While the impact of the shadow economy on direct tax revenues is a concern, its role in contributing to indirect taxes and economic growth is debatable, the Reserve Bank said. “The best way to contain the shadow economy is to improve governance and quality of public services, avoid excessive regulations, impose stringent penalties and have a compatible tax structure,” it said in the Financial Stability Report.
According to the RBI, one of the many problems with the shadow economy is that it renders official statistics unreliable and severely impacts policy formulations by governments. Besides, the loss of tax revenues may force governments to hike tax rates, which in turn may further encourage greater activity in the shadow economy.
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As per some analyses, in the US a 1 percentage point increase in personal income tax rates, other things being equal, tends to increase the size of the shadow economy by 1.4 percentage points. Similarly, a 1 point increase in a regulation index (ranging from 1 to 5) corresponds to a 10 per cent increase in the shadow economy, the RBI said.
“There is also evidence in some economies of dynamic mobility between the official and shadow economies depending on the relative ‘net’ wage levels; this in turn is an indication of the influence of tax rates and rigidities in labour markets on the size of the official versus shadow economies,” the RBI said.
Though estimating the size of the shadow economy is challenging, according to the Organisation for Economic Co-operation and Development half of the world’s workers were employed in the shadow economy in 2009 (this number is likely to grow to two-thirds by 2020). According to an article published in Foreign Policy, the global black market approximately valued at $10 trillion, is the world’s second largest “economy” and is also the fastest growing one.