Government expenditure–shadow economy nexus: the role of fiscal deficit

Purpose - The effects of government expenditure on the shadow economy have been investigated. However, the effect from a moderating factor that affects this relationship has been largely ignored in the existing literature. This paper investigates how fiscal deficit moderates the effects of government expenditure on the shadow economy for 32 Asian countries for the past two decades since 2000. Design/methodology/approach - The authors use various techniques, which allow cross-sectional dependence and slope homogeneity in panel data analysis, to examine this relationship in both the long run and short run. The analysis also considers the marginal effects of government expenditure on the shadow economy at different degrees of fiscal deficits. Findings - Empirical findings from this paper indicate that an increase in government expenditure and fiscal deficit will increase the shadow economy size. Interestingly, the effects of government expenditure on the shadow economy will intensify with a greater degree of the budget deficit. The authors also find that enhancing economic growth to improve income per capita and extending international trade appears to reduce the shadow economy in the Asian countries. Practical implications - The authors consider that policies targeting reducing shadow economy should follow conventional economic policies on economic growth, unemployment and inflation. Originality/value - To the best of the authors’ knowledge, this is the first empirical study conducted to examine the moderating role of fiscal deficit in the government expenditure–shadow economy nexus in Asian countries.