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

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.