Explaining Cross-national Variations in the Size of the Shadow Economy in Central and Eastern Europe

Abstract

Cross-national variations in the size of the shadow economy have been variously explained to be a result of: economic underdevelopment (modernization theory); high taxes, public sector corruption and state interference in the free market (neoliberal theory) or inadequate levels of state intervention to protect workers (political economy theory). The aim of this paper is to start to evaluate critically these competing theories by comparing cross-national variations in the size of the shadow economy with the various aspects of the broader economic and social environment denoted as determinants of the shadow economy in each of the theories. The finding is that across Central and Eastern Europe, smaller shadow economies prevail in wealthier, more modern and equal societies and countries with higher levels of social protection expenditure, greater state intervention in the labour market, more effective social transfers and lower levels of poverty. No evidence is, therefore, found to support the neoliberal suggestion that decreasing tax rates, deregulating the economy and cutting back work and welfare expenditure by the state will reduce the shadow economy. The paper concludes by discussing the theoretical and policy implications of the findings.