Reflection Paper on Comparative Business Ethics
Professor: Rajiv Krishnan Kozhikode
Group 5
Afrakoma Amponsah 301150605
Xiaoyi Zhuang 301114713
Reflection Paper on Comparative Business Ethics
The underground economy is a real life fact and there are strong indications that it is
increasing rapidly. In the assigned article, the author sheds light on some of the causes of
the underground economy. Some of these reasons are politicization of economic activity,
more regulation and bureaucracy, higher tax burden on those in the official economy,
weak rule of law, and high corruption.
According to Johnson, Kaufmann and Zoido-Lobatón if there is a high politicization of
economic activity, more regulations and bureaucracy, higher tax burden on those in the
official economy, weak rule of law, and high corruption, companies and individuals
simply react by moving to the shadow economy. In this critique we attempt to define
what the unofficial economy is, give a picture of the size and growth of the unofficial
economy in a variety of countries, shed more light on the causes of the growth of the
unofficial economy, the effects of the unofficial economy on the official economy and
methods used in measuring the shadow economy.
It is quiet difficult to fully define the shadow economy because it adjusts to changes in
taxes, sanctions from tax authorities and general moral attitudes (Schneider & H. Enste,
2000). The most comprehensive definition of what the unofficial economy is can be seen
in the table below:
Source: Rolf Mirus and Roger S. Smith (1997, p. 5), with additional remark.. As cited Schneider, F., & H. Enste, D’s
article “Shadow economies: Size, causes, and consequences”
Table 1 shows that the shadow economy comprises of illegal and legal activities.
According to Table 1, the shadow economy constitutes of all unrecorded income from the
production of legal goods and services, either from monetary or barter transactions, thus,
all economic activities that would have been taxed if were they reported to the tax
officials (Schneider & H. Enste, 2000).
Source: Schneider, F., & H. Enste, D’s article “Shadow economies: Size, causes, and consequences”
The size of the shadow economy varies from country to country. Table 2 above gives us
an idea of the magnitude of the shadow economy in selected developing, transition and
OECD countries. Developing countries like Nigeria, Egypt and Thailand have an
underground sector that is three-quarters the size of the officially recorded GDP. Asian
countries which have a comparatively small public sector, high tax morale and/or high
expected punishment such as Singapore and Hong Kong have shadow economies that are
as low as those of Northern European countries. The Scandinavian countries have quite a
high shadow economy as a result of the high fiscal burden1. While the countries with the
smallest shadow economies are usually countries with relatively small public sectors and
high tax morale such as USA and Switzerland (Schneider & H. Enste, 2000).
Although some western European countries and the USA have really low percentage of
shadow economy, there has been a significant growth in their shadow economies between
1960 and 1995 which can be seen in table 3. The size of the shadow economy, more than
doubled for each country (Schneider & H. Enste, 2000).
Source: Schneider, F., & H. Enste, D’s article “Shadow economies: Size, causes, and consequences”
There are many reasons for the existence and growth of the shadow economy. Some of
these reasons will be discussed below:
1. The rise of the burden of taxes and social security contributions: Taxes affect labourleisure choices (the trade off faced by workers between time spent in working and time
spent in deriving satisfaction in doing leisure activities) and could also stimulate labour
1
The influence of the tax levied on the taxpayer’s purchasing power (Wikipedia
Encyclopedia, 2011).
supply in the shadow economy. Therefore, the bigger the difference between the total
cost of labour in the official economy and after-tax earnings, the greater the incentive to
avoid this difference and to work in the shadow economy (Schneider & H. Enste, 2000).
Norman V Loayza carried a study in 1996 to show the effects of excessive taxes and
regulations on the informal sector especially when government lacks the capability to
enforce the rules. The results proved that tax burdens positively affect the growth of the
shadow economy. While the strength and efficiency of government institutions have a
negative influence on the shadow economy. This goes to support the second proposition
in the first article where Johnson says, “the unofficial economy should be larger when
there is a bigger tax burden on firms in the official sector, where "burden" on the firm is
the outcome of how the tax system is administered as well as what the rates are”
(Johnson, Kaufmann & Zoido-Lobaton, 1998).
2. Intensity of regulations – In Johnson et al. article they mention that the share of the
unofficial economy increases when there is more regulation and more discretion for
officials to decide how the regulatory system operates (Schneider & H. Enste, 2000). In
the second article, the intensity of regulations is measured by the number of rules and
requirements such as licenses, labour market regulations, labour restrictions for
foreigners and trade barriers. A high intensity of regulations makes labour cost in the
official market increase. In the unofficial market, organizations could shift these costs to
the employees hence they exist to the unofficial market. Government sometimes
increases the number of rules because it increases power to bureaucracy and higher
employment in the public sector. However, these findings emphasize on the fact that,
when its not exactly necessary to create more rules, government should emphasize on the
implementation of the rules instead of increasing the number of rules as not all politicians
may have a sincere interest in reducing the shadow economy.
3. Social Transfers: Countries with extremely generous social welfare systems create a
negative incentive for the beneficiaries to find a job in the official market. This is
because, if they are to find a job in the unofficial market, their combined income (i.e.
social welfare benefits plus income from unofficial market) will be greater than their
income if they solely find a job in the official market. It’s even more important to note
that the income made in the unofficial economy will not be taxed.
4. Public sector services –In Johnson et al. article they talk about the downward spiral
which is also supported by Schneider et al. An increase of the shadow economy actually
leads to a decrease in the quantity and quality of public goods and services and
administration that are being provided. This can eventually lead to higher tax rates and a
burden in the official economy and hence an even stronger motivation for companies and
individuals to move to the shadow economy (Schneider & H. Enste, 2000).
5. Labour market: Two main aspects of the labour market contribute to the shadow
economy. These are: overregulation and labour costs. In most OECD countries,
unemployment is to some extent caused by the high total labour costs. There are also
countries such as France and Germany that reduced working hours in order to reduce
unemployment. However, because some of the employees who had their hours reduced
were not necessarily in favour of the new labour hour regulations, so they began to work
in the shadow economy.
6. Although all the reasons mentioned above are economic, there are other reasons for
which people choose to work in the shadow economy. Some of these non-economic
reasons include tax morale and perceived fairness of the tax system, decline of civic
virtue and loyalty towards public institutions.
Since the shadow economy and the official economy are intertwined, officials should
take the shadow economy in consideration when making tax laws and regulations for the
official economy. There are two school of thought concerning the growth rate of the
official economy, as a result of the existence of the shadow economy. A study on
Belgium by Markus C. Adam and Victor Ginsburg (1985) show that there is a positive
relationship between the growth of the shadow economy and the official economy under
certain assumptions (i.e. the low entry cost into the shadow economy as a result of low
chance of enforcement). According to the study, an expansionary fiscal policy 2is positive
for both the formal and informal economy (Schneider & H. Enste, 2000).
Another hypothesis however, is that a decrease in the shadow economy leads to an
increase in tax revenues and public services which stimulate economic growth. Loayza
(1996) through a study discovered that in economies where the statutory tax burden is
larger than optimal and where enforcement of compliance is too weak, the increase in the
shadow economy limits economic growth (Schneider & H. Enste, 2000). This is because
Government policies that aim to increase government expenditure and reduces
taxes to influence the economy
2
of the negative correlation between the shadow economy and economic growth, while
public infrastructure is a key element of economic growth (Schneider & H. Enste, 2000).
There are three main ways by which the shadow economy is calculated and these will be
discussed below:
1. The direct approach - This is a microeconomic approach where surveys are voluntarily
filled or through tax auditing and other compliance methods. The advantage of this
method is the detailed information that is obtained about the shadow economy. However
just like any questionnaire, responses are subject to the way that the questions are formed
and also subject to the cooperation of the audience.
Additionally, the shadow economy could also be measured by the difference between the
income reported for tax purposes and their income measured by selective checks through
fiscal auditing. However, the shadow economy determined through this method is only a
portion that the authorities succeeded in discovering.
2. The indirect approach - These approaches look at calculating the shadow economy
from a macroeconomic level. The different types of indirect approaches will be discussed
below:
a. The Discrepancy between National Expenditure and Income Statistics - In national
accounting, the GNP expenditure should be equal to the national income of GNP.
Therefore the gap between the expenditure measure and the income measure can be used
as a measure of the shadow economy. Statisticians will try to minimize this difference
hence the initial difference calculated and not the published difference should be used.
This approach is of questionable reliability because its difficult to calculate an accurate
GNP expenditure (Schneider & H. Enste, 2000).
b. Discrepancy between the Official and Actual Labour Force - A decrease in labour
force activity in the official economy can be seen as an increase in the labour activity of
the shadow if total labour force participation is assumed to be constant. The disadvantage
of this method is that the differences in labour rate participation may be as a result of
other reasons. In addition, there are some workers who are active in both the unofficial
and official economy (Schneider & H. Enste, 2000).
c. The Transaction Approach - In the research for transaction approach, Feige (1979,
1989, and 1996) assumes that there is a constant relation over time between the volume
of transactions and the GNP. The shadow economy can be calculated by subtracting the
official GNP from total nominal GNP. However, some assumptions have to be made
about the velocity of money, the relationship between the value of total transactions and
the total nominal GNP (official +unofficial). This method also requires an assumption of
a base year in which there is no shadow economy thereby making it unreliable
(Schneider & H. Enste, 2000).
d. The currency demand approach - This method assumes that the shadow market
engages in only cash transactions; hence an increase in the shadow economy will lead to
an increase in the demand for currency. This method involves a mathematical formula
which actually takes into consideration just one factor which is tax burden and none
other. This happens to be one of the limitations of the currency method. Furthermore, not
all transactions in the shadow economy are actually paid in cash (Schneider & H. Enste,
2000).
e. The Physical Input (Electricity Consumption) Method - Kaufmann and Shleifer assume
that electricity consumption is the best physical indicator of overall economic activity.
With this method, the shadow economy is measured by subtracting the proxy
measurement of the whole economy from the estimates of the official GDP. The
limitation of this method is that, not all shadow economy activities require electricity
(Schneider & H. Enste, 2000).
3. The Model Approach – This is the most advanced way of calculating the shadow
economy. While other methods take only one factor into consideration when measuring
the shadow economy, this approach takes into consideration multiple causes which
include high taxation, heavy regulation and declining tax morality etc. A change in the
size of the shadow economy is reflected in the “indicators”, which are monetary
indicators – additional or less monetary transactions are required in the shadow economy,
production market indicators – more or less inputs are required in the shadow economy
and labour market indicators – more or less labour required in the shadow economy.
References
Johnson, S., Kaufmann, D., & Zoido-Lobaton, P. (1998). Regulatory discretion and the
unofficial economy. American Economic Review.
Schneider, F., & H. Enste, D. (2000). Shadow economies: Size, causes, and
consequences. Journal of Economic Literature, 38(1), 77-114.
Wikipedia. (n.d.). Fiscal burden of government. Retrieved from
http://en.wikipedia.org/wiki/Fiscal_burden_of_government.