Fiscal policy and shadow economy in Asian developing countries: does corruption matter?

Abstract

This article empirically studies how fiscal policy affects the shadow economy through the two tools of taxation and government expenditure, and how this effect depends on the presence of corruption. By using a panel data for 24 developing Asian countries over the period of 2002–2015, we find that the shadow economy is negatively affected by expansionary fiscal policies and positively affected by contractionary fiscal policies, extending the Voluntarist school of thought on shadow economy; and corruption and shadow economy are complements. Specifically, the tax burden from both direct and indirect taxes increases the shadow economy and the increase in corruption intensifies this effect. Furthermore, the government expenditure reduces the size of the shadow economy and the increase in corruption attenuates this effect. In addition, we find a stronger impact of indirect taxes, compared to direct taxes; a stronger effect of government expenditure, in comparison with direct and indirect taxes; and a dominating impact of corruption on the shadow economy in developing countries. The findings indicate that governments can utilize expansionary fiscal policies through appropriate combination of direct taxes, indirect taxes and government expenditure to reduce the shadow economy, provided that corruption is controlled.