On the relationship between income inequality and the shadow economy

The purpose of this study is to better understand the dynamic interrelationship between income inequality and the shadow economy. Specifically, we simultaneously estimate the linkages between the shadow economy and income inequality to account for the possible bidirectional causality between these variables. For example, individuals at the lower end of the income spectrum may choose to migrate underground for increased flexibility and autonomy, or they may be forced underground due to the limited opportunities available to the disadvantaged in the official economy because of their low skills and poor education. Moreover, the prevalence of the shadow economy may contribute to a growing income inequality if individuals become trapped in the low wage sector. Alternatively, the shadow economy may reduce inequality as individuals exploit the opportunities provided by the shadow economy to learn new skills or start a business that results in an increase in income mobility. We also account for the official sector and its effect on the shadow-inequality nexus.

To better understand the dynamic interrelationship between the informal economy and income inequality, we use cross-country data for 144 countries observed over the period from 1960-2009. Employing a panel vector autoregression model, we build impulse response functions to show the time path of income inequality following a shock to the shadow economy, and vice versa. The results reveal considerable dynamics underlying the relationship among the official economy, shadow economy and income inequality with a unidirectional inverse relationship between income inequality and the official economy; a bidirectional positive relationship between income inequality and the unofficial economy; and an inverse unidirectional relationship between the official and unofficial economy.