KINH tế NGẦM TRONG mối QUAN hệ với FDI, CHẤT LƯỢNG THỂ CHẾ và bất BÌNH ĐẲNG THU NHẬP BẰNG CHỨNG THỰC NGHIỆM từ các nước CHÂU á

UNIVERSITY OF ECONOMICS HO CHI MINH CITY HUYNH CONG MINH SHADOW ECONOMY IN THE RELATIONSHIP WITH FDI, INSTITUTIONAL QUALITY, AND INCOME INEQUALITY: EMPIRICAL EVIDENCE FROM ASIAN COUNTRI

UNIVERSITY OF ECONOMICS HO CHI MINH CITY

HUYNH CONG MINH

SHADOW ECONOMY IN THE RELATIONSHIP WITH FDI, INSTITUTIONAL QUALITY, AND INCOME INEQUALITY: EMPIRICAL EVIDENCE FROM ASIAN COUNTRIES

PhD THESIS

Ho Chi Minh City – 2018

UNIVERSITY OF ECONOMICS HO CHI MINH CITY

HUYNH CONG MINH

SHADOW ECONOMY IN THE RELATIONSHIP WITH FDI, INSTITUTIONAL QUALITY, AND INCOME INEQUALITY: EMPIRICAL EVIDENCE FROM ASIAN COUNTRIES

Major: Development Economics Code: 9310105

PhD THESIS

Advisors:

1 Dr Nguyen Hoang Bao

2 Dr Nguyen Vu Hong Thai

Ho Chi Minh City – 2018

This thesis submitted to the School of Economics, University of Economics Ho Chi Minh City, in partial fulfillment of the requirements for the degree of Doctor of Philosophy in development economics

DECLARATION

I hereby declare that this thesis is my own research Data and results are reliable, clearly originated, and have never been published in any other study

The author

ACKNOWLEDGEMENTS

First of all, I would like to express my great gratitude to Dr Nguyen Hoang Bao and Dr Nguyen Vu Hong Thai for their invaluable supervision and inspirations Thank you so much for keeping me on track throughout the research process, giving wise comments, advices and encouragement during such a long academic journey

Then I am honestly grateful to Dr Pham Khanh Nam, Dr Truong Dang Thuy,

Dr Le Van Chon, Dr Vo Tat Thang, Dr Vo Hong Duc, Associate Pro Dr Nguyen Huu Dung, Dr Nguyen Luu Bao Doan, Dr Pham Thi Thu Tra, Dr Pham Thi Bich Ngoc, Associate Pro Dr Vuong Duc Hoang Quan and the two independent Reviewers for their valuable comments and encouragements so that I can improve the quality of

my thesis

I cannot forget showing my special thanks to lecturers at school of economics as well as those at University of Economics HCMC such as Professor Dr Nguyen Trong Hoai, Dr Pham Khanh Nam, Dr Truong Dang Thuy, Associate Pro Dr.Nguyen Manh Hung, Dr Tran Thi Tuan Anh, Associate Pro Dr Tran Tien Khai… for their academic and practical instructions during my time of study and research at the university

Last but not least, I am deeply grateful to my beloved family, including my deceased father, my 83-year-old mother as well as my sisters and brothers who always support and encourage me in time for completing the thesis

TABLE OF CONTENTS

Declaration

Acknowledgements

Table of contents

List of Abbreviations

List of Tables

List of Figures

Pages

Chapter 1: Introduction 1

1.1 Research context and gaps 1

1.2 Research objectives 13

1.3 Research questions……… 13

1.4 Research subjects and scope 13

1.5 Research methodology and data ……… 14

1.6 Contributions 15

1.7 Limitations 17

1.8 Thesis outline 18

Chapter 2: Literature review and hypotheses 19

2.1 Shadow economy 20

2.1.1 Theories on shadow economy 20

2.1.1.1 Definition 20

2.1.1.2 Schools of thought 21

2.1.2 Empirical studies on shadow economy 31

2.1.2.1 Methods to estimate the size of the shadow economy 31

2.1.2.2 Determinants (causes) 35

2.1.2.3 The impacts of shadow economy (effects) 40

2.2 Shadow economy, FDI and Institutional quality 44

2.2.1 FDI and institutional quality 44

2.2.1.1 Theories on FDI (Definition, Theories, Determinants) 44

2.2.1.2 Theories of institutional quality (Definition, Theories, Determinants) 47 2.2.1.3 The relationship between institutional quality and FDI 48

2.2.2 Institutional quality and shadow economy 54

2.2.2.1 The effect of institutional quality on shadow economy 55

2.2.2.2 The effect of shadow economy on institutional quality 57

2.2.3 Shadow economy and FDI 59

2.2.3.1 The effects of FDI and FDI-institutional quality interaction on shadow economy 59

2.2.3.2 The effects of shadow economy on FDI 59

2.3 Shadow economy and income inequality 61

2.3.1 Income inequality 61

2.3.1.1 Definition 61

2.3.1.2 Theories 62

2.3.1.3 Measurements 65

2.3.1.4 Determinants 66

2.3.2 The impact of shadow economy on income inequality 67

Chapter 3: Methodology, model specifications, and data 73

3.1 Analytical framework 74

3.2 Empirical models and data 77

3.3 Econometric methodology 88

3.4 The sample selection of 19 Asian countries and their backgrounds on research problems 93

Chapter 4: Shadow economy, FDI and Institutional quality: empirical evidence from Asian

countries 96

4.1 Introduction 96

4.2 Data analysis 97

4.2.1 Data descriptive statistics 97

4.2.2 Unit-root test 99

4.2.3 Correlation analysis 101

4.3 Estimation results and discussions 102

Chapter 5: The impacts of shadow economy on income inequality in developing Asia 113

5.1 Introduction 113

5.2 Data descriptive statistics 116

5.3 Empirical results and discussions 119

Chapter 6: Conclusions and policy implications 125

6.1 Conclusions 125

6.2 Policy implications 128

6.3 Limitations and further research implications 129

List of publications 130

References 131

Appendices 158

LIST OF ABBREVIATIONS

2SLS: Two-stage Least Squares

3SLS: Three-stage Least Squares

ARDL: Autoregressive-distributed lag model

AR1: First-order Autocorrelation

AR2: Second-order Autocorrelation

ECM: Error correction model

EFR: Economic Freedom Report

FDI: Foreign direct investment

FE: Fixed Effects

FH: The Freedom House

GCI: Global Competitiveness Index

GDP: Gross Domestic Products

GLS: Generalized Least Squares

GNI: Gross National Income

MENA: Middle East and North Africa

MIMIC: Multiple Indicators Multiple Causes

MNCs: Multinational Corporations

HDR: Human Development Report

HF: The Heritage Foundation

ICRG: The International Country Risk Guide

IEF: Index of Economic Freedom

ILO: International Labor Organization

IMF: International Monetary Fund

IQ: Institutional quality

JGLS: Joint Generalized Least Squares

OLI: Ownership, Location, and Internalization

OLS: Ordinary Least Squares

POLS: Pooled Ordinary Least Squares

PRS: Political Risk Services Group

RE: Random Effects

SEM: Simultaneous equation model

SGMM: Two Steps System Generalized Method of Moments

SURE: Seemingly Unrelated Regression

UNESCO: United Nations Educational Scientific and Cultural Organization UNCTAD: United Nations Conference on Trade and Development

UNDP: United Nations Development Programme

WB: World Bank

WDI: World Development Indicators

WEF: World Economic Forum

WGIs: Worldwide Governance Indicators

LIST OF TABLES

Table 2.1 Labor market classification 23

Table 2.2 Structure of informal work typology 29

Table 4.1 Summary statistics 98

Table 4.2 Unit root tests for all variables 100

Table 4.3 The estimation results of the SEM by 3SLS and Two Steps System GMM 103

Table 4.4 The effect of FDI on shadow economy 110

Table 5.1 Definition and summary statistics 118

Table 5.2 Final estimation results for the impact of shadow economy on income inequality by FE and RE 120

Table 5.3 Estimation results for the impact of shadow economy on income inequality by 2 Steps SGMM 121

LIST OF FIGURES

Figure 1.1 Institutional quality by 5 components in Asian countries on average from 2002-2015 3 Figure 1.2 The size of shadow economy as a share of official GDP and FDI as the percentage of GDP in Asian countries on average from 1999-2015 4 Figure 1.3 Recent trends of income inequality in Asian developing countries 5 Figure 2.1 The place of institutions in the FDI determinants pattern 49 Figure 2.2 The theoretical framework for the link between shadow economy and income inequality 70 Figure 3.1 The analytical framework for the relationship among FDI, institutional quality, shadow economy and income inequality 74 Figure 5 The shadow economy and income inequality in Asian countries (1990-2015)

CHAPTER 1 INTRODUCTION

Chapter Outline

1.1 Research context and gap 1.2 Research objectives 1.3 Research questions 1.4 Research subjects and scope 1.5 Research methodology and data 1.6 Contributions

1.7 Limitations 1.8 Thesis outline

1.1 Research context and gaps

1.1.1 Practical background

For recent decades, shadow economy, investment from abroad, institutional quality and income inequality have attracted a great deal of attention in development economics because all of them relate to economic growth Both of foreign direct investment (FDI) and institutional quality (IQ) are considered important determinants

of economic growth and development (Borensztein, Gregorio, & Lee, 1998; Reichert & Weinhold, 2001; Rodrik, Subramanian, & Trebbi, 2004; Acemoglu,

Nair-Johnson, & Robinson, 2005; Hansen & Rand, 2006; Varsakelis, 2006; and Kandil, 2009) While the official economy is closely related to the shadow economy (Schneider

& Bajada, 2003; Vo & Pham, 2014) Moreover, economic growth is associated with income inequality (Kuznets, 1955; Barro, 2000) Especially, these variables and their relationships become worth studying in the context of Asia for its rising thorny features, such as high flow of FDI but low institutional quality, large shadow economy and rising income inequality

First, global foreign direct investment has significantly grown since the 1970s,

reached $1.76 trillion in 2015, fell 13% in 2016 ($1.52 trillion) and recovered in 2017; especially, developing Asia is now the largest recipient and accounts for almost one-third of total FDI inflows (UNCTAD, 2017) It is seen as the result of Asian countries

in effort to attract FDI for economic development by adopting an open door policy, governance changes & institutional innovation (Haggard, 2004; Lee, 2002) However, the positive impact of FDI on economic growth depends on the institutional quality in the host countries (Brahim & Rachdi, 2014; Jude & Levieuge, 2017) It is also Asia‘s specific concern, especially when there are many countries might be stuck in middle income trap in the region and deficient institutional quality is one of the main causes (Dollar, 2015) Figure 1.1 describes the institutional quality by 5 components (including Voice and Accountability, Political Stability and Absence of Violence, Government Effectiveness, Regulatory Quality, and Rule of Law) in 19 Asian countries1 on average from 2002-2015 The scale of measurement ranks from -2.5 (lowest quality) to 2.5 (highest quality) In general, the institutional quality in Asian countries is low The improvement has been seen but it is a slow progress FDI has flowed into Asian countries in great amounts, but institutional quality is still

1 Including Bangladesh, Bhutan, Cambodia, China, India, Indonesia, Kazakhstan, Kyrgyzstan, Laos, Malaysia, Maldives, Mongolia, Myanmar, Nepal, Pakistan, Philippines, Sri Lanka, Thailand, and Vietnam

problematic in the region Whether institutional quality really helps attracting FDI and FDI in its turn helps improving institutional quality Does this bidirectional relationship exist in Asian countries?

Figure 1.1 Institutional quality by 5 components in Asian countries on average from 2002-2015

(Source: Worldwide Governance Indicators, World Bank, 2017b)

Second, the shadow economy problematizes policy-makers in Asia, because the

size of the shadow economies in Asian countries has grown considerably since 1989, suggesting that national accounts data is on average significantly underestimated as national accounts are not supposed to capture shadow economies (Bajada and Schneider, 2005) The estimated average size of shadow economy in Asian countries over 1999 to 2015 is 30.94 % of official gross domestic products (GDP), and this period experiences an increase of 10.24% in the shadow economy size (Medina & Schneider, 2018) The lowest and the highest sizes are 29.04% and 33.41% in 2006 and

2009 respectively The size of shadow economy in Asian countries is empirically

Voice and Accountability Rule of Law

attributed to the money demand, tax burden, private consumption, interest rate and Gross National Income (GNI) per capita (Bajada & Schneider, 2005; Vo et al., 2015) The presence of shadow economy distorts the allocation of resources, alters income distribution and reduces governments‘ tax revenue (Alm & Embaye, 2013) If we ignore this sector, it is biased to evaluate the consequences of various economic policies Thus, it is imperative to comprehensively understand about the shadow economy in Asia in relation with other variables such as FDI and institutional quality Whether FDI is a channel to improve institutional quality and the improvement in institutional quality helps reduce shadow economy when institutional quality is a driver

of shadow economy? The figure 1.2 shows the shadow economy and FDI in Asian countries on average from 1999-2015

Figure 1.2 The size of shadow economy as a share of official GDP and FDI as the percentage of GDP in Asian countries on average from 1999-2015

(Source: World Bank, 2017a; and Medina & Schneider, 2018)

0 1 2 3 4 5 6

Third, recent rapid economic growth in Asia has reduced poverty but widened

income gap in many countries To Zhuang, Kanbur, and Maligalig (2014), the

Asia-wide Gini index rose at an annual rate of 1.4% from 0.39 in the mid-1990s to 0.46 in the late 2000s; 14 of 37 Asian economies now have a Gini coefficient of 0.40 or greater, widely considered the threshold for ―high inequality‖ However, the comparison between the two periods of mid-1990s and around-2012 shows that the average Gini index for 19 developing Asian countries decreases by 5.22% This improvement in income inequality mostly came from Central Asian countries such as Kyrgyz Republic, Kazakhstan, and Maldives Gini indexes were also seen falling in Cambodia, Thailand, Nepal, Malaysia and Mongolia On the contrary, China, Indonesia and India - covering 82% of the population in the region- experienced a rapid rising income inequality with their increases in Gini indexes by 18.8%, 14.9% and 14.1% respectively The income inequality was also found rising in Sri Lanka, Laos, Pakistan, Vietnam and Tajikistan The figure 1.3 provides the recent trends of income inequality in 19 Asian developing countries

Gini around 2012

Gini index

Figure 1.3 Recent trends of income inequality in Asian developing countries

(Source: World Bank, 2017a)

The rising inequality matters for many reasons First, highly unequal societies with the concentration of wealth on the rich are less likely to consolidate democracy, and may end up with social unrest or even coups (Acemoglu & Robinson, 2001) Second, it hampers the pace at which growth enables poverty reduction (Ravallion, 2004) Third, the inequality undermines the growth process through many channels of economic, social, and political mechanisms; it negatively affects growth and its sustainability (Ostry, Berg, & Tsangarides, 2014) Fourth, income inequality causes low quality of institutions- one of key factors for development (Chong & Gradstein, 2007b; and Zhuang et al., 2010); and excessively high levels of inequality erode institutional quality even in democracies (Kotschy & Sunde, 2016)

From the practical background above, there is a need to study the relationships amongst these variables so that policy makers can be provided with empirical studies for their decision-making in dealing with these aggregate variables simultaneously However, the motivation for carrying out this study is arisen not only from the practical background but also from the theoretical background

1.1.2 Theoretical background

FDI, institutional quality and shadow economy

The failure in explaining economic phenomenon by one theory has led to the tendency of using an integrative approach to bring insights in recent decades (Torgler

& Schneider, 2009) In fact, FDI is long documented as the main driver of host countries‘ economic growth (Borensztein et al., 1998; Nair-Reichert & Weinhold, 2001; and Hansen & Rand, 2006), while the emerge of the new institutional economics in recent decades gets a great deal of attention from economists (Kotschy &

Sunde, 2016; Neyapti & Arasil, 2016) On the other hand, a vast literature has attempted to study the shadow economy, especially from the transformation of the socialist economies such as China, Russia, and Vietnam in 1990s where institutional weaknesses and corruption are major obstacles to their market reforms (Gupta & Abed, 2002; Torgler & Schneider, 2009) Knowing the unknown and estimating the shadow economy are still a difficult task that has posed notable challenges in statistical studies

in the past decades (Torgler & Schneider, 2009) Fortunately, the availability of shadow economy‘s dataset re-highlighted the interests of economists into the relationships between shadow economy and other factors from both sides of economics and institutions (Gupta & Abed, 2002)

The nexuses between FDI, institutional quality and shadow economy can be

divided into three strands with ambiguous relationships In the first strand, the

relationships between FDI and institutional quality are concentrated, following

theories of international trade and institutions In particular, Dunning (1980) uses the eclectic paradigm, also known as the OLI-Model or OLI-Framework, to explain the various reasons why a multinational corporation (MNC) enters into a host country To him, an MNC decides to invest in the host country when advantages of OLI (Ownership, Location, and Internalization) are met In this context, governance and institutions can be seen as a location factor that may encourage or deter the investment inflows Similarly, North (1990) with the institutionalization theory shows that institutions set ―the rule of the games‖ which organizations and MNCs must follow in pursuit of their own learning and goals for resource allocation To him, institutions affect uncertainty level and allow individuals and firms interact effectively To attract investments, governments improve their governance to lower transaction costs in which investors might get higher profitability In addition, Westney (1993), by using a

improving the organizational patterns in host countries through subsidiaries Thus, to

helps improve institutional quality in the host country However, He (2006) with the Pollution Haven Hypothesis suggests that the motives of some FDI firms are to find a place to hide pollution, and developing countries with lax environmental regulations is the destination for these businesses By this view, low institutional quality will attract polluting FDI firms

Most of studies argued the role of institutional quality in determining FDI inflows

with three categories: i) FDI is positively affected by institutional quality represented

by single indicators such as transparency (Zhao et al, 2003), democratic accountability (Busse & Hefeker, 2007), intellectual property rights and contract enforcement (Du et

al, 2008), political rights and civil liberties (Tintin, 2013); ii) There is no impact of

institutional quality on attracting FDI (Kandil, 2009; Bellos & Subasat, 2011; Farla et

al., 2014; and Iloie, 2015); and iii) the new argument, especially in the case of China‘s

outward FDI, is found that the low institutional quality attracts higher FDI inflow (Fan, Morck, Xu, & Yeung, 2009) Meanwhile, the feedback effect of FDI on institutional quality of host countries has received less attention from researchers Larrain & Tavares (2004) find that FDI significantly reduces corruption levels Long, Yang, & Zhang (2015) find the same results on the effects of FDI inflows on institutional quality However, the bidirectional relationship between FDI and institutional quality is largely ignored except by a few including Fukumi & Nishijima (2010) for Latin America & the Caribbean, and Shah et al (2015) for Pakistan Then what is the bidirectional relationship between FDI and institutional quality in Asian countries and

is it illustrated by the Eclectic paradigm (Dunning, 1980), the Institutionalization

Pollution haven hypothesis? It is an empirical gap needed to fill, giving policy-makers

with evidences to consolidate their decision on FDI attraction and institutional innovation

The second strand focuses on institutional quality as a driver of shadow economy,

basing on Legalism school of thought on the informal economy Following this view,

better institutional quality reduces the shadow economy because of two reasons: i)

better institutional quality lessens the burden of regulations and procedures - the main cause that explain why people participate in informal activities - and thus lowers

shadow economy (Demsetz, 1974; ii) better institutional quality reveals informal

transactions which consequently turn official and hence reduces shadow economy (De Soto, 1989, 2000) The negative impact of institutional quality on shadow economy is empirically confirmed by Johnson et al (1998); Friedman et al (2000); Fugazza & Jacques (2003), Torgler & Schneider (2009), Dreher et al (2009), Dreher & Schneider (2010), Singh et al (2012), Razmi et al (2013), and Hassan & Schneider (2016) There

is no study on the feedback effect of shadow economy on institutional quality

However, this theoretical and empirical gap needs to be filled for 2 reasons: i) if the

feedback effect of shadow economy on institutional quality is found, Legalism theory may be modified in the view that institutional quality is not only the cause but also the

consequence of shadow economy; and ii) studies on this relationship should take the

endogeneity problems into consideration To fill this gap, I argue that shadow economy reduces the tax revenue and falling tax revenue diminishes government income which leads to less capacity to provide public goods with high quality

The third strand examines the linkage of FDI and shadow economy To the best of

my review, this strand is represented by three studies by Nikopour et al (2009), Davidescu & Strat (2015) and Ali & Bohara (2017) The result from Nikopour et al (2009) indicates that higher FDI reduces shadow economy However, Nikopour et al (2009) do not explain through which channels that FDI can negatively affect shadow

economy Similarly, Davidescu & Strat (2015) find a negative unidirectional short-run causality that runs only from FDI to the shadow economy in the case of Romania Meanwhile, Ali & Bohara (2017) confirm that higher shadow economy increases FDI inflows since MNCs take advantages of tax evasion in host countries with higher size

of shadow economy However, this bidirectional nexus needs to be further re-examined for both theoretical and empirical aspects for 2 reasons First, it is imperative to research through which channels that FDI can affect shadow economy as well as shadow economy can affect FDI Second, policy makers in Asia will be provided by empirical results to deal with FDI and shadow economy simultaneously whereas FDI inflows contribute to economic growth (Borensztein et al., 1998; Nair-Reichert & Weinhold, 2001; and Hansen & Rand, 2006), but shadow economy is regarded as one

of the major threats of development (Friedman et al., 2000; Ihrig & Moe, 2004; Alm & Embaye, 2013; and Porta & Shleifer, 2014) Taking institutional quality into the bidirectional relationship between FDI and shadow economy is the contribution to the third strand by combining the three theories including international trade, institutionalization and Legalism It is argued that FDI can reduce shadow economy through the channel of institutional quality improvements resulted from FDI inflows; and higher shadow associated with lower institutional quality which may discourage FDI inflows Besides, FDI inflows may have potential impacts on shadow economy by other channels such as creating jobs and increasing the official economic growth

As argued above, though FDI, institutional quality and shadow economy are correlated and even inter-dependently, their mutual relationships remain the gap in the

inter-literature This gap is imperative to be filled in because of two reasons First, studying

on this mutual relationship formulates the mechanism in which these variables interact

to foster economic growth, by using an integrative approach of combining three

relevant theories Second, FDI, institutional quality and shadow economy attract great

attention from policies makers because all of them are closely associated with economic growth and development The demonstrated results of their mutual relationships indicate that policies to tackle any one of them can affect the other two at the same time, and governments need empirical evidences to consolidate their policy-making on dealing with these aggregate variables simultaneously

Shadow economy and income inequality

The shadow economy attracts researchers on studying not only its causes but also its effects The shadow economy has an impact on many variables such as the labour market (Voinea and Liviu-Albu, 2011; Castells & Portes, 1989; Portes & Benton, 1984); the productivity (Friedman et al., 2000; Ihrig & Moe, 2004; La Porta & Shleifer, 2014); economic growth (De Soto, 1989; Johnson et al., 1997; and Loayza, 1997); and poverty (Kim, 2005; Nikopour & Habibullah, 2010; and De Martiis, 2014) However, attempts to investigate the impact of shadow economy on income inequality are still scarce Rosser et al (2000, 2003), by macroeconomic approach of using empirical data

for 16 transition economies between 1987 to 1989 and 1993 to 1994, conclude with

caution that there is a positive relationship between the degree of income inequality

and the size of the informal economy An increase in inequality causes more informal activities due to the decline in social solidarity and trust, and expanding informal activities lead to more inequality because of falling tax revenues and weakened redistributive policies

However, I propose new arguments in this thesis that shadow economy has a negative impact on income inequality by combining three schools of thought on shadow economy, including Dualism, Legalism and Voluntarism, with two theoretical

points as follows First, Dualists with the residue theory depict the shadow economy as

a set of survival activities performed in a marginal society, generating income for the poor (Hart, 1973; Sethuraman, 1976; and Tokman, 1978) Although the classical theory

of distribution concludes that income inequality increases in the process of economic growth because the expanding industrial sector absorbs the labor force surplus from the agriculture without increasing wages; classical economists did not forecast that marginal people who cannot be absorbed in the industrial sector may work underground, and increase their income by this way Thus by taking point into account,

the shadow economy is expected to increase the income share of the poor Second,

Legalists and Voluntarists with the alternative theory of shadow economy contend that the rising shadow economy creates unfair competition for businesses and employees between the formal and informal sectors (Chen, 2012) Nevertheless, this unfair competition between the two sectors eventually turns out to be a channel to help reduce income inequality because to dual approach, shadow economy attracts most of the poor and small businesses, but not the rich and big businesses Therefore, the unfair competition from shadow economy may reduce the income share of the rich as the poor get more benefit from working underground As a result, the shadow economy may lessen the income inequality This new argument needs to be empirically

confirmed in the context of Asia for two reasons First, if this negative affect is

demonstrated, the research will extend theories in the context of Asian developing

countries on the positive effects of shadow economy in the literature Second, the result

may provide policy-makers with empirical evidences that policies to deal with the shadow economy should take the poor into close consideration with other simultaneous solutions for poverty eradication and income inequality reduction

In summary, for the above practical background, theoretical background and research gaps, the thesis is carried out to examine the inter-relationship among FDI, institutional quality and shadow economy, as well as to investigate the impact of shadow economy on income inequality in Asian countries The research objectives will

be presented in details as below

1.2 Research objectives

The thesis has two main objectives: (1) to examine the causal relationship among FDI, institutional quality and shadow economy in Asian countries; (2) to investigate the impact of shadow economy on income inequality and the channel of the impact in Asia

1.4 Research subjects and scope

The above research questions will be answered correctly and specifically when the subject and scope of the study are limited in a specific way In the thesis, research subjects are: the bidirectional relationships among FDI, institutional quality, and the

shadow economy; and the impact of shadow economy on income inequality in Asia These concepts are legibly defined in the chapter 2 (section 2.1.1, 2.2.1, 2.3.1) The research scope is limited in 19 Asian countries, including China, Mongolia, India, Bangladesh, Bhutan, Maldives, Nepal, Pakistan, Sri Lanka, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Thailand, Vietnam, Kazakhstan, and Kyrgyzstan Data for variables in the thesis are annually collected in the period 1999-

2015

1.5 Research methodology and data

The quantitative methodology is employed to deal with both research objectives

To examine the relationship among FDI, institutional quality and shadow economy in Asian countries, the author uses the simultaneous equation panel data model (SEM) including three equations for three independent variables: FDI, institutional quality and shadow economy The SEM model is estimated by both econometric methods: The Three-stage Least Squares (3SLS) and the Two-step System Generalized Method of Moments (System GMM) 3SLS is as an appropriate estimation method for the SEM model when Ordinary Least Squares (OLS) estimator for SEM will be biased, inconsistent, and inappropriate (Zellner and Theil, 1962) The Two-step System GMM can perform with linear dynamic panel-data estimation to solve the problems of endogeneity, heteroskedasticity and autocorrelation (Blundell and Bond, 1998) Meanwhile, the linear equation model is applied for studying the impact of show economy on income inequality, using two ways of estimations: Fixed Effects (FE) and Random Effects (RE), which can remove the effects of country unobserved characteristics The Two-step System GMM is also employed to check the robustness

of the estimation and to control endogeneity caused by the feedback effect of income inequality on shadow economy

Data for all variables in the models are collected from: Medina & Schneider (2018); World Development Indicators (WDI) from World Bank (WB), Worldwide Governance Indicators (WGIs) from WB; The International Country Risk Guide (ICRG) provided by the Political Risk Services (PRS) Group; UNESCO Institute for Statistics; Global Wage Report 2017 provided by International Labor Organization (ILO); Freedom in the World, Freedom House; Index of Economic Freedom, The Heritage Foundation; Economic Freedom Report 2016, the Fraser Institute; Global Competitiveness Index (GCI), World Economic Forum; KOF Globalization Index, collected from KOF Swiss Economic Institute; International Monetary Fund (IMF); Human Development Report, United Nations Conference on Trade and Development (UNCTAD)

1.6 Contribution

The research will be expected to have certain significance for both academic and practical contributions

First, the research combines the three theories of international trade, institutions

and shadow economy with an integrative approach to investigate the three-way linkages between FDI, institutional quality and shadow economy in the context of Asian countries, formulating the mechanism these variables interact to foster economic growth To the best of my knowledge, this is the first study that explores the three-way linkages amongst these variables In particular, the thesis fills the empirical gap of the positive bidirectional relationship between FDI inflows and institutional quality in the context of Asian countries by combining the Eclectic Paradigm (Dunning, 1980) and the Institutionalization Theory (North, 1990), opposing the Pollution Haven Hypothesis (He, 2006) on aggregate level In addition, the negative bidirectional nexus between institutional quality and shadow economy found from the thesis modifies the Legalism theory of shadow economy: institutional quality is not only the cause (main arguments

of Legalists) but also the consequence of shadow economy (findings from the thesis); and therefore studies on this relationship should take the endogeneity problems into consideration Furthermore, the negative bidirectional relationship between FDI and shadow economy fills the theoretical and empirical gaps in Asia by taking institutional quality into account: FDI inflows reduce shadow economy through the channel of institutional quality improvements resulted from FDI inflows; higher shadow is associated with lower institutional quality which discourages FDI inflows; and the interaction of FDI and institutional quality also has a negative impact on shadow economy, indicating that FDI inflows negatively affect the shadow economy and institutional quality improvements intensify this effect

Second, a simultaneous-equation modelling approach of both non-dynamic and

dynamic functions is employed to examine the three-way relationships between FDI, institutional quality and shadow economy for the first time In specific, the Three-stage Least Squares (3SLS) and the Two Steps System Generalized Method of Moments (SGMM) are applied to estimate the three-way causality effects: i) institutional quality and shadow economy on FDI; ii) FDI and shadow economy on institutional quality; and iii) FDI and institutional quality on shadow economy Especially, with the dynamic simultaneous-equation model, taking the impacts of the past values of three independent variables into account, the author estimates the short-run elasticities, instead of long-run elasticities in which panel cointegration and panel unit root approach were used in the literature for some of the above separate linkages such as FDI – institutional quality nexus or the impact of institutional quality on shadow economy

Third, the research examines the negative impact of shadow economy on income

inequality by increasing the income share held by lowest quintile and decreasing the income share held by highest quintile This result is opposite to previous studies

(Rosser et al., 2000, 2003), adding more arguments to the literature which supports the view on advantages of shadow economy especially to the poor The findings can be explained by combining the three schools of thought on shadow economy: Dualism, Legalism and Volutarism with two theoretical points: First, Dualists with the residue theory depict the shadow economy as a set of survival activities performed in a marginal society, generating income for the poor (Hart, 1973; Sethuraman, 1976; and Tokman, 1978) Thus the shadow economy is expected to increase the income share of the poor Second, Legalists and Voluntarists with the alternative theory of shadow economy contend that the rising shadow economy creates unfair competition for businesses and employees between the formal and informal sectors (Chen, 2012) Nevertheless, this unfair competition between the two sectors eventually turns out to be

a channel to help reduce income inequality because to dual approach, shadow economy attracts most of the poor and small businesses, but not the rich and big businesses Therefore, the unfair competition from shadow economy may reduce the income share

of the rich as the poor get more benefit from working underground As a result, the shadow economy may lessen the income inequality

Fourth, research results are expected to provide policy-makers with empirical

evidence for their social-economic decision-making in the region by two aspects: i) policies to simultaneously promote FDI and institutional quality are solutions for reducing the size of shadow economy and vice versa; ii) policies to deal with the shadow economy should take the poor into close consideration with other simultaneous solutions for poverty eradication and inequality reduction

1.7 Limitations

The measurement of shadow economy seems to be sensitive to the estimation method Although the data set from Medina & Schneider (2018), released by IMF in which the most popular MIMIC approach is used for shadow economy estimation, is

the newest one that I use in this thesis, it is more robust if various scenarios of how the shadow economy estimated should be considered Besides, the unavailability of data is also the weakness of the thesis when all Asian countries cannot be investigated

1.8 Thesis outline

The thesis is organized into six chapters Following the introduction in chapter one, the remainder of the thesis is structured as follows Chapter two depicts the review of theoretical and empirical literature Chapter three justifies the methodologies, model specifications, data and samples In chapter four, the empirical results for the first research objective are discussed Chapter five shows the empirical results and discussion for the second research objective Finally, chapter six provides conclusions and policy implications

CHAPTER 2 LITERATURE REVIEW AND HYPOTHESES

2.1.2 Empirical studies on shadow economy

2.1.2.1 Methods to estimate the size of the shadow economy

2.1.2.2 Determinants (causes)

2.1.2.3 The impacts of shadow economy (effects)

2.2 Shadow economy, FDI, and institutional quality

2.2.1 FDI and institutional quality

2.2.1.1 Theories on FDI (Definition, Theories, Determinants)

2.2.1.2 Theories of institutional quality (Definition, Theories, Determinants) 2.2.1.3 The relationship between institutional quality and FDI

2.2.1.3.1 The impact of institutional quality on FDI

2.2.1.3.3 Bidirectional relationship between FDI and institutional quality

+ Hypothesis 1: Better institutional quality in the host countries helps attract FDI

inflows and FDI inflows improve institutional quality in the host countries

2.2.2 Institutional quality and shadow economy

2.2.2.1 The effect of institutional quality on shadow economy

2.2.2.2 The effect of shadow economy on institutional quality

+ Hypothesis 2: There is a negative bidirectional linkage between institutional quality and the shadow economy

2.2.3 Shadow economy and FDI

2.2.3.1 The effects of FDI and FDI-institutional quality interaction on shadow economy

2.2.3.2 The effects of shadow economy on FDI

+ Hypothesis 3: There is a negative bidirectional nexus between FDI inflows and shadow economy

+ Hypothesis 4: The interaction of institutional quality and FDI is negatively associated with the shadow economy

2.3 Shadow economy and income inequality

2.3.2 The impact of shadow economy on income inequality

+Hypothesis 5: Shadow economy negatively affects income inequality through the channels of increasing the income share held by lowest quintile, and decreasing the

income share held by highest quintile

informal production and illegal production Based on a taxonomy of underground economic activities, a broad definition of the shadow economy includes unreported income from all market-based production of goods and services, either under monetary

or barter transactions that would generally be taxable if they were reported to the tax authorities (Mirus and Smith, 1997) To Alm & Embaye (2013), the shadow economy consists of ―all market-based goods and services that escape inclusion in official accounts‖

In spite of adopting inconsistent definitions of shadow economy, researchers have generally concurred on a typical aspect of the shadow economy: the sector covering economic activities that are not recorded in the national accounts However, this typical aspect of the shadow economy does not specify on the incentive goals of hidden economic activities Schneider (2007, 2010, 2016) in a narrower way, defines the shadow economy includes all production activities of goods and services based on market but they are deliberately hidden from public authorities for avoiding of income payment, tax payment, payment for social security contributions; for avoiding of

"having to meet legal labor market standards", such as maximum working hours, minimum wages, safety standards ; for avoiding of "complying with certain administrative procedures" such as completing administrative forms or statistical questionnaires Medina and Schneider (2018) estimate the size of shadow economy of

158 countries all over the world by using this definition This definition of the shadow economy will be also used in this research due to its comprehensive and specific meaning

2.1.1.2 Schools of thought

The theories on shadow economy can be viewed from different approaches such

as dual economy sectors, labor market sectors, by-product theory, alternative theory,

complementary theory, the context of working, and individuals‘ rational choice under uncertainty, being categorized into five dominant schools of thought

2.1.1.2.1 The Dualist school with the residue theory (Dual-sector model, Todaro model, and Dual labor market theory)

Harris-The appearance of shadow economy is initially described by Boeke (1953), Lewis (1954) and Harris and Todaro (1970) in their models by the concepts of a dual economy and social marginality

Boeke (1953) and Lewis (1954), in their Dual-sector model that gives the

grounded base for shadow theories, divide the economy into two sectors: the capitalist and the subsistence The capitalist sector includes those who use capital and labor, standing for industrial (modern, urban) sector with high productivity The subsistence sector stands for labor supply from the agricultural (traditional, rural) sector with low productivity The expansion of capitalist sector draws labor from the subsistence sector, but this rural-urban migration does not affect the output of agricultural sector since marginal product of labor is assumed to be zero with fixed land and unlimited labor supply Therefore, the transfer of labor from the agricultural sector to industrial sector continues until the industrial marginal product of labor equalizes the agricultural marginal product of labor in equilibrium Harris and Todaro (1970) in their named model argue that in this equilibrium there will be positive unemployment in the urban sector because the rural-urban transition is greater than the capacity of urban sector which may invest in capital-intensive production methods rather than labor-intensive ones As a result, those people who are not absorbed in formal sector will participate in the informal economy The informal economy is ―just as a residue‖ (Williams, 2008)

Similarly, the Dual labor market theory proposed by Doeringer and Piore

(1971) gives initial background implications for the presence of shadow economy To

this theory, the labor market can be classified into primary and secondary sectors The primary sector includes the privileged jobs with high salaries, status, responsibilities, good working conditions and job security On the other hand, the secondary sector comprises jobs characterized by negative quality like lower wages, poor working conditions, lacking of respect and job security, and less promotion prospects Cross & Johnson (2000) expand the Dual labor market theory by splitting labor market into more other 2 sectors: informal and illegal The informal sector includes people who are unable to access the primary and secondary sectors Jobs in the informal markets are those of self-employment, unregulated arrangement and off-the-book working Meanwhile, all criminal activities are grouped in the illegal sector The primary and secondary sectors follow labor regulations and tax duties but the informal and illegal sectors do not The labor market categories are displayed in the table 2.1

Table 2.1 Labor market classification

Primary Sector Secondary Sector Informal Sector Illegal Sector

(Source: Cross & Johnson, 2000: 102)

Followers for this doctrine with Dual-sector model, Harris-Todaro model, and Dual labor market theory are called dualists who view the shadow economy as encompassed by autonomous activities that have few linkages with the formal sector and generate income for the poor (ILO, 1972; Hart, 1973; Sethuraman, 1976; and Tokman, 1978) To this school of thought, two reasons for rising shadow economy are the imbalanced rates between population growth and industrial employment, and the mismatch between people‘s skills and industrial requirements By this view, the shadow economy is distinguished by some characteristics such as ease of entry, family enterprises, small-scale of operations, unregulated and competitive markets… Dualists

view shadow economy as a marginal society in underdevelopment and it will disappear

as a result of development advancement Although paying less attention to the relation between informal enterprises and government regulations as well as formal sector, scholars suggest that governments should create more formal jobs and provide financial and business development services to informal firms

However, the residue theory (dualistic approach) is criticized by three reasons First, the concept of a dual economy is later criticized for its descriptive rather than explanatory feature (Harding and Jenkins, 1989) Second, the informal sector does not disappear as expected in advanced economy (Willman-Navarro, 2008) The shadow economy still expands with modern and industrial growth at present Third, it is impossible for a ―disconnection‖ between the two sectors (Potts, 2008) Other schools

of thought find that the shadow economy is linked to the formal economy through production, trading, and distribution (Chen, Vanek & Carr, 2004)

Chen, Vanek & Carr (2004) debated that the residue theory should be rethought Out of the above criticism on the residue theory, they summarize the discrepancies between the new and old concepts of informal economy First, the shadow economy is not only a social marginality, but also an important provider of jobs, goods and services for lower-income groups Second, the shadow economy includes not only street traders and very small-scale producers, but also a wide range of informal jobs—both ‗old forms‘ such as casual day labor in agriculture and construction, as well as

‗new forms‘ such as temporary and part-time jobs plus homework for high tech industries Third, underground employment includes not only self-employment but also salary employment, and informal firms include not only survival activities but also stable businesses and dynamic growing enterprises Finally, instead of not being the subject for economic policies, informal activities are virtually affected by economic policies

2.1.1.2.2 The Structuralist school with By-product theory

Similar to Dualists, Structuralists with by-product theory view the informal economy as a marginal sector, but in contrast to the former, describe the informal sector as an integral part of the formal sector – a necessary by-product of the formal economy The shadow economy composes of subordinated economic units and workers to reduce costs of input and labor of large capitalist companies, and thereby increase their competitiveness (Castells and Portes, 1989; Moser 1978) The presence

of shadow economy by this thought is due to the structural nature of capitalism, the process of industrialization and globalization (sub-contracting chains, off-shore industries, flexible specialization) The marginalized population accepts the exploitative work for a part of their ―survival strategy‖

Another reason that structuralists explain for the appearance of shadow economy is formal labour market imperfections such as minimum wage laws or collective bargaining agreements These regulatory distortions keep labor costs high and structural unemployment happens as a result Those who cannot find formal jobs will work in the shadow economy (Fields, 1975) However, Stiglitz (1974) and Mazumdar (1976) argue that the labour turnover and efficiency wages can lead to a similar formal/informal dualism Structuralists admit the intrinsic link between the shadow and official economies and therefore recommend that governments should regulate both commerce and employment relationships to reduce inequality between

―big businesses‖ and subordinated producers and workers

Both of dualists and structuralists have a feature in common for depicting the shadow economy: the engagement in the shadow economy is a necessity rather than a choice However, the concept of a dual economy (dualists) and social marginality

(structruralists) are opposed by legalists and voluntarists who approach the shadow economy under the alternative theory and the theory of individuals‘ rational choice They do not view the informal economy as a set of survival activities performed in a marginal society They find a dependency of unofficial economy on official one although it can be either alternative or complementary

2.1.1.2.3 The Legalist school with alternative theory

The Legalist school sees the shadow economy as comprised of businessmen who choose to operate informally to avoid costs, time and effort of formal registration (Demsetz, 1974; De Soto, 1989, 2000; Schneider and Dominik, 2000) This school of thought considers low institutional quality (such as bad governance, weak legal system, heavy burden of regulations, high corruption, ineffective rules of law…) as the key causes of working in the shadow economy The shadow economy is considered as a positive alternative to the formal economy It is ―a site of resistance to the formal economy that is growing‖ (Williams, 2012) By this approach, the participation in the shadow economy is a choice, rather than a necessity, with three perspectives including

the neo-liberal perspective, green perspective, and post-capitalist theory

In the neo-liberal perspective, informal activities are attributed to hostile legal

system with cumbersome government rules and procedures Responding to the lack of free market space, people choose to take part in informal activities by bypassing inappropriate legal regulations with easier informal norms, rules and laws Neoliberal theorists suggest that governments should simplify bureaucratic procedures to reduce costs of becoming formality (registration, license) and remaining formality (taxes, compliance with regulations and laws) for decreasing the size of shadow economy

Both green perspective and post-capitalist theory claim that people choose to

join in informal activities because they are dissatisfied with the negative sides of

modern and capitalist free market, such as polarization and pollution People seek for

an alternative economy which is more local, sustainable, environmental and community-based

2.1.1.2.4 The Voluntarist school with the theory of individuals‘ rational choice

Another approach to the shadow economy is based on the theory of individuals‘ rational choice under uncertainty Individuals respond rationally They make choices to maximize the utility Their decision to work underground is similar An individual faces trade-off between gains if their informal activities are not exposed and losses if disclosed and punished If the expected benefits from working underground exceed the formal costs and potential fines, individuals voluntarily participate in the shadow economy Schneider and Buehn (2016) theorize the shadow economy by individuals‘ rational choice approach in details with a structural equation To this framework, informal activities are negatively associated with the probability of detection and potential fines (which determined by enforcement actions by the tax authority and facilitating activities accomplished by individuals to avoid detection); and positively associated with the opportunity cost of being formal (that determined by tax burden and high labor costs) Followers of this approach are early named Voluntarists

The Voluntarist school looks at the shadow economy as comprised of entrepreneurs who decide to operate in the informal economy to avoid taxes and social security contributions (Tanzi, 1982, 1999; Schneider, 1994, 1997; Gile, 1999; and Maloney 2004) These businesses are not willing to pay taxes By operating underground, they try to keep all economic profits for themselves Being different from Legalists, Voluntarists argue that entrepreneurs do not complain governments for inconvenient rules and procedures, they voluntarily choose operating informally after weighting costs of formality (payroll taxes and social protection contributions) and benefits of informality (earning income while avoiding costs of formality) To

Voluntarists, governments should expose informal businesses to formal environment to increase the tax and competitiveness

2.1.1.2.5 The school of complementary theory and shadow economy

Different from legalists and voluntarists, who view the shadow economy as an alternative for the official economy, scholars argue that shadow economy and official economy are complementary in that they grow or decline in tandem This view is advocated by Adam and Ginsburgh (1985), Jensen et al (1995), and Williams & Round (2008) They find that those who are better-off have more chances to earn informal income while lowest-income households are the least likely to report informal activities Greenfield (1993) sees the development of the informal and formal sectors in

a parallel way, with the notion that the direct and indirect demand for goods and services produced in the informal sector will increase its size as the formal economy expands The positive relationship between formal and informal economies is due to the advantages from the informal economy such as social cohesion through mutual aid and reciprocity, social networks of material support, provision of goods and services to those in need…

Besides, another approach to the shadow economy is one based on the context

of work (International Labour Organization, 2002; and Losby et al., 2002) A person

who is self-employed or works for someone else can be categorized into contexts of work as depicted in the table 2.2