Shadow-economy is a complex phenomenon, as it is difficult to fix its scope and impact. Shadow-economy has multitudinous definitions and channels. Of which, tax avoidance, undisclosed ownership, unmatched transactions (i.e., trading of goods), and bribery are the most common indicators. In simple terms, shadow transactions bypass formal channels, hide the sources, and do not count towards the volume of formal economic activities in a country. 'Underground economy' and 'informal economy' are synonyms tagged to shadow-economy.
Presence of informal transaction is often connected to lack of regulatory foreknowledge and institutional corruption that are common in high growth developing economies. Motivation behind shadow economic activity is diverse. Tax avoidance and evasion, cost reduction, hiding the sources of the wealth, and geographic value transfer are some of the key motivations. Interestingly, due to poor legal superstructure, some of these illegal activities often happen within the purview of the formal banking system.
Shadow-banking activities are reaching new heights every year. In recent years, we have seen several examples of questionable loans being approved for less qualified companies. The rules of engagement for a 'related party transaction' is often violated against a cushion of 'hypothetical growth' of the borrower that never exists. Problem persists once similar banking activities often take place under the bigger, wider, but shallow umbrella of the country's political system.
What are the impacts of the shadow economic activities? These activities can be broadly categorised into monetary and non-monetary transactions. Transactions impacting the monetary value and money supply, which may have implications for fiscal budget of the government include over- and under-invoicing, manufacturing and trading of drugs, illegal gambling, smuggling, prostitution, and other frauds. These activities directly impact the tax collection of the government, restricting development activities. Due to shortage of funds from the formal activities, government may reduce services and may have to borrow at unworthy cost from the financial markets. Shadow activities are also defined as the ones that are not reported using official channels. As a result, these massive economic activities are not reflected while formulating policies. Money laundering, smuggling and bribery are some of the activities that also affect the quality and efficiency of public as well as private sector growths.
There are several ways to measure the size of shadow-economy. Elgin et al. (2021) published several proxies. These include a model based on: (1) dynamic general equilibrium (DGE) model of the proportion of informal output in a country of its gross domestic products (GDP); (2) multiple indicator multiple causes (MIMIC) model of the percentage of informal output to GDP ratio; (3) self-employment as a percentage of total employment; (4) labour force with pension as a percentage of total labour force;, (5) informal employment as a percentage of total employment estimates by International Labour Organisation (ILO); (6) ILO estimates of the employment outside the formal sector as a percentage of total employment, (7) Executive Opinion Survey (EOS) by the World Economic Forum (WEF); (8) World Bank Enterprise Survey (WBES) estimate of the percentage of firms competing against informal firms; (9) WBES estimate of percentage of formally registered firms to total firms in a country; (10) WBES estimate of the number of years a firm operated without formal registration in a country; (11) WBES estimate of the percentage of firms reporting the practices by informal sector competitors; (12) World Values Survey (WVS) survey responses on "Justifiable: cheating on taxes" question. These are the most robust estimates found on a global scale.
Most influential of the proxies is the Executive Opinion Survey by the World Economic Forum. The survey estimates 'the proportion of the activities undeclared or unregistered' in a country using a seven-point scale where '1' identify 'most undeclared/ unregistered economic activities.' A higher point resembles a more formal economy.
Bangladesh has been in the highlight globally due to its climate change, as a model of socio-economic development using microfinance, and political stability, which is often characterised by limited partaking by the opposition and limited rights of the minority groups. In recent years, there are several reports published by mainstream media on the extreme political affiliation and mismanagement in the banking sector, leading to renewed attention on the size of the shadow economy in the country.
Figure-1 presents a summary comparison of the MIMIC model of percentage of informal output to GDP ratio in five countries. Average MIMIC ratio for Bangladesh stays around 35 per cent, while the same for India is 21 per cent , 36 per cent for Pakistan, 43 per cent for Sri Lanka, and 50 per cent for Thailand. In general view, Bangladesh is doing much better compared to many countries.
Figure-2 illustrates the comparative percentage of informal employment to total employment in five countries. We expect a general decline of this ratio that indicates strength of the formal sector. Average proportion of informal employment in Bangladesh is close to 90 per cent and has been on the rise. The same ratio in Sri Lanka is around 70 per cent and around 60 per cent in Thailand. A higher percentage of informal sector resembles a system that results in lower reported outputs and income from taxes.
The other way of looking into the size of the shadow-economy is though an expert survey. Hassan (2011) presented an early estimate of the size of the shadow-economy in Bangladesh using an expert survey. The survey had 202 respondents from Dhaka, Chittagong and Khulna, having major participants from Dhaka (150). Around 80 per cent of the respondents strongly agreed that black money was bad for Bangladesh economy. Whitening black money by paying a small amount of tax on the undisclosed income became an integral part of budget declaration in most years. Even though 84 per cent of the respondents believed that black money (whitening) is a clear indication of (income) inequality, almost 48 per cent agreed (and strongly agreed) that the black money helped increase investment and production. Nonetheless, 50.50 per cent agreed that black money was harmful for the country.
Two important conclusions can be reached from this information. First, Bangladesh has followed a practice of 'rewarding' black money earners. Second, there is an internal demand to use black money for investment and production. The government should have a clear objective of reducing the size and impact of informal economy. Laws and practices should be introduced to reward formal sector and penalise the process of acquiring unreported asset. Alongside honest political intention, awareness of the general people should work as a force to proscribe shadow-economy. Te government may consider more investment in electronic governance and ease the process of private sector engagement.
Kabir Hassan Is a Professor of Finance at the University of New Orleans, USA. Mamunur Rashid Is a Senior Lecturer at the Canterbury Christ Church University, USA.