Modelling the Shadow Economy: An Econometric Study of Technology Development and Institutional Quality

This econometric analysis models the conditional expectation of Europe’s shadow economy size as a function of technologization and institutional quality indicators, using a balanced panel of 29 countries from 2007 to 2022. Technologization is measured through the four dimensions of Desai’s Technological Achievement Index, and institutional quality via core World Government Indicators variables. Rigorous diagnostics select a random-effects model with year dummies and Driscoll-Kraay standard errors, explaining 61% of the variance in informality. Development of Human Skills delivers the largest individual reduction (−7.2 pp), strongly supporting the core hypothesis. Control of Corruption is also highly significant (−2.8 pp). While New Technology Creation showed a negative association, its statistical significance proved unstable across model specifications. Technology diffusion becomes insignificant when common global time shocks are absorbed, implying that mere adoption has limited independent effect. Furthermore, the impact of human skills intensifies significantly in countries with high New Technology Diffusion (−12,489), revealing a potent synergy between human capital and technological advancement. Policy priorities therefore include anti-corruption enforcement, Research and Development incentives, and sustained investment in skills, especially where technology diffusion is high, to draw hidden activity into the formal sector.