Paddington Masamha: Economic and Social Woes of a Shadow Economy

By Paddington Masamha

The shadow economy has a significant impact on the normal functioning of the formal economy. Without necessarily debugging the academic conflicts with regards to having an accurate definition of shadow activity; various interchangeable names such as ‘informal, hidden, black, underground, gray, clandestine, illegal and parallel’ generally describe the broader concept of the shadow economy. Thus basically any economic activity which is outside national income accounts or government accounting is a shadow or hidden or part of the unofficial economy.  

Whilst academics are engaged with the challenge of defining shadow and or underground economy, what remains essentially unchallenged are the repercussions of shadow activities on the formal economy. This article therefore focuses on the area where consensus exists and ‘fight shy of’ the contentious shadow economy theory unification for the academics or experts.  

Generally, a shadow economy has potential extortions on formal markets, national budgets, legitimate businesses, individual consumers and potential economic growth of any nation. Essentially, the shadow economy is a universe that can complement or contradict the formal economy depending on its magnitude, size and extent of development.

Though they may take some form of progress in short run cases, shadow activities are fundamentally undesirable. Presently in Zimbabwe the harmful and jeopardizing economic and social consequences of the shadow economy include but not limited to the following discoursed issues;

Possibility of ‘bad equilibrium’

A shadow economy has a potential of causing a ‘bad equilibrium’ and ultimately deterring economic growth efforts of a nation. An economy which is dominated by underground activities such as tax evasion, tax avoidance, black markets, regulatory burdens on businesses and a variety of criminal activities is inevitably plagued with macro-economic instabilities. In accompaniment, shadow economies also create political instabilities particularly in developing countries.

Zimbabwe is currently battling with a buoyant foreign currency black market which has triggered a variety of economic imbalances. Driven by the currency crisis in the country; the resurgence of the inflation spiral, goods shortages and general public economic distress is the new order.

A counterpart goods black market has been gathering impetus (particularly fuel and basic commodities in short supply). Given that shadow markets thrive on bribery, the accompanying corruption weevil is having ravaging effects on macro-economic fundamentals.

A shadow economy phenomenally erodes the proper functioning of a formal economy. Importantly, shadow transactions represents a fiscal leakage through the financial hemorrhage of tax revenues. The opportunity cost of revenue lost through ‘off the book’ transactions imply that potential income that could be used for national growth purposes is only available to a limited number of economic agents.

However, supporters of shadow economies argue that the information efficiency and competitiveness within informal markets actually bolster an economy’s potential to grow. For instance, given the conspicuous spending patterns within shadow markets, some researchers argue that income earned in the shadow economy is quickly spent within the official economy. Such a positive effect is however miniature to outdo the innumerable negative repercussions of shadow activities on macro-economic fundamentals.

Going forward, shrinking the shadow economy has a better potential to extinguish the ‘bad equilibrium’ and bolster economic growth. A transition from unofficial to official economy has a better potential to increase tax revenues, improve regulatory compliance and stimulate public spending. Such a scenario leads to escalating economic growth rates.

Increase in budget deficit and or tax rates

Without laboring to consider the theoretical underpinnings of this argument, the Zimbabwean case is a clear testimony of the negative impact of a shadow economy. For instance, Zimbabwe has over the years been running on persistent budget deficits which are predominantly exacerbated by government overspending.

The massive existence of almost 60% of informal trading activity partly explains the government revenue collection conundrums. The limited capacity to collect revenue stems from the inaccessibility and ‘off the book’ nature of the shadow activities.  

As such, the alternative explanation of budget deficits is based on the basic argument of having enormous shadow activities which do not pay taxes or not contributing any of the mandatory social security schemes. Therefore, the limited tax collection base reduces the income side of government budgets hence the deficit.

As the Zimbabwean case shows, the usual temptation is to increase taxes, without necessary solving the root cause of limited revenue collection base. The combination of persistent budget deficits and having a highly taxed formal economy does affect the state’s fiscal well-being. Policy direction should thus target reducing or transitioning shadow markets into formal markets.

Notably, Zimbabwe is a highly taxed regime. Driven by the desire to capture most informal RTGs and mobile money economic transactions, the Ministry of Finance introduced a compulsory 2% per dollar transaction tax system. Viewed positively, the main motivation of the gruesome tax system is to capture the ‘off the book’ economic transactions within the economy. However, a highly taxed economy negatively impacts on the poor majority instead of incentivizing their meagre incomes.

Often times, whenever government sets higher tax rates; corporates and individuals always find ways to avoid or evade the tax. Corporates and individuals then spend more time skimming and plotting tax evasion and tax avoidance strategies. Such unproductive efforts could have been used more industriously and help towards producing better output of goods and services. The unproductive behavior is thus an economic distortion which further creates economic imbalances.

Lead to incorrect information for policy making

Fundamentally, all shadow activities are unrecorded. As such, the official national income accounts or statistics do not accurately represent the true state of a country’s economy. National economic policies are formulated basing on the national income statistics. Hence the policy cogency, validity and robustness is compromised by the statistical inaccuracies.

Therefore, in Zimbabwe given the more pronounced level of underground activities; the inaccurate figures might lead to inappropriate policy responses. On the other hand, the presence of a shadow economy maybe a manifestation of poor, imprudent, ill-advised and or misguided policy promulgations as heralded in the previous article.

Zimbabwe is a combination of both ends. The existence of overly burdensome regulatory policies and excessive taxation has largely exacerbated the informal activities. On the other hand, disproportionate and inaccurate policies have been promulgated given the serious disjoint between formal and informal national statistics. In worst case scenarios, underground markets (e.g. black markets) have a considerable force to control and determine prices as well as the supply of goods and services in an economy.

The significant economic control that black market shadow activity has on the Zimbabwean economy is a reflection of how inappropriate and inefficient the Zimbabwean monetary control measures are. Specifically the exchange control regulation of 1:1 parity between the RTGs/Bond notes to US dollars was one such incongruent policy. The ultimate speculative currency attack (confirmed by the 20 February 2019 MPS statement) is a clear testimony of the ruinous effects of shadow activities. 

Wrong policies create a shadow economy, whilst the shadow economy leads to inaccurate policy interventions. 

Poor public service delivery systems

By virtue of the shadow economy leading to ineffective or wrong policies being adopted, the resultant poor public service provision is unavoidable. The state of public goods service delivery in Zimbabwe is deplorable. For instance, street lighting, public roads, public broadcasting, fire brigade services and police services are largely underprovided. Faced with the public outcry against poor public services, the public sector corporations largely bemoan with the poor revenue collection (though their main problem is public sector corruption).

To some extent, the under-provision of public goods is partly explained by the low and intermittent nature of informal economy revenue collections. The poor revenue collections (coupled with corruption) in turn reduce state corporations’ ability to provide public goods and services.

This government failure largely increases pressure to raise individual and corporate tax rates. A new vicious cycle of moving from formal to informal channels thus emerges. Whenever corporates and individuals are faced with poor quality of public goods and public administration, punitive tax systems and excessive regulations; their appetite for shadow dealings is bolstered.

Every time a government’s public service management system deteriorates; the leadership’s going concern is threatened, capital flights into underground markets are inevitable, the legitimacy of the regulatory system is undermined (limited respect of the national rule of law) and serious macro-economic imbalances become commonplace.

Lack of access to professional services and weakened collective bargaining

Given that a shadow economy is an underground or off the book transaction, in most cases there is limited or no legal recourse available whenever there is breach of contracts. In more specific terms, employees working in the informal sector do not have legal bodies to represents their rights for instance national employment councils, trade unions, workers committees and or works councils.

As such, the lack of representation in most circumstances denote fundamental rights infringements. In most cases, there is over-reliance on manipulation, violent activity or death threats as a method of ensuring that both parties to the underground contracts fulfil their obligations. Hence the limited access to legal and judicial systems prejudices informal market participants to justice.

The gradual weakening of economic and social basis of collective bargaining is imminent in an informal economy. For instance, informal sector employees are usually faced with unsafe working conditions, they have limited access to government social protection schemes and usually earn incomes below the poverty datum line.

Significantly, informal traders do not enjoy the security which comes with the protection of intellectual property and the vested private property rights which come with operating in the formal economy. Given their limited access to formal structures, most informal businesses are deprived of access to investment capital and or formal credit lines. As such, mediocre services is usually the norm and hence rob members of the general public to have access to professional health, education and transport services.

The lack of professional services largely stems from the fact that most of the informal sector participants are unregistered and unregulated enterprises, hence the ‘hit-and-run’ strategies are common. As such, the current ‘short-termism’ and rent seeking behavior engulfing the economy becomes a serious economic monster.

By their very nature, informal markets do not ascribe to ethical and corporate governance standards. Consequently, the twin problems of poor services and corrupt practices are inescapable.

Increases socio-economic vulnerabilities and societal externalities

Firms operating in the formal markets largely dependent on the formal regulatory system and the inherent private property rights acquired through formal systems. However, both business and individuals working in shadow economy are exposed to various forms of vulnerabilities. For instance, cases of sexual harassment, child abuse, violence, corruption and bribery dominate informal sector establishments. 

Underground economic activity poses significant societal externalities for instance increased crime, prostitution, drug abuse, sexual abuse, robberies and various forms of violent behavior. An increase in such societal externalities implies that government needs more funding for police services, military operations and various crime related units which help combat the spread of the identified ills. As such, government is faced with the need to increase public defense and security services but having insufficient tax revenues since the criminal activities do not pay any taxes.

Societal externalities are also exacerbated by the fact that underground firms are usually not compliant with consumer protection, environmental and employment regulations or laws. As a result, members of society who elect to transact in the underground economy are over-exposed to consumer rights violations, manipulation and poor quality goods and services.

Conclusion

By and large, a shadow economy knocks off-balance the very foundations of the formal economy. Through its debilitating effects on almost every facet of economic activity, robust shadow markets create an uneven playing field for formal businesses.

Government suffers largely from lost revenues, reduced tax morale, miscalculated policy responses and macro-economic imbalances among other things. To the society at large; the poor quality of goods and services, lack of professional services and negative externalities are the major negative ramifications of shadow markets.

Going forward, the Zimbabwean government needs to deliberately put resources towards researching on ways and methods of transitioning the significant shadow economy into a formal economy. The over-reliance on the formal economy and intentionally disregarding the heavy presence of shadow activities is an unsustainable economic trajectory. Future editions of publications shall discourse the shadow economy transformation strategies into formal markets.

Paddington Masamha is an independent Financial and Economic Analyst. He can be reached on email [email protected] and Twitter @PMasamha