Of strong governance and political will: Taming the underground economy

 

IT is widely believed that the underground economy represents a significant share of economic activity and has been growing faster than the formal sector. It is present in nearly every country, although the size and impact vary widely.

The shadow economy, also known as the underground or informal economy, refers to economic activities that are not regulated by the government and bypass taxes or other legal requirements.

The Rational Choice Theory in criminology explains that smart criminals enter the underground economy by weighing potential risks against rewards, often exploiting weaknesses in both structural and human governance.

According to the International Monetary Fund (IMF), the underground economy makes up roughly 23% of global gross domestic product (GDP). It typically accounts for 10‒15% of GDP in advanced economies and 30‒40% in emerging and developing countries.

Countries like Switzerland, Singapore and Japan keep shadow economies under 10%. In contrast, nations with weak institutions, complex taxes and low public trust struggle with large underground economies.

In 2024, Inland Revenue Board of Malaysia (LHDN) former CEO Datuk Abu Tariq Jamaluddin stated that the shadow economy  has grown  to an estimated  RM350 bil (roughly 30% of the current GDP).

The illegal tobacco trade costs Malaysia about RM10 bil annually, with around RM5 bil lost in taxes and high enforcement costs, while corruption is expected to drain RM60 bil each year.

Former Auditor-General Tan Sri Ambrin Buang noted that corruption and mismanagement caused up to 30% of public projects to lose their value.

Hawala is an informal system for transferring money across countries through trusted brokers or money changers, without banks or physical cash and facilitate underground economic activities.

Digital technologies and the digital economy have transformed organised crime by creating a highly profitable, low-risk environment for illicit activities.

Research by the IMF shows a strong correlation between corruption and the size of the shadow economy.

Based on the Transparency International’s Corruption Perceptions Index (CPI), countries scoring above 70 typically have underground sectors that make up less than 15% of their GDP, while scores of 40 to 60 points correspond to 20‒35% of GDP, and scores below 30 often mean a shadow economy exceeding 40% of GDP.

Malaysia’s CPI score is in the 50s, placing it in the middle ground.

The underground economy is driven by weak rule of law, corruption, unemployment, poverty, limited access to formal opportunities, and low public trust, pushing individuals and businesses outside official systems.

The shadow economy reduces tax revenue, distorts competition, and limits investment, while workers lack protections and fair wages. It weakens institutions, fuels corruption, complicates economic measurement, and can slow long-term growth.

Japan, Switzerland, and Singapore manage the shadow economy through strong governance and political will, low corruption, transparent political financing, independent judiciaries, procurement reforms, and whistleblower protections.

A new 2025 EY study found that only data-driven, comprehensive policies can curb the shadow economy.

Putrajaya is combating revenue losses with e-invoicing, mandatory Tax IDs, digital reforms, expanding formal financing and using streamlined rules including Anti-Money Laundering, Anti-Terrorism Financing and Proceeds of Unlawful Activities Act 2001 (AMLA) enforcement, and incentives to enhance compliance, formalise businesses, and encourage inclusive growth.

The government aims to raise Malaysia’s CPI score to above 65, placing it among the top 25 least corrupt countries. This means reducing its underground economy to below 20% of GDP. 

 Datuk Seri Dr Akhbar Satar is the president of Malaysian Integrity and Governance Society.

The views expressed are solely of the author and do not necessarily reflect those of  MMKtT.

- Focus Malaysia.