Environmental taxes and the economy: New evidence of the shadow economy

Abstract This study examines the influence of environmental taxes on the shadow economy for a global sample of 61 countries in two subsamples (high‐income group—HIG and low‐ and middle‐income group—LMG) with data available from 2002 to 2018. Environmental taxes are found to increase the shadow economy significantly across the globe and two subsamples. The proportion of the shadow economy of GDP rises by about 0.201 percentage points on average when the environment taxes to GDP ratio increases by one percentage point. We use a simultaneous equations model to delve into the mechanisms through which environmental taxes might exert their influence, which we find to be transmitted through two main channels, namely, unemployment and the tax burden. Increases in environmental taxes cause higher unemployment and increase the tax burden, resulting in greater informal economic activities. Interestingly, among the four different forms of environmental taxes, an energy tax expands the shadow economy consistently across samples. Pollution and resource taxes have a positive effect on the shadow economy, primarily in HIG. Taxes on energy appear to increase unemployment and then cause an increase in the size of the shadow economy. In contrast, taxes on pollution, resources and transport seem to be associated with a higher tax burden, which causes an increase in the size of the shadow economy. In general, a crucial policy consideration involves the careful selection of environmentally related taxes that do not disrupt primary economic activities. The findings also suggest that the implementation of environmental taxes should be accompanied by policies designed to mitigate the potential adverse impacts on unemployment and the tax burden, both of which can impose significant societal costs.