A Measure of the Shadow Economy in a Small Economy: Evidence from Household-Level Expenditure Patterns

In this paper we measure the size of the shadow economy in North Cyprus by using micro-econometric approaches and then calculate its implications on national accounts and fiscal balances. There is a relatively new strand of literature that focuses on comparing income-expenditure patterns of households to calculate the degree of underreporting of income levels by self-employed and privately employed individuals, as compared with public servants. We use the 2008 Household Budget Survey of North Cyprus and analyze the differences in food consumption patterns among three kinds of employees: self-employed, privately employed, and public. We found that self-employed and privately employed individuals underreport their income levels by 20 percent and 13 percent, respectively, compared with publicly employed individuals. This has important implications for the aggregate economy in North Cyprus, where we estimate that the shadow economy created by underreporting is as much as 8.6 percent of GNP and 11.1 percent of total tax revenue