Does the economic freedom hinder the underground economy? Evidence from a cross-country analysis

We evaluate the impact that the economic freedom exerts on the shadow economy for a sample of 152 countries from 1995 to 2017. In order to solve endogeneity issues, we rely on an instrumental variable approach and find that a change in the economic freedom index, induced by the level of independence of financial markets from government actions, adversely affects the hidden economy. To corroborate the interpretation of our results we also show how each subcomponent of the economic freedom index explains the downward change registered in the shadow economy. Further, the negative effect is mainly found in countries characterized by a low level of democracy and strong corruption, whereas in more democratic and less corrupt countries the economic freedom positively affects the size of the shadow economy. Consistent with these findings, we also highlight that the effect of the composite indicator of economic freedom on the hidden economy is U-shaped and this relationship is exclusively driven by both business regulation and the freedom in the legal system and property rights.