The Shadow Economy

High tax rates have led to shadow economy worth over £150 billion in UK



  • Measurement of the shadow economy is notoriously difficult as it requires estimation of economic activity that is deliberately hidden from official transactions. Surveys typically understate the size of the shadow economy but econometric techniques can now be used to obtain a much better understanding of its size.
  • The shadow economy constitutes approximately 10 per cent of GDP in the UK; about 14 per cent in Nordic countries and about 20–30 per cent in many southern European countries.
  • The main drivers of the shadow economy are (in order): tax and social security burdens, tax morale, the quality of state institutions and labour market regulation. A reduction in the tax burden is therefore likely to lead to a reduction in the size of the shadow economy. Indeed, a virtuous circle can 
be created of lower tax rates, less shadow work, higher tax morale, a higher tax take and the opportunity for lower rates. Of course, a vicious circle in the other direction can also be created.
  • Given this relationship, the high level of non-wage costs (averaging 39 per cent of total labour costs) and the penalty on individuals who move from earning one third to two thirds of the median wage (averaging 58 per cent of the increase in earnings for a one-earner couple) in the European Union should be a matter of real concern. The latter figure
is 79 per cent in the UK and thus low-paid UK workers have a huge incentive to supplement their incomes in the shadow economy.
  • The number of participants in the shadow economy is very large. Although up-to-date figures are not available, at the end of the twentieth century up to 30 million people performed shadow work in the EU and up to 48 million in the OECD. Reliable detailed studies are not available for many countries. In Denmark, however, the latest studies suggest that about half the population purchases shadow work. In some
sectors – such as construction – about half the workforce
is working in the shadow economy, often in addition to formal employment. Only a very small proportion of shadow economy workers can be accounted for by illegal immigrants in most countries.
  • In western Europe, shadow work is relatively prevalent among the unemployed and the formally employed. Other non-employed (for example, the retired, homemakers
and students) do relatively less shadow work. This has implications for policy in terms of the importance of social security systems that reduce the opportunities for shadow work among the unemployed and the importance of tax systems that do not discourage the declaring of extra income.
  • Policies focused on deterrence are not likely to b