Fiscal Policy Effects on Shadow Economy: Empirical Evidence from Developing Countries

In most developing countries, the large size of the shadow economy is often attributed to ineffective macroeconomic policies, particularly fiscal policy. Additionally, any empirical analysis of the shadow economy, as well as policy recommendations that disregard the role of fiscal policy, would be incomplete and potentially misleading. Therefore, this present study empirically examines the impact of fiscal policy on the shadow economy in developing countries. Utilizing an annual panel dataset spanning 127 selected developing countries from 2002 to 2018, the study employs panel data estimation methods including fixed effects and system GMM. Overall, the study reveals that expansionary fiscal policy tends to reduce the size of the shadow economy, whereas contractionary fiscal policy increases it. Specifically, tax revenue contributes to the growth of the shadow economy, while government expenditure reduces its size. Furthermore, the study identifies a stronger impact of tax revenue compared to government expenditure on the shadow economy. The findings of this study imply that governments in developing countries can influence the size of the shadow economy through expansionary fiscal policies, with a particular emphasis on the structure of taxation. However, the effective utilization of government spending also proves to be a viable strategy for controlling the size of the shadow economy.