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.
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