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Regional Estimates of the Shadow Economy in Europe

Egle Tafenaua; Helmut Herwartza; Friedrich Schneiderb
a
Institute of Statistics and Econometrics, Christian-Albrechts-Universitt zu Kiel, Kiel, Germany b
Department of Economics, Johannes Kepler University of Linz, Linz, Austria

Online publication date: 13 December 2010

To cite this Article Tafenau, Egle , Herwartz, Helmut and Schneider, Friedrich(2010) 'Regional Estimates of the Shadow
Economy in Europe', International Economic Journal, 24: 4, 629 636
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 International Economic Journal
Vol. 24, No. 4, 629636, December 2010

Regional Estimates of the Shadow

Economy in Europe

EGLE TAFENAU , HELMUT HERWARTZ &

FRIEDRICH SCHNEIDER
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Institute of Statistics and Econometrics, Christian-Albrechts-Universitt zu Kiel, Kiel, Germany,

Department of Economics, Johannes Kepler University of Linz, Linz, Austria

ABSTRACT The aim of the paper is to estimate the extent of the shadow economy in the
regions of the European Union. For this purpose the multiple-indicators multiple-causes
approach combined with elements of spatial econometrics is implemented. The analysis
shows that the shadow economy is most extensive in Eastern and Southern Europe, con-
firming results from previous literature. Within countries, the poorest regions tend to exhibit
the highest shadow economy quotas. The smallest extent of shadow activities is obtained
for the Netherlands and the United Kingdom, while in Poland the shadow economy is most
extensive.

KEY WORDS: Shadow economy, European Union, MIMIC modelling, spatial effects
JEL CLASSIFICATIONS: O17, C39, H26

Introduction
In this paper, the extent of the shadow economy in the regions of the European
Union (EU) is estimated with the help of the multiple-indicators multiple-causes
(MIMIC) approach. The analysis is applied to the NUTS 2 level regions (NUTS
the Nomenclature of Territorial Units for Statistics, NUTS 2 regions com-
prise a population of 0.83 million people) as they are the main reference units
for implementing the EU regional policy. In the estimation, interactions among
regions located close to each other are taken into account.

Correspondence Address: Egle Tafenau, Institute of Statistics and Econometrics, Christian-

Albrechts-Universitt zu Kiel, Olshausenstr. 40, 24098, Kiel, Germany. Email: tafenau@bwl.uni-
kiel.de
1016-8737 Print/1743-517X Online/10/0406298 2010 Korea International Economic Association
DOI: 10.1080/10168737.2010.526010
 630 E. Tafenau et al.

The shadow economy estimates at a regional level deliver additional infor-

mation compared with the country level estimates. First, they help to develop
region-specific policies for combating the shadow economy. Second, knowledge
on the extent of shadow activities is an important input in designing regional
development policies and evaluating the economic situation in each region. For
example, in the EU, the eligibility for funding from the Structural Funds and
Cohesion Fund relies heavily on the regions GDP per capita relative to the EU
average. Although the EU countries are required to include all economic activi-
ties whether legal or illegal, hidden from the governmental agencies or not in
the GDP, the extent of adjustments for non-reported economic activities varies a
lot across countries (United Nations, 2008). Therefore, regional estimates of the
shadow economy quotas offer valuable information for policy decisions.
Although several methods can be applied to estimate the extent of the shadow
activities (an overview is Schneider & Enste, 2000) only a few of them are usable
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at a regional level if international comparability is of interest. For example, survey

based methods can not be implemented as the surveys are not standardised and
are, thus, internationally incomparable. Further methods have to be excluded
due to data unavailability: money demand or electricity consumption that are
often key variables in the shadow economy measurement are not determined for
sub-national territorial units. Due to these considerations, the MIMIC approach
is chosen for the regional analysis. In this approach, the extent of the shadow
economy is modelled as an unobservable variable. The extent of shadow activities
is determined from the empirical and model-based covariance structure of its
causes and indicators. Further details of the MIMIC estimation procedure are
provided in Bollen (1989).
Our analysis reveals that the shadow economy is more extensive in regions and
countries with high tax rates, poor labour market opportunities and an excessive
public sector. The country level estimates are similar to the estimates in earlier
literature (Schneider, 2007), although in several countries the extent of the shadow
economy varies considerably across the regions.
In the next section, the causes and indicators that are used to determine the
extent of the shadow economy are discussed. After that, the parameter esti-
mates are presented. The following section documents the estimated extent of
the shadow economy in the regions of the EU. The fifth section concludes.

The Model and Data

There are six cause and two indicator variables in the model. As the classification
of variables into causes and indicators is ambiguous, they are chosen based on
the model of DellAnno et al. (2007).
Among the cause variables are nominal tax rates (tax wedge and value added
tax (VAT) rate), but also a paid taxes variable that shows the proportion of
income and wealth taxes in households incomes. In general, taxes are expected
to have a positive effect on the extent of shadow activities: high taxes raise the
attractiveness of tax avoidance and evasion. However, the tax rates, especially
imputed tax rates as represented by the paid taxes variable, can also reflect the
 Regional Estimates of the Shadow Economy in Europe 631

quality and extent of the public services or tax morale. Both of these phenomena
increase the willingness to pay taxes and, thus, to report the economic activities.
Therefore, the relationship of a tax variable with the shadow economy can be
mixed.
A related cause variable is the size of the public sector, measured as the share
of public sector employees in the labour force. As in the case of the tax variables,
this variables interaction with the shadow economy can be twofold. On the one
hand, a large public sector can offer more and better public services and motivate
moral behaviour. On the other hand, a large public sector can be perceived as
inefficient by economic agents. In that case, they rather incline to withhold the
due taxes.
Further cause variables are the unemployment rate and the self-employment
rate, both of which are expected to exhibit a positive correlation with the extent
of the shadow economy. The unemployed have more time to engage in shadow
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activities and the self-employed more opportunities to hide their true incomes in
comparison with employees.
As the indicators, the gross domestic product (GDP) per capita in purchasing
power standard (PPS) and the labour force participation rate are considered in
the model. Both are expected to be lower if the shadow economy is extensive.
Although these variables should comprise both the official and unofficial activ-
ities, the unofficial activities are less likely to be reported. In order to solve the
identification problem characteristic to the MIMIC approach, the GDP per capita
is chosen as the normalising variable, with its coefficient fixed to 1.
In addition to the ambiguity in the classification of cause and indicator vari-
ables, there arises a potential endogeneity problem. For example, tax rates have to
be set higher in the case of an extensive shadow economy in order to compensate
for the non-paid tax revenues. However, as the nominal tax rates are set at the
country level, but the analysis applies to a regional scale, the endogeneity problem
diminishes.
In the case of regional data, another factor that can influence the reliability of
the estimation results is spatial autocorrelation. Therefore, the model has also
been estimated based on spatially adjusted indicators. For this purpose, a weight
matrix based on the interregional distances is used such that only regions at a
distance up to 90 km (the cut off distance) are considered to matter for the spatial
adjustment.
The data are drawn from the Eurostats online databases, with the exception
of the nominal tax rates. The tax wedges and VAT rates are the only variables
measured at the country level and are obtained from Eurostat (2006) and European
Commission (2009), respectively. In the estimation, the variables are used in the
form of their relative difference from sample averages. The initial sample includes
all NUTS 2 regions of the 27 EU member states. Mainly due to missing data,
the overseas territories, Bulgaria, Cyprus, Luxembourg, Malta, Romania and
two regions of the United Kingdom, North Eastern Scotland and Highlands and
Islands, are omitted. Denmark and Slovenia are not represented with their NUTS
2 regions, but with the country as a whole. After these adjustments, 238 regions
remain in the sample. The year of the analysis is 2004, chosen as the year with
least missing data.
 632 E. Tafenau et al.

Table 1. MIMIC parameter estimates

Variables Model 1 Model 2

Causes
Paid taxes 0.598 (5.89) 0.522 (5.01)
Tax wedge 0.363 (4.05) 0.247 (2.81)
VAT 0.548 (5.64) 0.615 (6.29)
Share of public employment 0.193 (2.73) 0.078 (1.02)
Unemployment rate 0.128 (4.13) 0.148 (4.39)
Self-employment rate 0.154 (4.53) 0.150 (4.89)
Indicators
GDP (PPS) per capita 1.0 1.0
Labour force participation 0.284 (6.77) 0.459 (6.80)
Statistics
Degrees of freedom 25 25
2 33.07 22.73
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RMSR 0.004 0.004

AGFI 0.950 0.965
R2 0.539 0.983
Spearmans rank correlation of 1.000 0.991

Source: Own calculations. GLS estimation results. The indicator variables have been
adjusted for spatial effects in model 2. t-statistics in parentheses. denotes |t-statistic| >
1.96. GDP per capita is the normalising variable with its coefficient fixed to 1. RMSR
root mean squared residual, AGFI adjusted goodness-of-fit index, R2 = 1 /Var[]
coefficient of determination for the unobserved variable , the estimate of the variation
of the estimation error of the unobserved variable.

The Parameter Estimates

The results from generalised least squares estimation (GLS) are documented in
Table 1. In model 1, no variables are corrected for spatial effects, while in model 2
the indicator variables are adjusted for spatial interactions.
According to the adjusted goodness-of-fit index, both models have a very good
fit. The 2 -test of overall model fit conforms with the hypothesis of equal implied
and sample covariance matrix at the 5% significance level. In the model with spa-
tial adjustments the coefficient of determination for the unobserved variable, R2
is remarkably higher than in the model without spatial adjustments. R2 was also
the criterion in determining the suitable cut-off distance and spatial adjustment
coefficients in model 2. The obtained spatial adjustment coefficients suggest, first,
that the GDP per capita of neighbouring regions does not indicate the extent of
the shadow economy in the region under consideration. Second, the labour force
participation rate is adjusted upwards due to the spatial interaction. A high labour
force participation rate indicates in general good labour market possibilities and,
thus, low activity in the shadow sector, not only in a region of interest but also in
the surrounding regions if those are at a commuting distance.
Considering the parameter estimates, the two models deliver qualitatively very
similar results and the signs of the parameter estimates conform with the discus-
sion in section 2. Specifically, the shadow economy is more extensive in countries
 Regional Estimates of the Shadow Economy in Europe 633

and regions with high nominal tax rates, unemployment and self-employment
rate. The sign of the parameter estimates for the paid taxes and the public sector
size variables was claimed to be ambiguous. In the case of the paid taxes variable,
the negative parameter estimate shows that the variable is rather determined by
tax morale and the extent of public goods than by the nominal tax rates. This
interpretation is confirmed by changes in the parameter estimates when the tax
wedge or public sector size variable is removed from the model (Herwartz et al.,
2010).
The positive parameter estimate for the size of the public sector indicates inef-
ficiencies in the public sector rather than the extent and quality of its services.
However, this is the only variable that turns insignificant at the 5% significance
level in the spatially adjusted estimation. Thus, the public sector inefficiency dom-
inates only weakly over the quality and extent of public goods in the interpretation
of the public sector size variable.
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The indicator variables are both negatively related to the extent of shadow
activities. The plausibility of the parameter estimates both for the cause and
indicator variables gives support to the normalisation of the coefficient for the
GDP per capita to a negative value.

Table 2. The national averages of the shadow economy in 2004, in

percentage of reported GDP

Country Model 1a Model 2b Schneider (2007)c

Netherlands 9.2 9.7 11.6

Denmark 10.8 12.0 16.4
United Kingdom 11.8 12.1 11.0
Austria 13.9 14.2 9.7
Germany 15.1 14.6 15.7
France 16.2 15.8 13.5
Sweden 15.8 15.9 16.8
Ireland 14.3 15.9 14.5
Finland 15.9 16.4 16.1
Slovenia 16.2 16.6 27.8
Estonia 16.3 16.6 38.7
Spain 16.5 16.9 20.9
Belgium 17.4 16.9 20.0
Czech Republic 16.7 17.1 18.8
Portugal 18.8 19.3 20.8
Latvia 21.0 20.4 39.9
Italy 20.4 20.5 24.0
Greece 20.6 20.9 26.9
Slovak Republic 22.0 22.3 18.7
Hungary 22.3 22.4 24.8
Lithuania 22.9 22.4 30.8
Poland 28.8 29.2 27.8

Source: Own calculations.

a No spatial adjustment.
b Indicators spatially adjusted.
c Average over the estimates for 2003/2004 and 2004/2005.
 634 E. Tafenau et al.

The Extent of Shadow Activities

As the MIMIC estimation requires a normalisation, only a preliminary shadow
economy index can be derived based on the parameter estimates. Specifically, the
preliminary index is calculated as
r =  xr (1)
where r stands for the preliminary index of the unobserved variable (shadow
economy) in region r, the q 1 vector xr = (x1r , x2r , . . . , xqr ) collects the q
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Figure 1. The deviation of the regional shadow economy quotas from the country average (%) in
the EU NUTS 2 regions. Based on model 2.
 Regional Estimates of the Shadow Economy in Europe 635

cause variables of shadow activities and = (1 , 2 , . . . , q ) the corresponding

parameter estimates.
To obtain the estimates of the shadow economy quotas, an appropriate scale
and anchoring value have to be chosen. As the results are very sensitive to these
base values if the adjustment relies on a couple of specific observations, the sample
mean and standard deviation have been used instead. The sample mean (17.2%)
and standard deviation (5.4%) are derived from the country level estimates of
Schneider (2007), taking into account the size and number of regions in each
country.
The obtained estimates of the shadow economy shares in the GDP at country
level are documented in Table 2. Again, the results are similar for the two estima-
tion procedures. Only in the cases of Denmark and Ireland the estimated shadow
economy quotas differ by more than one percentage point. Compared with the
results of Schneider (2007) the only alternative estimates that are comparable
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across a large cross section of countries there are remarkable differences for
several Eastern European countries (Estonia, Slovenia, Latvia, Lithuania). In the
case of four Western European economies (Denmark, Austria, Spain, Greece),
the difference is more than four percentage points. However, the ordering of the
countries is similar: the extent of the shadow economy is, in Eastern and Southern
Europe, higher than in Western and Northern Europe.
Figure 1 shows the regional variation of the shadow economy quotas.1 The
within-country differences reveal that not only the relatively poor countries but
also the least wealthy regions within a country exhibit an above average extent of
shadow economic activity. This holds, for example, for Germany and Italy, where
the highest shadow economy quotas are obtained for the eastern and southern
regions, respectively. Considering the whole sample, the lowest shadow economy
quotas are estimated for the Netherlands and highest for Polish regions.

Conclusions
This paper shows that within several European countries the extent of the shadow
economy varies a lot. The largest regional differences are found in Belgium, Ger-
many, Spain, Greece, Italy and the Slovak Republic. Thus, to combat a shadow
economy it is recommended to take into account the local situation, such that
policy is regionally diversified. It is important to find the main reasons why agents
engage in shadow activities and in which sectors the hidden activities are most
extensive. Such information from additional studies at the local scale would help
to improve the measures for reducing shadow activities.
Besides negative effects, such as deficient tax revenues or distortions in com-
petition, the shadow activities also exert positive effects. For example, shadow
engagement of the unemployed helps to maintain their skills and working habits.
Moreover, a large share of shadow incomes is spent in the official economy
(Schneider, 2008). This increases the demand for officially produced goods and
services and contributes to economic growth. Therefore, it can be reasonable to

1 We are grateful to Lorena Gola and Cornelius Peters for preparing the map.
 636 E. Tafenau et al.

tolerate in the poor regions a larger extent of shadow activities than in the rich
regions.
In spite of such positive effects, the development prospects of the backward
regions can be improved if the shadow activities are transformed into the official
economy. The poor regions suffer under low tax revenues both because of the
narrow economic base and the large extent of the shadow economy. This reduces
their ability to participate in regional development programs and to offer good
public services. To escape this trap, it is necessary to improve the attractiveness of
the region as a business location and to transform the hidden activities to the offi-
cial economy. A possible way to achieve this is to enhance, with external resources
that are given to backward regions, the quality of public goods and services. An
efficient public sector with a high-quality output motivates tax compliance and is
indispensable in the long term (Enste, 2008). Our results confirm this argument,
although the size of the tax rates and labour market conditions also impact on
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the decisions to participate in the shadow activities.

Acknowledgements
Earlier versions of the paper have been presented at conferences in Toila (Estonia), Mnster and Potsdam (both
Germany), in the research seminars at the Christian-Albrechts-Universitt zu Kiel and University of Tartu.
The authors are grateful to the participants for their helpful remarks. Special thanks to Karsten Staehr for his
thorough comments.

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