Making up just above half of its GDP, Ethiopia's shadow economy is one of the largest in Africa
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A report published by Ernst & Young estimated Ethiopia’s shadow economy to be 50.2 % of the nation’s GDP. By that metric, Ethiopia was ranked to have the 3rd largest shadow economy in Africa, next to Sierra Leone and Niger.
But putting it this way might diminish the scale of Ethiopia’s shadow economy. The top 5 countries in the above list are Sierra Leone, Niger, Ethiopia, Burkina Faso, and Tanzania. Take out Ethiopia, and the remaining four countries have a total combined nominal GDP of approximately $129 billion. Ethiopia’s, on the other hand, is estimated to be $200 billion. So, Ethiopia has a larger GDP than the top 4 countries combined, and half of it is a shadow economy. Based on this, it’s completely fair to say Ethiopia’s shadow economy, in absolute terms, is the largest in Africa.
Before we see how we got here, let’s understand the shadow economy.
What is a Shadow Economy?
Simply put, the shadow economy is an ominous way of saying businesses that don’t pay taxes and aren’t regulated by the government. It generally refers to economic activities that are either completely hidden from the authorities or whose revenues are only partially disclosed, hence the name shadow. In some cases, such businesses may serve as a front for criminal activities, but most of the time, they are run by people who just don’t want to pay taxes. So, why is Ethiopia’s shadow economy so big?
What Grows a Shadow Economy?
Countries with weak taxation systems that struggle to enforce compliance often see informal economies thrive. But they’re not necessarily what causes them. A paper published in the American Journal of Theoretical and Applied Business identified several factors with varying degrees of causation.
Tax Burden: Tax burden has a positive relationship with the shadow economy. An increase in taxation makes it more attractive for individuals and businesses to operate in the informal economy to avoid paying taxes. This also makes it harder for existing informal businesses to transition to the formal economy and encourages new entrants to choose the informal sector. Specifically, the paper claims that for every one percentage point increase in tax burden, the shadow economy grows by 1.15 percentage points.
Inflation Rate: The inflation rate also significantly contributes to the rise of the shadow economy. High inflation increases the demand for cheaper goods and services found in the shadow economy. It can also lead to "bracket creep," pushing incomes into higher tax brackets and providing an additional incentive for taxpayers to work for "cash in hand" to evade the increased tax burden. High inflation can force small businesses out of the formal market, pushing them towards informal activities.
Lack of Trade Openness: While trade openness reduces the shadow economy, a lack of trade openness contributes to a larger shadow economy. A less open economy, or a more restrictive trade regime, incentivizes entrepreneurs to operate underground to avoid regulations, leading to an increase in illegal activities like smuggling and black markets. Conversely, promoting greater trade relations and economic openness can reduce informal sector activity by encouraging businesses to formalize their operations.
The Result?
As a result, Ethiopia’s tax-to-GDP ratio has been declining steadily in the past decade. This low level of tax collection limits the government's ability to invest in infrastructure, public services, and social programs, which in turn drives more economic activity underground. When businesses see that public services are inadequate or inconsistent, they have less incentive to comply with tax regulations.
Another factor is the size of the informal workforce. A large portion of Ethiopia’s labor force operates in small-scale trade, agriculture, and service sectors where formal employment contracts and tax reporting are minimal. This widespread informal employment makes it difficult for authorities to capture economic activity and contributes to the persistence of the shadow economy.
Efforts to shrink the shadow economy will likely require a combination of lower taxation rates, simplified regulatory procedures, and improved public services. Promoting transparency, encouraging formal registration, and creating incentives for informal businesses to transition into the formal sector could gradually reduce the size of Ethiopia’s shadow economy.
Until such measures take effect, the shadow economy will remain a defining feature of Ethiopia’s economic landscape, shaping both challenges and opportunities for the country’s growth.
