Why the shadow economy persists and how governments are responding

The shadow economy is also known as the “non-observed” or “unregistered” economy. It involves unreported economic activity from both registered and unregistered entities, where no invoices or fiscal receipts are issued, rendering transactions unreported and taxes unpaid. It is a significant component of the tax gap, which is the difference between the total amount of taxes owed to the government versus what is actually paid. It also distorts competition, reduces the quantity and quality of public goods, acts as a barrier to investment and growth, and degrades economic institutions and social attitudes.

The study presents an in-depth examination of the shadow economy, focusing on its multifaceted components as well as relationship with the tax gap and informal employment. It provides crucial insights into the functioning of these components, the detrimental effects they generate, and the strategies applied to mitigate their adverse impacts.

The study investigates five areas of actions undertaken by various governments to tackle tax noncompliance:

1. Increasing taxpayers’ trust toward public administration and the tax system;
2. Overcoming businesses’ lack of formalization;
3. Making better use of available technologies to increase detection of non-compliance;
4. Taking advantage of third-party information; and
5. Enhancing whole-of-government approaches and international cooperation.

The report identifies crucial drivers of the shadow economy in developing countries (informal businesses, low government effectiveness) and advanced economies (tax rates). It suggests customized policy response based on countries’ individual needs, which can be explored with various methodological approaches. The study underscores the necessity of local context in crafting compliance strategies and combining long-term initiatives like enterprise formalization and enhancing institutional quality with short-term improvements, e.g., in noncompliance detection. Targeted measures informed by noncompliance insights promise greater efficiency, while field experiments can validate some policies before full implementation. Caution and gradual approach should be considered in curbing informal activities, which often serve as a safety net for the poor.

Ultimately, the report concludes that only through comprehensive and data-driven policies can governments effectively alleviate the adverse effects of the shadow economy.