Green rules & grey markets: Do environmental policies influence the informal economy?

What the paper says

The relationship between environmental policy stringency and the shadow economy is a critical issue, as stringent regulations can either formalise economic activities or push businesses into informality. This study aims to analyse how different types of environmental policies influenced the size of the shadow economy across 24 countries from 2003 to 2020. This study uses panel data regression techniques, including Fixed Effects and Random Effects models, to evaluate the impact of market-based policies, command-and-control regulations, and environmental taxation on informal economic activities. The results indicate that overall environmental policy stringency is negatively correlated with the shadow economy, with a one-unit increase in policy stringency reducing the informal economy by approximately 2.18 percentage points. Market-based environmental policies, such as carbon trading schemes and financial incentives, are more effective in reducing informality than command-and-control regulations. However, high environmental taxation, particularly sulphur oxide taxes, is associated with an increase in the shadow economy, suggesting that excessive regulatory costs may incentivise tax evasion and informal operations. The study highlights the importance of balancing environmental regulations with economic incentives and governance reforms to ensure both sustainability and economic de-shadowing.