Effect of the Shadow Economy on Tax Reform in Developing Countries

Abstract

The present analysis has examined the effect of the shadow economy on tax reform in developing countries. The first type of tax reform is the “structural tax reform” (STR) characterized by large episodes of tax revenue mobilization, identified by Akitoby et al. (2020) [Tax revenue mobilization episodes in developing countries, Policy Design and Practice 3: 1–29] using the narrative approach that allows obtaining the precise nature and exact timing of major tax actions in several areas of tax policy and revenue administration that truly led to increases in tax revenue. The second type of tax reform is referred to as “tax transition reform” (TTR) and reflects the reform of the tax revenue structure that involves the reduction of its dependence on international trade tax revenue at the benefit of domestic tax revenue. The analysis has used various estimators and shown that the shadow economy reduces the likelihood of STR (notably in low-income countries), including in several tax policy areas and in the revenue administration area. The shadow economy also undermines the TTR process in countries whose tax revenue structure is strongly dependent on international trade tax revenue. Finally, it fosters the TTR process in countries that enjoy greater trade openness.