A simultaneous equation model of economic growth and shadow economy: Is there a difference between the developed and developing countries?

The shadow economy is a complex phenomenon present, to a large extent, in the developing, and the developed countries. This study builds a dynamic simultaneous equation model that establishes an inter-connection between economic growth and the shadow economy for 17 developing and 33 developed countries over the 2005-2015 period. Using the data of the shadow economy size from Medina and Schneider (2018), we found that the relationship between economic growth and the underground economy is unidirectional in the MENA countries, but it is bidirectional in the OECD countries. The results also suggested that institutional quality interacts strongly with the relationship between economic growth and the underground economy. More specifically, we found that a higher GDP per capita is associated with a smaller shadow economy in countries with a good institutional quality. However, in countries where institutional quality is low, the increase of GDP per capita does not influence the size of the underground economy.