What are the reasons for such differences in the size of shadow economy?

Question

Have a look at this graph for some OECD countries:

What are the reasons for such differences in the size of shadow economy?

One reason for the size of the shadow economy I have listened many times is taxation: the higher the taxes, the bigger the size of the shadow economy (according to this argument, people and companies are willing to accept taxation up to some level, in which they start to try not to pay taxes). However, the graph above does not seem (at a first glance) to reflect this explanation. For example, Austria has high taxes, whereas taxes in Korea are low.

After a quick look, it seems to me there is a correlation (not implying causation) between culture/origin and underground economy: Mexico, Greece, Italy, Portugal, and Spain do have shadow economies larger than 20% of their GDP. Is this just correlation or there is also causation?

How do the US (a much bigger economy than Switzerland, Luxembourg, and Austria) achieve such a low shadow economy?

Answer 1

You didn't give a source for that picture so there is no way to know about the methodology used to calculate those figures.

Let's start with the shadow economy. Obviously it can only be guessed but a big problem is that some things are illegal in some countries and arn't in others. What about the gun trade or prostitution? Switzerland and the US seem to have comparable shadow economies but prostitution is illegal in the US and isn't in Switzerland. So is there as much illegal gun trade in Switzerland as there is prostitution in the US (as % of the GDP, not in raw numbers, obviously)? Then Canada has the weirdest law of all time: http://www.taxpage.com/Articles/illegal-income.html so how is that reflected? Assuming everyone does play by the rules and reports their illegal income the actual GDP is higher even though that growth is entirely financed through illegal means. Assuming nobody does is there a double counting with the illegal income and the tax evasion?

Opportunity is a big factor as well. How easy is it to get away with tax fraud (and how hard is the punishment) and how likely is it that all people will agree to do it (A plumber doesn't ask "Do you need a bill for that?" if he think that the other party will take offense to that and maybe even fill a complaint) Then there is tax morale. If the government in the eye of the public doesn't seem to hold up it's side of the social contract then the incentive of not paying taxes raises. Thus depriving the government of funds and creating a vicious cycle.

For a more in-depth study (that ignores drugs/burglary/... - so all that concerns the average citizen) http://www.iea.org.uk/sites/default/files/publications/files/IEA%20Shadow%20Economy%20web%20rev%207.6.13.pdf

Now on to the GDP. New offical EU regulation (though Greece already did parts of it to meet the criteria to join the Euro http://en.wikipedia.org/wiki/Economy_of_Greece#Eurozone_entry) is to include parts of the shadow economy in the GDP calculation. http://www.zerohedge.com/news/2014-05-22/hookers-and-blow-how-changing-definition-gdp-officially-jumped-shark (Though that makes the levels more comparable. So I guess a positive effect?)

Then if you take a look at your picture all ratios are really close to each other. However, as the shadow economy is really hard to estimate:

Estimates of the size of the shadow economy by the MIMIC method are generally thought to have a margin of error of +/–15 per cent (that is, there is a probability of 95 per cent that the true value of the shadow economy is between 8.5 per cent and 11.5 per cent of national income if the estimated value is 10 per cent).

So the order might vary a bit (assuming that this method was also used in your picture)

Now for the conclusions: Obviously the US (even though it's a bigger economy) archive a lower ratio because it's a ratio? (Size of shadow economy) / (GDP)? The actual sizes don't matter for the ordering.

But what about the top (or worst?) countries in this picture?

Korea's had a financial crisis just shortly before the time frame given (so a reduction in GDP) and then had to get a IMF bailout with the known consequences (weaker labor laws, higher taxes, financial restraint (so less social spending) -> The state provides less and thus the people need to keep more for themselves to balance that) which can erode trust in the state and thus make less likely that the full taxes are being payed. Then there is high corruption / high interconnectivity between the big cooperations and the government http://www.hofstra.edu/pdf/biz_MLC_Lee3.pdf

Mexico is plagued by the drug war and has the rich neighbor just across the border - doesn't lead to a favorable view of the state either.

Greece, Portugal and Spain were ruled by dictators up to the mid seventies. From that point on to the noughties there were various crisis (e.g. Oil crisis), IMF bailouts, ...

Answer 2

There are three main factors that drive the low shadow economy in the US.

Some of the largest factors of corruption and shadow activity in these countries are legitimized in the United States. Laws have been written that allow the rich and powerful to legally avoid taxes. There are methods where corporations and rich individuals can legally contribute to government officials. This in turn leads to laws that are filled with loopholes and exceptions that favor these parties. This reduces the need for forces that would contribute most to the shadow economy to operate outside the law.

For the less wealthy and powerful there is the fact that enforcement in the US is quite strict.

The incarceration rate in the United States of America is the highest in the world. As of October 2013, the incarceration rate was 716 per 100,000 of the national population.[2] While the United States represents about 5 percent of the world's population, it houses around 25 percent of the world's prisoners. SOURCE

Tax evasion is punished in the US with sentences that are often more strict than those imposed for violent crimes. In addition a large portion of the incarcerated in the US are there for crimes that would fall into the Shadow economy. This combined with the opportunities for success without straying to the shadows works to keep the vast majority operating in the light.

This may be listed last but it is the biggest factor, OPPORTUNITY. The US provides opportunities that just do not exist in other countries. The economy is diverse, and drives the world market. A poor child can grow up to be very successful regardless of what race, color, national origin, or sex they are. That just doesn't happen in most of the world. That opportunity means that most people do not have to operate in the shadows to survive and those that do contribute little to the economy anyway. The truth is that it is not that there is so little shadow activity in the US so much as it is there is so much success happening in the light. The one thing that stands out in the chart is that the 7 worst rated are in countries that have little opportunities for success, and as a result have a struggling economy.

Answer 3

The U.S. appears to have a smaller shadow economy for a few reasons in no particular order.

1. A reasonable amount is being attributed to Mexico due to drug cartels being based there, but deriving income from the U.S. possibly true for Canada as well.
2. The U.S. GDP is huge (~16 trillion), 1.6 trillion is a lot of drugs/sex/organs/whatever. Japan is the next highest GDP country on your graph with ~6 trillion and ~11% meaning ~660 billion. The U.S. economy is simply strong enough to dwarf a huge shadow economy.
3. In the U.S. its simply way more profitable to do things legally. You can be a congressman and exploit insider trading, lobby congress for defacto monopolies, exploit the third world with relative immunity, etc.

list of countries by GDP