Navigating the shadows: Exploring the interaction between social progress and the shadow economy

Abstract

This paper uniquely examines the noneconomic dimensions of a nation’s overall wellbeing by focusing on social progress and its impact on the shadow economy. The shadow economy serves an important function in a market economy by supplying goods and services that meet the social demands of society. We argue that deficits in social development, or social regression, prompt the expansion of the shadow economy. Employing cross-country panel data for 124 countries from 1991 to 2017 and two-way fixed effects instrumental variables estimation, the results show that advancements in social progress reduce the size of the underground sector. In terms of magnitude, the influence of social progress is nontrivial: a 1 percent increase in social progress reduces the shadow economy by about 2 percent. Moreover, considering the distinct dimensions of social performance, the findings reveal that improvements in basic human needs and opportunity aspects of social progress have the most robust effect in reducing the shadow economy. Our results underscore the value of investing in social development to curb the spread of the shadow economy.