The shadow economy refers to all economic activities that are hidden from the government--both legal activities in which people get paid in cash but do not pay taxes, and illegal activities (such as smuggling, illicit trade).
Shadow economy operates because of a number of reasons. First, complicated government rules push small businesses to operate without official licences. Second, to avoid high tax burdens, business firms and workers in that sector want to keep all their money instead of paying taxes. Third, although governments around the globe have strengthened formal tax collection methods, large sums of capital continue to circulate in hidden channels. Fourth using cash makes it easy to skip recording sales and paying taxes. Fifth, lack of adequate number of formal sector jobs forces many people into informal sector jobs (including gig workers, both location-based e.g., ride-sharing and delivery services, and online remote work e.g., freelancing and other digital tasks) for their survival.
Shadow economy generates over US$12 trillion globally, i.e., around one-fifth of total global economic output. Its size and impact vary considerably across different regions. Sub-Saharan Africa and Latin American regions have the largest shadow economies (between 35 and 40 per cent). High-income OECD member countries have the lowest share of shadow activities (between 10 and 15 per cent of official GDP). In Asia, the size of the shadow economy varies substantially, depending on the level of development.
In Asia, the shadow economy makes up between one-fifth and two-fifths of the economy. Due to highly regulated economies, strong digital banking and strict tax laws, developed countries such as Japan and Singapore have small shadow economy (less than 10 per cent), followed by China (12 per cent), Vietnam and South Korea (each 15 per cent). In contrast, it is higher in Indonesia and Malaysia (around 24 per cent each), and considerably higher in Cambodia, the Philippines, and Thailand (around 40 per cent each).
In Afghanistan, the shadow economy accounts for about three-quarters of the country's economy. Driven by a lack of formal sector jobs, restricted banking access (with around 85 per cent of adults not having a bank account) and a history of narcotics production, it serves as the primary financial lifeline for ordinary Afghans. The shadow economy includes farming, cross-border trade with Iran and Pakistan, and unregulated mining (small-scale, unauthorised extraction of minerals providing income for locals). After the Taliban take over, many formal sector jobs disappeared, forcing many businesses to operate in secret. Further, it has pushed many women into home-based, underground businesses like carpet weaving, tailoring, and food production. Although shadow economy is the only way for many people to avoid starvation, large sums of capital continue to circulate in hidden channels, thereby depriving the government of the much-needed taxes for development work.
In Bangladesh, shadow economy accounts for around one-third of the country's total economic output. Shadow economy thrives because of several factors. First, many private enterprises avoid formal registration bypassing strict, bureaucratic regulations. Second, high corporate and personal income tax rates, combined with considerable under- and over-invoicing of goods, encourage businesses to operate informally. Third, corruption, and illicit funds from bribery, smuggling, extortion, and illicit capital flight help the generation of untaxed black money. Fourth, the majority of the workforce is engaged in the informal labour market lacking formal documentation.
Bhutan's shadow economy accounts for around one-fifth of the country's economy, mostly concentrated in subsistence agriculture, rural bartering, cottage industries, and small-scale trading. Rural and agricultural labour dominates the sector, with over three-quarters of the employed working in the informal sector. In urban centres like Thimphu, women street vendors operate in the margins due to a lack of administrative licensing. These informal retail networks are vital to local food distribution. Despite the rise of modern banks, informal lending circles remain a significant driving force, with around one-quarter of rural households relying exclusively on informal loans. Although the sector provides employment and livelihood to many people, the government is deprived of taxes.
India's shadow economy accounts for between one-fifth and one-quarter of the country's total economic output. It involves the untaxed, unregistered, but legal activities of small-scale vendors, subsistence farming, and domestic helpers, as well as illicit, underground transactions, including corruption, smuggling, counterfeiting, and illegal gambling. Complex and overlapping tax structures, perceived high tax burdens, and rigid labour laws motivate both individuals and small businesses to operate in secret avoiding regulatory attention. While shadow economy provides safety net for the poor and the needy, it deprives the government of uncollected tax revenues.
In the Maldives, shadow economy accounts for around one-quarter of the country's total economic output, consisting mostly of informal small businesses (fishing, agricultural production for household use, unregistered stalls, and small service providers). The major drivers include large number of undocumented foreign workers in construction, domestic services, and tourism, including guesthouses and related tourism services. The government loses in terms of uncollected taxes. Further, legal businesses find it difficult to compete with cheaper, unregistered businesses.
Shadow economy contributes around two-fifths of Nepal's total economic output. About half of small businesses (real estate, agriculture) operate unregistered. Even among the registered businesses, less than half maintain proper financial statements. Widespread tax evasion and inadequate regulatory oversight impede formalisation efforts.
Around one-third of the total economic output in Pakistan comes from its shadow economy. It encompasses unrecorded agricultural activities, undocumented small-scale manufacturing, untaxed retail trade, and illicit activities (like smuggling and the drug trade). Cumbersome administrative procedures, high corporate tax rates, and stringent labour regulations force businesses to operate informally. Arbitrary enforcement encourages bribery and bypassing of official rules. Reliance on cash makes it almost impossible for institutions to track revenue and enforce tax collection. While the shadow economy provides an essential economic safety net for millions, it has severe consequences. It limits the government's tax base and creates unfair competitive advantages for untaxed informal businesses compared with compliant, formal-sector enterprises.
Sri Lanka's shadow economy accounts for between two-fifths and three-fifths of the country's total economic output. Most people in the hidden market work in agriculture, street vending, small crafts, private transportation, construction, modern freelance, ride-sharing, and online delivery work. Strict laws, heavy taxes, and complicated licence processes push businesses to work informally. The government loses considerable tax earnings, thereby unable to spend adequately on development projects, including those in the social sectors. Further, registered businesses that pay their full taxes have a hard time competing with hidden businesses.
REVERSAL STRATEGIES: A multifaceted approach, combining both incentives and punishments, is needed to successfully reverse the shadow economy. The incentives could take the form of tax simplification, streamlining business registration, and promoting digital transactions. Enhancing auditing, strengthening labour inspections, and imposing stringent penalties for tax evasion would deter businesses to operate informally.
Governments in many Asian countries are undertaking measures to reduce the size of the shadow economy by making it easier for small businesses to acquire legal status as well as by lowering some tax rates, and promoting digital payments. The Bangladesh government is focusing on tax audits, digitising transaction trails, and regulating undocumented practices. The Indian government has introduced the Goods and Services Tax (GST), the drive towards electronic payments, and making registration easier for small businesses and street vendors. The Maldivian government is forcing businesses to register, and to more frequently check work visas of migrant workers. The government in Nepal is making business registration easier, and strengthening workplace compliance. The government in Pakistan has been trying to simplify business registration, and modernise digital tax filing systems. The Sri Lankan government is working to better track the hidden businesses, and bring these workers into the formal system.
Professor Barkat-e-Khuda, PhD is former professor and chairman, Department of Economics, University of Dhaka.
barkatek@yahoo.com