causes for he increase of shadow economic aciviies. 4 See Ense in Bajada/ Schneider (2005), Schneider (2005, 2006), Alm (1996) 5 See Schneider (1994b, 1998b) for a similar resul of he effecs of a major ax reform in Ausria on he shadow economy. 6 For Canada, Spiro (1993) found such reacions of people facing an increase in indirec axes (VAT, GST). page 4 ou of 39

6 Source: Schneider (2006). Figure 2.1 illusraes he grea imporance of ax and social securiy conribuion burdens on he size and he developmen of he shadow economy. Furher empirical sudies of he influence of he ax burden on he shadow economy by Schneider (1994b, 2000) and Johnson e al. (1998a,b) also show saisically significan evidence for he influence of axaion on he shadow economy. A srong influence of indirec and direc axaion on he shadow economy is addiionally demonsraed by empirical resuls for Ausria and Scandinavian counries from Schneider (2005). (2) Inensiy of regulaion The original objecives of regulaions were o avoid marke failures, hence he goal was o increase welfare, reducing exernal effecs and redisribuion of wealh for higher jusice wihin he populaion. Labour marke regulaion mosly for employees and workers proecion mainly show, a leas in he long erm, posiive effecs. However, regulaions also lead o he fac ha people ofen consider such inervenions of he governmen as a limiaion of heir personal freedom. In addiion, fullfilling laws normally causes supplemenary cos and may herefore have a negaive influence on producion possibiliies and compeiiviy of individuals and firms. A higher scope of regulaion leads in mos cases o higher bureaucraic expendiures for individuals and firms as well as for public auhoriies (Schneider (2000)) and may be a hobed for corrupion, paricularly in developing counries. To sum up, individuals ofen consider increasing inensiy of sae regulaion as cos-rising and freedom-limiing. Therefore, increasing inensiy of regulaion suppors he swich o shadow economic aciviies. These heoreical consideraions are suppored by empirical sudies, which show, ha increasing inensiy of regulaion leads o a growing shadow economy. 7 A his poin i is should be menioned, ha a higher possibiliy of deecion and/or higher expeced 7 Compare Schneider (2005), Wagner (1984), Ense (2005) and especially he survey of Schneider and Ense (2002). page 5 ou of 39

7 punishmen also influence he growh of he shadow economy negaively (Wagner (1984)). (3) Changes in labour marke condiions and he employmen sysem A raioning (i.e. srong policy inervenion) on he official labour marke, e.g. reducion of maximum working hours per week, or a decrease of he age for reiremen have he effec ha people have available much more ime which can be used for shadow economic aciviies. Anoher argumen could be ha afer such changes people find hemselves confroned wih circumsances where heir desired oal working ime no longer corresponds o heir acual one, so ha hey have a srong incenive o engage in shadow economic aciviies. An economic crisis may also lead o a reducion of he work force needed in he official labour marke; hence i is common ha during recessions he official demand for labour decreases and unemploymen rises. Thus, i is no surprising ha during he worldwide recession in he 70s a general increase in he exen of shadow economic aciviy was observed (Gijsel (1984)). An increase in ransfers (e.g. unemploymen benefis, pensions, ec.) reduces he incenives o work in he official economy, oo. As a consequence, people choose o work less in he official economy and as a resul may increase heir shadow economic aciviies. Anoher incenive for working in he shadow economy is a rise in he wage rae in he informal secor (e.g. caused by higher demand for illici work) as his increases he renabiliy of illici work relaive o employmen in he official secor. In a similar way, a reducion in he ne wage rae in he official economy (e.g. due o an increase in payroll ax) decreases he renabiliy of work in he official economy or he marginal uiliy of he exension of official working ime which may also lead o an increase of shadow economic aciviy. However, his argumenaion is only valid for consideraions on a microeconomic basis. According o macroeconomic heory, lower wages lead o higher employmen as demand for labour increases and lower unemploymen implicaes, ceeris paribus, lower aciviy in he shadow economy. 8 (4) Changes in individual values and general aiude owards shadow economic aciviy In all civilized socieies poliicians inerfere in he economy in order o fix he limis beween legaliy and illegaliy and o regulae he funcioning of economic life. These inervenions, however, may no be according o everybodies idea of moraliy and 8 Schneider/ Ense (2002), Wagner (1984), Ense (2005) and Kirchgässner (2006). page 6 ou of 39

8 undersanding of jusice (Besozzi (2001)). This means ha people have no bad feelings owards normal shadow economic aciviies; people ofen may find i easy o jusify heir unofficial supply or demand for goods and services because friends and family members jus do he same (Schneider (2000, p.8)). The erm changes in individual values generally consiss of all possible changes in moraliy of a cerain group or a whole counry s populaion relaing o heir willingness o accep sae regulaions. They may also change heir view of he compeence of public auhoriies, ax morale and he common aiude owards shadow economic aciviies. In general, if rus of he public auhoriies is high handling heir affairs and if he populaion shows a posiive aiude owards fiscal inervenions, one normally expecs lower shadow economic aciviies (Haslinger (1984) and Kirchgässner (2006)). For insance a change in individual values may happen, when axpayers suddenly believe ha hey no longer receive adequae social services or benefis for he revenues paid o he governmen. Anoher example is he increase in overall ax burdens which is no accompanied by immediae and visible increases in (social) sae services. Such evens lower he accepance and he rus in public auhoriies and increase he incenive o engage in he shadow economy, parly because in such siuaions people may feel he need o balance subjecively fel individual welfare losses ou hemselves Theoreical reasoning abou he ineracion beween official and inofficial economies Obviously here are many ineracions beween he official and inofficial (shadow) economies in a counry, hence a sric separaion of hese wo pars of he economy is no possible. 10 Therefore i is no surprising ha here is a coninuous ineracion beween official and unofficial economy. Naylor (1996) emphasizes ha he official par of he economy could never work efficienly if i were oally separaed from he unofficial par. A sudy carried ou by he OECD confirms furher, ha he shadow economy permanenly compees wih he official economy, on he oher hand Lubell (1991) saes ha he formal and informal economies also complemen each oher. Oher sudies (Lubell (1991), Besozzi (2001) and Schneider (2005)) show, ha a cerain influence of he shadow economy on he efficien funcioning and developmen of he official economy can no be denied. 9 Schneider (2000) and Greschmann (1984). 10 Compare Besozzi (2001), Naylor (1996) cied in Besozzi (2001, p.12), Lubell (1991) and Schneider (2005). page 7 ou of 39

9 One of he shadow economy s main influences is he one on he ax syem. As a consequence, redisribuion policies based on ax revenues and he overall financing of he public secor are affeced. For insance, one hypohesis is ha a reducion in he size of he shadow economy leads o higher ax revenues, if and only if his leads o an increase in economic aciviies in he official secor, which happens only o a very limied exen. These addiional resources can hen be invesed in a qualiaive and quaniaive improvemen of public goods and services which in urn induces economic growh (Schneider (2005)). On he oher hand, Schneider (2005) argues ha shadow economic aciviy even generaes addiional ax revenues if hese shadow aciviies are complemenary o he official economy and if he earned exra income is spen in he official economy for goods and services. Frey (1989) menions ha especially in developing counries pars of he raw maerials and semi-produced goods used in he official economy originae from shadow economic sources. Paricularly in developing counries, he acors of he informal economy esablished hemselves as imporan cusomers, suppliers and business parners of firms working in he official economy (Besozzi (2001)). This again underlines he srong inerdependence beween formal and informal economy (Wie (1996) and Lubell (1991)). Applying he allocaion heory, he shadow economy has posiive effecs on he overall funcioning of an economy: more efficien use of scarce resources, simulaion of markes and compeiion, incenives for firms and individuals, enlargemen of marke supply wih addiional goods and services, generaion of addiional income, more creaiviy and more innovaion, ec. However, he allocaion effecs of he shadow economy are no exclusively posiive. Unfair ruineous compeiion due o cos advanages of suppliers in he informal economy may cause official suppliers o be pushed ou of he marke as hey are no longer compeiive. In addiion, a lack of ransparency and a lacking srucure of he inoffical secor may lead o problems in informaion flows and consequenly will lead o a higher inransparency of he markes which means ha condiions for boh, suppliers and consumers, become harder for efficien comparisons of qualiy and prices. On he oher hand, unofficial suppliers ofen work under perfec compeiion, so ha he condiion of seing prices equal o marginal cos holds. Higher compeiion creaes incenives, which lead o more efficien resource allocaion on boh sides, he official and he shadow economy (Schneider (2003a)). page 8 ou of 39

10 Anoher problem caused by he shadow economy is he bias in he officially published daa of economic figures which are used for economic policy decisions, oo. As he informal par of he economy does no appear in official saisics, i can only be aken ino consideraion wih rough approximaions or in he exreme case, no a all. Hence, all sabilizing, redisribuional and fiscal policies are based on inaccurae or even false indicaors. A sudy by Feige and McGee (1989) shows, for insance, ha radiional anicyclical moneary and fiscal policy measures do no have he desired sabilizing bu desabilizing effecs if shadow economic aciviy is no aken ino consideraion. McGee (1989) describes a very impressive model in which moneary policy, aiming a full employmen and only based on indicaors of he official economy, disregarding he shadow economy, does no lead o he required posiive labour marke effecs bu causes sagflaion. Wheher economic efficiency or jusice should be he primary ineres for poliics is a conroversial issue, however, governmens usually implemen redisribuion policies o some exen, where efficiency is srongly influenced by he shadow economy. As he size of he informal secor can only be esimaed and also he individuals acing in he underground can no be idenified precisely, i is possible ha hose benefiing from public services and allowances inended o suppor he underprivileged par of he populaion idenified by official saisics, are no he real needy. The easier i is for individuals o chea and he more are doing i, he higher are he official expendiures in hese caegories leading o an even higher ligh budge siuaion. This eiher leads o an increase in overall axaion, or o a reducion in social services and allowances. Regardless of how a governmen finances his discrepancy, here will always be many ciizens feeling cheaed (hose who are forced o pay more and more axes, hose who receive oo lile social benefis despie heir neediness, ec.). This may easily end in a vicious circle, as individuals, who feel unfairly reaed rapidly begin esablishing jusice hemselves, doing heir own redisribuion policies by migraing ino he shadow economy which causes he official redisribuion policies o fail heir objecives even more (Schneider and Ense (2002)). In his respec, Fleming, Roman and Farrell (2000) claim ha he size of he shadow economy may even serve as an indicaor of how efficien or inefficien poliical sraegies are, as inappropriae policies are incenives for individuals o begin acing in he underground. Various sudies (e.g. Schneider (2005 and 2006)) demonsrae he ineracion beween he official and he shadow economy, sill, bu heir resuls are discussed conroversially, especially, wheher posiive effecs predominan negaive ones or vice page 9 ou of 39

11 versa. As hese effecs among ohers always depend on he concree size of he shadow economy, he inensiy of ineracion beween formal and informal secor and he specific economic siuaion of a counry, an answer can only be given afer an empirical analysis is underaken for concree counries, which we will do for he case of a developing counry, namely Colombia. page 10 ou of 39

12 3. Empirical esimaes of he size of he shadow economy in Colombia 3.1. Esimaion mehod and variables One possibiliy o esimae he size and developmen of he shadow economy is o use he currency demand approach 11. We have chosen his approach for Colombia and have applied wo variaions of he currency demand model, which also have been esimaed: The firs uses as dependen variable, he raio of cash holdings o checkable deposis (CD), he second uses as dependen variable, currency demand per capia (CDC). Using hese wo differen specificaions of he dependen variable, robusness and reliabiliy of he esimaion resuls can be examined. The independen variables used o explain he official currency demand are: (1) he real Gross Domesic Produc (GDP) per capia (GDPPC), (2) he yearly average ineres rae on deposis of 90 days (IRD), (3) he cumulaive real value of impored cash dispensers (depreciaions of 20 % per year deduced) as a proxy variable for cash subsiues describing changes in cash demand over ime (ICD). The variables included in he model for explaining he currency demand induced by shadow economic aciviies are (4) he average real direc (TY) and indirec (TC) ne ax raes (ax on income and VAT), (5) he unemploymen rae (UNEMP), and (6) he real expendiures for public employees in % of GDP (as a proxy for he inensiy of regulaion and conrol) (EPE). 12 Esimaion equaion for model 1 based on he raio of cash holdings o checkable deposis: CD = β + β EPE β1 ln GDPPC + β 2 IRD + β 3 ln ICD + β 4 ln + u TY + β TC 5 + β UNEMP 6 (1) Esimaion equaion for model 2 based on currency demand per capia: ln CDC = β 0 + β1 ln GDPPC + β 2 IRD + β 3 ln ICD + β 4 ln β UNEMP + β EPE u TY + β TC 5 + (2) 11 For a deailed descripion and criicism on he currency-demand mehod see appendix A. 12 For a deailed descripion of he variables used see appendix B., Table 1.1. page 11 ou of 39

13 Based on moneary heory, he real GDP per capia is expeced o have a posiive effec on he dependen variable in boh equaions, whereas he ineres rae should have a negaive impac. Also he proxy variable for cash subsiues should influence he dependen variables posiively, as i faciliaes wihdrawals. From he above heoreical consideraions on he facors influencing he size and developmen of shadow economic aciviy, he coefficiens of direc and indirec axaion, he unemploymen rae and he proxy variable for he inensiy of regulaion are expeced o have posiive signs. To summarize, for boh equaions we derive for he independen variables he following signs: β1 > 0, β 2< 0, β 3 > 0, β 4, β 5, β 6and β 7 > Esimaion resuls Table 3.1 shows he regression resuls for he wo esimaions based on he currency demand mehod. The deailed resuls including all saisics are shown in Appendix B, Tables 2.1 and 2.2. According o he heoreical consideraions, one of he mos imporan causes for shadow economic aciviy is he (oal) ax burden, bu he wo ax variables included in he currency demand equaions are no saisically significan a a 5 % level 13 - wih he excepion of he indirec ax burden (TC) in model 1. One reason for his may be mulicolineariy beween he wo ax variables and in order o avoid his, we also ried an overall ax burden (direc and indirec ax burden), which showed up saisically significan in boh equaions. In our regressions we use yearly daa for he period from 1976 o For model 2, we use he naural logarihm of currency demand per capia; in boh varians of model 2, an ARIMA model has been specified o correc for firs order auocorrelaion. For model 1, a sandard OLS regression has been run for he original model (var. 1a wih boh ax variables included) as well as for he variaion (var. 1b wih only one oal ax variable) as es saisics here do no indicae ime series problems. 13 In his paper we follow he usual procedure o declare coefficiens as saisically significan, if heir saisical significance is given on a 5 % or beer significance level. page 12 ou of 39

14 Table. 3.1: Regression resuls using he currency demand mehod. endogenous variables exogenous variables regression resuls model 1 model 2 raio cash holdings o currency demand per checkable deposis capia (ln) esim. coefficiens esim. coefficiens Var. 1a Var. 1b Var. 2a Var. 2b GDPPC: real GDP per capia (ln) * * * IRD: ineres rae on bank deposis (yearly average) ICD: cumulaive value of cash dispensers (ln) TY: average ne ax rae on income TC: average ne ax rae on consumpion * T overall axaion on income and * (*) consumpion (y+c) UNEMP: unemploymen rae * * * * EPE: real expendiures for public employees (% of real GDP) consan erm * * * * significan on 5 % level (*) significan on he 10% level Source: Own calculaions. For more deailed ables of he regression resuls see appendix B.2. The coefficiens of he independen variables of boh regression models show he heoreically expeced signs. Only he sign of he proxy variable for cash subsiues (ICD) is ambiguous, bu considering ha i is no saisically significan in none of he four esimaions, his is no oo worrying. 14 I may be ha his variable is no a good proxy for explaining changes in currency demand via cash subsiues. Anoher explanaion could be ha he increasing availabiliy of cash dispensers generally has an ambivalen influence on currency demand: A higher number of cash dispensers may conribue o he araciveness of using plasic money (higher circulaion of credi and debi cards), while hey simulaneously increase currency demand making wihdrawals considerably more convenien. Hence, i is highly likely ha he effecs cancel ou each oher. Regarding he oher independen variables explaining he currency demand, real GDP per capia (GDPPC) has a saisically significan and quaniaively large influence on he dependen variable in all models. If real GDP per capia rises by 1 %, he raio of cash holdings o checkable deposis increases by and in esimaion 1a and 1b respecively and he currency demand per capia increases by 5.3 %, ceeris 14 Also he low bea-coefficiens of he variable underline ha i is relaively unimporan (see appendix B.2). page 13 ou of 39

15 paribus. Sandardized bea-coefficiens also show he imporan impac of GDP per capia on he endogenous variables, paricularly in model 2a, where he bea-coefficien for real GDP per capia is 0.38 which is by far he greaes value compared o he beacoefficiens of he oher variables. The coefficien on he average ineres rae on bank deposis (IRD) has a negaive sign in all regressions presened, which indicaes he expeced decrease in cash holdings wih rising ineres raes. However, he coefficien is no saisically significan (p-values beween 0.24 and 0.38) in all four equaions. The variables explaining currency demand induced by shadow economic aciviies (direc and indirec ax raes: TY, TC and unemploymen rae: UNEMP) also show he expeced signs: The posiive relaion beween rising unemploymen, as well as increasing direc and indirec ax raes and he dependen variables are in line wih our hypohesis ha hese facors suppor he growh of underground aciviies and hence have a posiive impac on currency demand. Personnel cos for public secor employees (EPE) as a proxy variable for he inensiy of regulaion and conrol shows a negaive effec on currency demand in hree of he four regressions presened. According o our heoreical argumenaion his is he wrong sign for his variable, as higher inervenion in he marke should increase he size of he shadow economy and consequenly he demand for cash. One explanaion for he negaive relaion deeced could be ha higher personnel cos were due o a widening of he saff in he execuive areas which means higher possibiliy of deecion of informal aciviies and herefore a decrease in he araciveness of illici work and oher underground aciviies. However, as his variable is no saisically significan in boh models and heir varians, a deailed inerpreaion of his variable is no necessary. Wih respec o he saisical significance of he independen variable unemploymen rae (UNEMP), his variable is highly saisically significan in all models and also has a grea quaniaive effec on he endogenous variables. This can be shown by a comparison of he regression coefficiens as well as by he sandardized beacoefficiens. In our regression resuls, a rise in he unemploymen rae by one percenage poin increases he raio of cash holdings o checkable deposis by and for varian 1a and 1b respecively and money per capia in circulaion by 0.05 %, ceeris paribus. The ax variables, which are considered as one of he main causes for shadow economic aciviies, have an imporan effec on he demand for money: An increase by one percenage poin of he indirec average ne ax rae (TC), whose saisical page 14 ou of 39

16 significance is saisfacory in boh of he main equaions, increases he raio of cash holdings o checkable deposis by 0.02 and he currency demand per capia by %, ceeris paribus. The direc average ne ax rae (TY), oo, has a grea influence on demand for cash: If he average ne ax rae on income rises by one percenage poin, currency demand per capia increases by % and he raio of cash holdings o checkable deposis increases by However, he impac of he ax rae on income is smaller han ha of he ax rae on consumpion and is no saisically significan. The reason for ha may be ha he ax variables are highly correlaed (correlaion coefficien (Cor[TY,TC] = ) and hus here migh be a problem of mulicolineariy. Neverheless, sandard F-ess show a high join saisical significance of he ax variables. To avoid he problem of mulicolineariy, a oal ax burden variable is used and variaions 1b and 2b of he main equaion models have been esimaed. The resuls show a large quaniaive impac of overall axaion as well as saisical significance on a high level (p-values are and for varian 1b and 2b respecively). Furher saisical ess show a high join significance of he variables (TY, TC, UNEMP, EPE) used for describing demand for money induced by shadow economic aciviies in boh models: The four variables are joinly saisically significan on a 15 % level and he hree variables TY, TC and UNEMP even on a 1 % level in boh of he main equaion models 15. In he nex sep we underake simulaions, where he values of he variables used o explain he currency demand induced by shadow economic aciviies (TY, TC, UNEMP, EPE) were held on heir lowes levels, in order o calculae he heoreical ( official ) currency demand per capia. The difference beween he real observed and he calculaed heoreical demand for money gives he esimaed currency demand per capia induced by shadow economic aciviies. These resuls muliplied by he velociy of money in he official economy provide value added figures of he esimaed size of he shadow economy which can be shown as a percenage of GDP. The simulaion resuls of he differen models for he size of he shadow economy in Colombia lie relaively closely ogeher, especially he simulaions derived from he wo regressions wih only one cumulaive ax variable (varians 1b and 2b). The resuls are presened in Figure 3.1 which also shows he robusness of he models presened in his paper. Even if he simulaion resuls generally show higher divergences in earlier 15 See appendix B.2 for deails. page 15 ou of 39

17 years, he esimaes presen he same rend: The size of he shadow economy in Colombia increases rapidly unil he mid 80s, followed by a sligh decrease unil he mid 90s. From he mid 90s on, he size of he Colombian shadow economy experiences anoher drasic increase. Only a he end of he period under consideraion his rend comes o an end and a new sligh decrease can be noiced. Figure 3.1: Four simulaions of he esimaed size of he shadow economy in % of nominal GDP for Colombia, % 50% 40% 30% 20% 10% 0% model 1 - var. A model 1 - var. B model 2 - var. A model 2 - var. B Source: Model 1 var. A and model 1 var. B are based on he regression resuls of model 1, varians a and b respecively, using he raio of cash holdings o checkable deposis as endogenous variables whereas model 2 var. A and model 2 var. B use he resuls of he second regression s varians using currency demand per capia as endogenous variable. The rends in he developmen of he shadow economy in Colombia resuling from he above simulaions correspond o he general expecaions: The increase unil 1985 can be explained by he generally poor official economic siuaion in he counry during ha period (decreasing growh raes of GDP, rapid increase of he unemploymen rae). During ha ime, underground aciviy was he only possibiliy for many people o generae income, especially for hose from he poorer par of he populaion. The following decrease in he size of he shadow economy reflecs he beginning sabilizaion of he economic siuaion. The drasic increase in he shadow economy over he las decade ( ) is plausible due o anoher slowdown in official economic growh beginning in he mid 90s; i resuled in he wors recession he counry experienced in he las cenury in The ineracion of he shadow economy wih he official one in Colombia 4.1. The esimaions of a growh model page 16 ou of 39

18 To esimae he influence of he shadow economy on he official one, a growh model has o be specified, explaining he growh of real official GDP per capia (GGDPPC) by he independen facors influencing economic growh given using general economic heory. The mos imporan facors are: inflaion rae [IR], domesic and foreign direc invesmens [DI, FDI], size of he populaion [POP], human capial, measured as average schooling years per capia [SPC], paricipaion rae on labour marke [LPA], public spending on consumpion [PCGDP]) as well as he size of he shadow economy [SE]. Applying his we ge he following regression equaion: Regression model: ln GGDPPC = β 0 + β1 ln GGDPPC 1 + β ln POP + β SPC β LPA + β PCGDP + β SE 7 + β IR + β ln DI β ln FDI 4 + u (3) According o general economic growh heory, he expeced signs of he regression coefficiens of he independen variables are posiive for he lagged endogenous variable (GGDPPC), domesic and foreign direc invesmens (DI, FDI), oal populaion (POP), average schooling per capia (SPC) and he paricipaion rae on he labour marke (LPA), whereas he signs of he coefficiens for inflaion rae (IR) and governmen consumpion (PCGDP) are negaive. Equaion (3) has been esimaed using several variaions of he independen variable shadow economy: The firs one uses he simulaions on he size of he shadow economy calculaed from he regression resuls of he firs model, varians 1a and 1b (variable: raio of cash holdings o checkable deposis) and he second variaion uses he esimaions from model 2, varians 2a and 2b, based on he currency demand per capia. Therefore, in oal, four regressions have been run o esimae he influence of he shadow economy on official economic growh Economeric resuls The resuls are shown in Table 4.1, deailed ones (including es-saisics) are presened in appendix B.3. The esimaed coefficiens, in general, show he expeced signs. Capial invesmens and oal populaion have a posiive and saisically significan effec on economic growh which is in line wih economic growh heory. Foreign direc invesmen, he paricipaion rae on he labour marke and average years of schooling per capia also influence growh posiively, alhough hey do no show high saisical significance in all model variaions. The price level and governmenal consumpion spending have he expeced negaive effec on economic growh and are highly saisically significan in all cases. page 17 ou of 39

19 page 18 ou of 39

20 Table 4.1: Empirical resuls esimaing he effec of he shadow economy on economic growh in Colombia, Source: Own calculaions. See appendix B.3 for a more deailed lising of he regression resuls. For he mos ineresing independen variable, he shadow economy, he regression resuls show a quaniaively subsanial and saisically highly significan posiive influence on GDP growh: An increase in he size of he shadow economy by one percenage poin (measured in percen of GDP), leads o a rise of he growh rae of real GDP per capia by beween 0.20 and 0.22 percenage poins, ceeris paribus. The (sandardized) bea-coefficiens 16 also poin ou he relaively large influence of shadow economic aciviy on economic growh. As bea-coefficiens allow for a direc comparison of he imporance of he various esimaed coefficiens of he independen variables, we go he resul ha he shadow economy has a quaniaively larger effec on economic growh han invesmens, paricipaion rae and he average educaional level Simulaions on he relaive and absolue influence of he shadow economy on economic growh Finally, we empirically deermine he relaive and absolue influence of he shadow economy for each year of our invesigaion; i.e. from 1983 o Applying a dynamic simulaion, he difference beween he official and he heoreical growh of real GDP per capia (he heoreical growh rae is correced for he influence of he shadow economy) can be calculaed: Muliplying he yearly variaion of he esimaed size of he shadow economy wih is regression coefficien provides he concree influence of he 16 See appendix B.3 for deails. page 19 ou of 39

21 shadow economy on GDP growh for each year in percenage poins. Taking hese values one can easily calculae he absolue effecs of he informal economy on economic growh. The corresponding simulaion resuls are shown in Figure 4.1. Figure 4.1: Absolue and relaive influence of he shadow economy on economic growh (of real GDP per capia) in Colombia, , 2-years-averages, in USD and percenage poins. Source: Own calculaions. While average values of he growh of real GDP per capia vary beween -2.3 and +3.4 % or -19 and +24 USD wo periods, he average values of he relaive and page 20 ou of 39

22 absolue influences on growh by shadow economic aciviy lie beween and percenage poins and -10 and +14 USD respecively, which again shows he subsanial effec of underground aciviy on economic growh. Due o he sligh decrease of he size of he shadow economy in he 80s, here is a predominaely negaive conribuion of he informal economy on growh in his period which changes ino a posiive one a he beginning of he 90s. Especially in he years 1999 and 2000 when he Colombian economy experienced is bigges recession of he 20 h cenury he posiive conribuion of he shadow economy on economic growh seems o be paricularly imporan. These resuls clearly demonsrae ha especially during an economic crisis, shadow economy conribued o (parly) equalize he negaive growh raes. A simulaion of he heoreical developmen of economic growh under exclusion of shadow economic effecs makes i clear ha he heoreical growh raes (excep during he second half of he 80s) coninuously lie below he officially recorded economic growh raes which include he influence of he shadow economy. The resuls are shown in Figure 4.2. Figure..4.2.: Comparison of officially regisered yearly growh raes of real GDP per capia in Colombia and simulaed heoreical growh raes excluding he effecs of shadow economic aciviy on growh, Source: Own calculaions. page 21 ou of 39

23 To underline his subsanial influence on official economic growh caused by he informal economy, anoher simulaion has been carried ou which compares he developmen of he officially regisered real GDP per capia and a simulaed heoreical developmen of he GDP per capia correced for he influence of he shadow economy. The resuls are shown in Figure 4.3. The basis for his simulaion is he officially regisered real GDP per capia in For he calculaion of he heoreical developmen of real GDP per capia for he years unil 2002, yearly growh raes were correced for he effecs of he shadow economy. They again demonsrae he grea impac of he shadow economy by which he officially regisered GDP per capia is influenced. The difference beween he heoreical and he officially regisered value is bigges in he period 1999 o 2000 when he Colombian economy experienced is major crisis of he 20 h cenury. For he year 2000, he simulaed real GDP per capia correced for he effec of he shadow economy lies 37 USD below he officially regisered one. Figure 4.3: Comparison of he developmen of he officially regisered real GDP per capia and he simulaed real GDP per capia correced for shadow economic influences, Colombia, Source: Own calculaions. To sum up, all variaions of he differen simulaions illusrae a significan posiive impac of he shadow economy on economic growh in Colombia. Furhermore, he simulaions on he absolue and relaive effecs demonsrae ha he shadow economy page 22 ou of 39

24 considerably conribues o (a leas parially) offse negaive growh raes in economic crises. 5. Summary and conclusion Applying he currency demand approach, he firs major finding of our paper is he large size of he shadow economy in Colombia, over he period from 1976 o Afer a sligh decrease in he second half of he 80s, shadow economic aciviies have increased again in he las years (1995 o 2002) so ha he shadow economy presenly has reached a level of more han 50 % of real official GDP in Colombia. Our empirical analysis of he main causes for underground aciviies shows ha on he one side rising unemploymen has a grea effec on he growh of he shadow economy, and on he oher side we find a considerable influence caused by increases of direc and indirec axaion. Our second major finding is he posiive effec of he shadow economy on economic growh in Colombia. Our resuls demonsrae a clear posiive relaion beween he size of he shadow economy and he growh raes of real GDP per capia: The average growh rae of real GDP per capia beween 1977 and 2002 is 1.11 %, and an average beween 0.07 and 0.27 percenage poins of he growh is explained by shadow economic aciviies. The simulaions also demonsrae ha paricularly during recessions, he shadow economy a leas parly offses he negaive growh raes of he official economy. Considering hese wo major findings we draw he following wo conclusions: (1) Even if our economeric esimaes provide he clear resul of a posiive (i.e. simulaing) effec of he shadow economy on official economic growh, we are aware ha here are sill grea laen poenials and produciviies in he shadow economy which can no be (fully) used due o he generally low produciviy of he shadow economic aciviies and resricions on human and financial capial resources. This may be one of he reasons why Colombia keeps being classified as a developing counry and why is economic sandard is sill relaively low compared o wesern indusrialized OECD naions. Colombia s governmen is aware abou hese los poenials by no using hese underground produciviies and has already implemened various programs o inegrae he shadow economy in he official economy. We hink i is reasonable o follow his sraegy o benefi more from he shadow economic poenials For a furher discussion of inegraion sraegies see Tokman (2006) and Lubell (1991). page 23 ou of 39

25 (2) Moreover, Colombia was one of he firs counries, where he governmen acively began dealing wih he problems and poenials of shadow economic aciviies. Already from he beginning of he 70s, Colombia s governmen has no only implemened sraegies o inegrae he shadow economy bu also programs were se up o aim a he reducion of shadow economic aciviies. Unforunaely, hese programs have no been of grea success, mainly due o a lack of a long-erm sraegy and oo lile coordinaion of differen programs. 18 One suggesion for a beer coordinaion of he various programs dealing wih he shadow economy could be he so-called wo-pillar sraegy which is an all-embracing approach on a macroeconomic basis aiming a a slow-down or reducion in shadow economic aciviies See for example O Grady (2006) for a discussion of coninuous drawbacks in axaion policy and Gracia/ Urdinola (2000) for a debae on changes in labour marke regulaions. 19 For a deailed explanaion of he wo-pillar sraegy consul Schneider/Ense (2002). page 24 ou of 39

26 Appendix A: Currency demand approach The currency demand approach was firs used by Cagan (1958), who considered he correlaion beween he demand of currency and ax pressure (as one cause of he shadow economy) for he Unied Saes over he period Tweny years laer, Gumann (1977) used he same approach bu wihou any saisical procedures. Cagan s approach was furher developed by Tanzi (1980, 1983), who economerically esimaed a currency demand funcion for he Unied Saes over he period 1929 o 1980 in order o calculae he size of he shadow economy. His approach assumes ha shadow (or hidden) ransacions are underaken in he form of cash paymens, so as o leave no observable races for he auhoriies. An increase in he size of he shadow economy will herefore increase he demand for currency. To isolae he resuling excess demand for currency, an equaion for currency demand is economerically esimaed over ime. All convenional possible facors, such as he developmen of income, paymen habis, ineres raes, and so on, are conrolled for. Addiionally, such variables as he direc and indirec ax burden and governmen regulaion, which are assumed o be he major facors causing people o work in he shadow economy, are included in he esimaion equaion. The basic regression equaion for he currency demand, proposed by Tanzi (1983), is he following: ln( / M 2 ) β 0 + β1 ln(1 + TW ) + β 2 ln( WS / Y ) + β 3 ln R + β 4 C = ln( Y / N) + u wih β 1 >0, β 2 >0, β 3 <0, β 4 >0 where ln denoes naural logarihms. C/M 2 is he raio of cash holdings o curren and deposi accouns, TW is a weighed average ax rae (o proxy changes in he size of he shadow economy), WS/Y is a proporion of wages and salaries in naional income (o capure changing paymen and money holding paerns), R is he ineres paid on savings deposis (o capure he opporuniy cos of holding cash) and Y/N is he per capia income. 20 Any excess increase in currency, or he amoun unexplained by he convenional or normal facors is hen aribued o he rising ax burden and he oher reasons leading people o work in he shadow economy. Figures for he size and developmen of he shadow economy can be calculaed in a firs sep by comparing he difference beween he developmen of currency when he direc and indirec ax burden and governmen regulaion are held a lowes values, and he developmen of currency wih he curren (higher) burden of axaion and governmen regulaion. Assuming in a second sep he same income velociy for currency used in he shadow economy as for legal M1 in he official economy, he size of he shadow can be compued and compared o he official GDP. This is one of he mos commonly used approaches. I has been applied o many OECD 20 The esimaion of such a currency demand equaion has been criicized by Thomas (1999) bu par of his criicism has been considered by he work of Giles (1999a,b) and Bhaacharyya (1999), who boh use he laes economic echniques. page 25 ou of 39

27 counries 21 bu has neverheless been criicized on various grounds. 22 The mos commonly raised objecions o his mehod are: (1) No all ransacions in he shadow economy are paid in cash. Isachsen and Srom (1985) used he survey mehod o find ou ha in Norway, in 1980, roughly 80 % of all ransacions in he hidden secor were paid in cash. The size of he oal shadow economy (including barer) may hus be even larger han previously esimaed. (2) Mos sudies consider only one paricular facor, he ax burden, as a cause of he shadow economy. Bu ohers (such as he impac of regulaion, axpayers aiudes oward he sae, ax moraliy and so on) are no considered, because reliable daa for mos counries is no available. If, as seems likely, hese oher facors also have an impac on he exen of he hidden economy, i migh again be higher han repored in mos sudies. 23 (3) As discussed by Garcia (1978), Park (1979) and Feige (1996), increases in currency demand deposis are due largely o a slowdown in demand deposis raher han o an increase in currency caused by aciviies in he shadow economy, a leas in he case of he Unied Saes. (4) Blades (1982) and Feige (1986, 1996) criicize Tanzi s sudies on he grounds ha he US dollar is used as an inernaional currency so ha Tanzi should have considered (and conrolled for) he presence of US dollars, which are used as an inernaional currency and held in cash abroad. 24 Frey and Pommerehne (1984) and Thomas (1986, 1992, 1999) claim ha Tanzi s parameer esimaes are no very sable. 25 (5) Mos sudies assume he same velociy of money in official and shadow economies. As argued by Hill and Kabir (1996) for Canada and by Klovland (1984) for he Scandinavian counries, here is considerable uncerainy abou he velociy of money in he official economy, and he velociy of money in he hidden secor is even more difficul o esimae. Wihou knowledge abou he velociy of currency in he shadow economy, one has o accep he assumpion of an equal money 21 See Karmann (1986, 1990), Schneider (1997, 1998a), Johnson e al. (1998a), and Williams and Windebank (1995). 22 See Thomas (1992, 1999), Feige (1986), Pozo (1996), Pedersen (2003) and Ahumada e al. (2004). 23 One (weak) jusificaion for he only use of he ax variable is ha his variable has by far he sronges impac on he size of he shadow economy in he sudies known o he auhors. The only excepion is he sudy by Frey and Weck-Hannemann (1984) where he variable ax immoraliy has a quaniaively larger and saisically sronger influence han he direc ax share in he model approach. In he sudy of Pommerehne and Schneider (1985) for he US, besides various ax measures, daa for regulaion, ax immoraliy, minimum wage raes are available, he ax variable has a dominaing influence and conribues roughly % o he size of he shadow economy. See also Zilberfarb (1986). 24 Anoher sudy by Tanzi (1982, esp. pp ) expliciely deals wih his criicism. A very careful invesigaion of he amoun of US dollars used abroad and US currency used in he shadow economy and for classical crime aciviies has been underaken by Rogoff (1998), who concludes ha large denominaion bills are a major driving force for he growh of he shadow economy and classical crime aciviies, due largely o reduced ransacions coss. 25 However in sudies for European counries Kirchgässner (1983, 1984) and Schneider (1986) conclude ha he esimaion resuls for Germany, Denmark, Norway and Sweden are quie robus when using he currency demand mehod. Hill and Kabir (1996) find for Canada ha he rise of he shadow economy varies wih respec o he ax variable used; hey conclude when he heoreically bes ax raes are seleced and a range of plausible velociy values is used, his mehod esimaes underground economic growh beween 1964 and 1995 a beween 3 % and 11 % of GDP. (p. 1553). page 26 ou of 39