The relationship between the unterground economy and the developments in the official economy in Croatia

Abstract

The goal of this thesis is to develop both a theoretical model and an empirical model of the underground economy in Croatia. First part consists of a theoretical model, and the second of an empirical model. The theoretical model looks at the idiosyncratic shocks on the Croatian economy in order to determine the effects of the underground economy on the official economy. In the second part, this paper then estimates the size of the underground economy as percent of GDP in Croatia for the period 2000 - 2010. In the theoretical model, idiosyncratic shocks are applied to a two-sector economy with a goal of determining effects of the presence of the underground economy on the real business cycle of the Croatian economy. The theoretical model predicts somewhat the movements in the official economy for the periods 2000 - 20005 and 2010 - 2011. Just as in the case of the Busato and Chiarini model (2004), consumption is almost held constant in this model because of the buffering effects of the underground economy. The main cause of the buffering effects of the underground sector is the interconnections between the two sectors through the consumers, who have the possibility to work in both sectors. Another cause is the interconnection between the two stochastic technological parameters in the production functions. Interesting result of the theoretical model is that movements for the period 2010 - 2011 can only be achieved if the economy experiences a negative productivity shock, indicating a presence of sectorial shifts in the Croatian economy. The empirical part estimates the size of the underground economy in Croatia as percent of GDP using the multi indicator multi cause model (MIMIC). Since in MIMIC models only correlation coefficients are estimated, a starting value of the size of the underground economy must be obtained from another model, which can then be used to obtain the size of the underground economy as percent of GDP. In the literature, two extreme values of the size of the underground economy have been obtained. On one side are the low values estimated through the expenditure model by Madzarevic - Sujster and Mikulic (2001) and high values by Schneider (2009). This paper fails to reproduce the results by Schneider, who used the currency approach to obtain the benchmark value of the underground economy, because the anchoring value used was from the national expenditure model by Madzarevic - Sujster and Mikulic (2001). However, what the MIMIC model indicates is that, independent of the anchoring value, the movements of the underground economy will be the same.