Most previous studies that examined the relationship between the size of shadow economy and the pillars of sustainable development maintained that this relationship is linear. This paper provides an empirical contribution to the literature by arguing that this relationship is likely to be nonlinear, and it might be subject to threshold effects. For this purpose, in addition to the static threshold panel model of Hansen (1999. “Threshold Effects in Non-dynamic Panels: Estimation, Testing, and Inference.” Journal of Econometrics 93 (2): 345–68), the dynamic panel threshold model suggested by Seo and Shin (2016. “Dynamic Panels with Threshold Effect and Endogeneity.” Journal of Econometrics 195 (2): 169–86) has been applied to a larger panel-data set covering 83 developed and developing countries over the 1996–2017 period. Empirical results from both models yield evidence advocating the existence of threshold effects of the shadow economy on the economic, social, and environmental dimensions of sustainable development for the global sample as well as the sub-samples of developed and developing countries. Moreover, for the global sample and developing countries, our findings show that shadow economy would spoil the three sustainable development pillars only when its size exceeds a certain threshold critical size. While, the impact for developed countries was found negative even for low levels of underground activities. These finding are shown to be robust to alternative proxies for the size of the shadow economy and have important policy implications, especially for developing countries. In these countries, a moderate size of the shadow economy might have positive spillovers on long-term growth and sustainable development. Our research also suggests that, for developing and developed countries to achieve sustainable goal 8.3, the extent of the shadow activities should be taken into account.
In this paper, we develop a novel and an alternative empirical approach based on the Seo and Shin’s (2016) dynamic FD-GMM panel threshold model to explore whether the impact of the size of the shadow economy on the three key pillars of sustainable development – economic growth, human development, and environmental quality – varies with the level of governance quality. We consider economic, political and institutional dimensions of governance to assess which of them are likely to moderate the shadow economy-sustainable development linkage. Employing panel data for 82 countries over the period 1996–2017, our evidence indicates the presence of a significant threshold, suggesting that the impact of shadow economy on each of the above-mentioned pillars is regime-specific, depending on the countries’ level of governance quality. Moreover, our findings show that the initially detrimental effect of the shadow economy on sustainable development would be attenuated and even turn into a beneficial one if countries reach a certain threshold level of governance quality.This pattern is shown to be robust to various indicators of governance and alternative measures of shadow economy. The findings in this paper therefore suggest that enhancing governance quality can serve as an effective policy tool for abating shadow economy activities and thereby reaping the benefits of economic, social and environmental sustainablility. JEL classification: C33, E26, Q01, O17, O43
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