Testing the relationships between shadow economy and unemployment: empirical evidence from linear and nonlinear tests

Abstract The aim of this paper is to empirically investigate the dynamic linkages between unemployment and shadow economy for 32 developing and developed countries for the period 1980–2009 using parametric and non-parametric techniques. To this end, the Hansen and Seo (2002) threshold cointegration approach and the nonlinear causality test of Kyrtsou and Labys (2006) are applied to assess these relationships. Results obtained clearly do not support the view that unemployment and shadow economy are neutral with respect to each other, except in the case of Bolivia, China, Colombia, Pakistan, Philippines and Portugal, where a neutral relationship is found. We find, however, considerable evidence of bi-directionality in Finland and Sweden. This indicates that high levels of unemployment lead to high levels of shadow economy and vice versa. We also find clear evidence of unidirectional causality running from unemployment to shadow economy in the US, Jamaica and Venezuela which implies that, in these three countries, a faster rate of unemployment promotes a higher share of the underground economy in total GDP. Further, the causality relationship appears to be uni-directional but reversed for Chile. Overall, our findings suggest that policy implications of the unemployment-shadow economy relationships should be interpreted with caution, taking into account the test-dependent and country-specific results.