Using currency demand to estimate the Palestine underground economy: An econometric analysis

The study investigates the size of the underground (informal/hidden) economy in Palestine and its determinants, focusing on the period 2008–2017. Motivated by the substantial policy relevance of unobserved economic activity—particularly in contexts with political fragmentation, limited sovereignty, and multi-currency circulation—the paper applies Tanzi’s currency demand approach (CDA) to estimate the underground economy. The rationale emphasizes that ignoring informal activities biases official economic indicators and undermines effective development planning. Given Palestine’s unique political and institutional context (division of territories, limited administrative control, and data constraints), the research aims to quantify the underground economy and assess how factors such as taxation, government wages, interest rates, self-employment, and per-capita income affect it through their influence on currency demand.

The paper reviews definitions and scope of the underground economy, citing Feige, Schneider, Frey and Pommerehne, Smith, and others, encompassing unreported legal and illegal market-based production that evades regulation, taxation, or observation. It summarizes cross-country evidence from Medina and Schneider (2018), noting average shadow economy shares (global average 31.9%) and selected regional figures (e.g., Qatar 15.93%, Saudi Arabia 16.56%, Syria 19.58%, Egypt 34.24%, Morocco 34.1%, Lebanon 31.58%, Algeria 30.86%, UAE 26.45%; Switzerland 2.7%, Austria 8.09%, Bolivia 62.3%, Zimbabwe 60.6%). The Tanzi (1980, 1983, 1999) currency demand approach is identified as widely used, estimating excess currency attributable to tax-evading underground transactions under key assumptions (notably equal velocity of money in formal and underground economies). The review acknowledges methodological weaknesses: not all underground transactions are cash-based; typical overemphasis on tax burden as the sole driver; the equal velocity assumption; the need for a base year with no hidden economy; and the requirement to accurately measure currency in circulation. Prior empirical applications in various countries (e.g., Asiedu and Stengos; Ardizzi et al.; Nchor and Konderla; Raut et al.) establish the approach’s relevance and challenges.

The study applies Tanzi’s currency demand model (CDA) using quarterly time-series data for Palestine from 2008 to 2017. Core assumptions: (1) underground transactions are predominantly cash-based; (2) the underground economy is driven by tax burden changes; (3) the velocity of money is equal in formal and underground economies; (4) liquidity is measured using the broad money aggregate (M2). Model specification for currency demand: ln(CC/M2)t = β0 + β1 ln(1 + (T/Y)t) + β2 ln(W/Y)t + β3 Rt + β4 ln(SE)t + β5 ln(GDPpc)t + εt, where CC/M2 is currency outside banks relative to M2; T/Y is tax-to-GDP; W/Y is government wages and salaries-to-GDP; R is the interest rate on USD saving deposits; SE is the share of self-employed (workers in own private business) in total employment; GDPpc is per capita GDP. The ln(1 + T/Y) transformation accommodates instances where T/Y could be zero. Estimation proceeds in four steps: (1) estimate currency outside banks (CC) under the observed tax regime (CC1, Tax ≠ 0) and under a hypothetical zero-tax regime (CC2, Tax = 0); (2) compute illegal/excess currency as CC2 − CC1; (3) multiply excess currency by the velocity of broad money (GDP/M2) to obtain underground economy value; (4) divide by GDP to get the underground economy share. Econometric procedure: Stationarity is tested with the Augmented Dickey-Fuller (ADF) test. Cointegration is examined using Engle-Granger and Johansen tests (trace and maximum eigenvalue). Given cointegration among variables, the long-run currency demand function is estimated via Fully Modified OLS (FMOLS), which corrects for endogeneity and serial correlation. A Vector Error Correction Model (VECM) is used to assess short-run dynamics and the speed of adjustment (error-correction term ECt−1). Diagnostic checks include correlation analysis among regressors, tests on residual means, and normality (Jarque-Bera). The estimated long-run currency demand equation used to compute CC1 and CC2 is: Ln(CC/M2)t = 7.9794 − 11.1621·Ln(1 + T/Y)t + 0.0804·Ln(W/Y)t − 0.515·Ln(R)t + 0.924·Ln(SE)t − 1.1532·Ln(GDPPC)t.

• Size and trajectory of the underground economy: Annual underground economy share ranged from 28.60% (2010) to 12.71% (2017), with an average of 18.37% over 2008–2017. Quarterly values spanned approximately USD 275.036 million (12.97%) in 2008Q1 to USD 821.819 million (34.57%) in 2010Q1. The abstract reports the 2010 level at 28.6% of GDP, about USD 2,676.227 million. - FMOLS regression on Ln(HE) (Table 4): • Constant: 7.4792 (p<0.001). • Ln(T/Y): 0.8127 (t=20.53, p<0.001) — positive and significant. • Ln(W/Y): 0.0381 (t=0.914, p=0.367) — not significant. • Ln(R): −0.4501 (t=−24.34, p<0.001) — negative and significant. • Ln(SE): 0.8257 (t=4.36, p=0.0001) — positive and significant. • Ln(GDPPC): 0.3502 (t=2.673, p=0.0116) — positive and significant. Adjusted R² ≈ 0.974, indicating the model explains ~97.4% of the variation in the estimated underground economy. - VECM result: The error-correction coefficient for D(LHE) is 0.2324 (p=0.507), indicating no statistically significant long-run adjustment toward equilibrium. - Elasticities/policy-relevant magnitudes: • A 10% increase in tax-to-GDP is associated with an ~8.13% increase in the underground economy. • A 10% increase in the interest rate on USD deposits is associated with a ~4.5% decrease in the underground economy. • A 10% increase in the self-employment share is associated with an ~8.26% increase in the underground economy. • A 10% increase in per-capita GDP is associated with a ~3.5% increase in the underground economy. Government wages-to-GDP shows no significant effect.

The findings confirm the central hypothesis of Tanzi’s approach: higher tax burden increases demand for currency and, by extension, the size of the underground economy. Significant positive elasticities for taxes and self-employment suggest that stronger tax enforcement and formalization of self-employed activities could reduce informality. The negative elasticity with respect to bank deposit interest rates implies that incentivizing savings through higher deposit returns and a more attractive formal financial sector could shift transactions from cash to formal channels, reducing underground activity. Contrary to expectations, per-capita GDP has a positive association with the underground economy, interpreted by the authors as evidence of persistent cash preference among Palestinians as incomes rise, which sustains cash outside banks and supports hidden transactions. Government wages and salaries do not significantly influence the underground economy, possibly reflecting low public-sector pay that does not directly stimulate hidden activity; some public employees may engage in private business outside formal channels, but the wage bill ratio itself is not a driver. The VECM results indicate no significant long-run equilibrium adjustment in the system, suggesting that short-run dynamics and structural constraints dominate over the sample period. Overall, the results support policy measures aimed at tax policy reform and compliance, financial sector development to reduce cash reliance, and targeted formalization of self-employment.

The study applies Tanzi’s currency demand approach with robust time-series econometrics (ADF, cointegration tests, FMOLS, VECM) to estimate Palestine’s underground economy (2008–2017) and identify its determinants. It finds an average underground economy share of 18.37% of GDP, peaking at 28.60% in 2010 and declining to 12.71% by 2017. Taxes and the self-employment share significantly expand the underground economy, higher bank deposit interest rates reduce it, and per-capita GDP is positively associated with informality; government wages-to-GDP is not significant. The authors provide policy recommendations, including rethinking tax policy and compliance, integrating the underground economy into development strategies, improving data systems, and promoting savings and financial intermediation. The VECM indicates no significant long-run adjustment over the sample, highlighting structural rigidities. The paper contributes an empirical baseline for Palestine and reinforces the relevance and limitations of CDA in complex institutional settings.

Study- and context-specific constraints acknowledged by the authors include: (1) lack of full sovereignty over territory; (2) use of multiple currencies (ILS, USD, JD, EUR); (3) inability to obtain comprehensive wage and salary data due to cross-border employment; (4) lawlessness in some areas outside administrative control; (5) limited information and data availability from government agencies. Methodological limitations of the currency demand approach noted include: (a) not all underground transactions are cash-based; (b) frequent focus on tax burden as the sole driver; (c) assumption of equal velocity of money in formal and underground economies; (d) need for a base year with no hidden economy; and (e) reliance on accurate measures of liquid money in the model.