Multiple indicators multiple causes : estimating the relationship between fiscal illusion and the shadow economy in Malta

Abstract

This dissertation looks at the relationship that exists among two complex phenomena in Malta, the shadow economy and fiscal illusion, with specific focus given to the adequacy of the Multiple Indicators and Multiple Causes (MIMIC) modelling in estimating this relationship. The literature and analysis presented in this dissertation unearthed several valuable insights. First and foremost, literature outlines a scenario where both the shadow economy and fiscal illusion are perceived in tandem, building on the existing literature in relation to the relationship between the two phenomena. Furthermore, this study employs an annual time-series dataset starting from 1980 until 2019, where specific focus is given to the behaviour of variables over this time period. MIMIC estimates provide an enhanced insight on the variables that are robust in explaining the relationship between the two phenomena specifically in Malta. The obtained results in relation to the unidirectional relationship between the two phenomena indicates that the shadow economy negatively affect fiscal illusion, and fiscal illusion positively affect the shadow economy. Additionally, various justifications are pointed out as to why certain MIMIC estimated coefficients are not entirely appropriate in measuring this relationship as at to date, in particular the small sample size due to lack of data availability. In essence, this study concludes that the unemployment rate and GDP per capita are the two most important variables in explaining the relationship between fiscal illusion and the shadow economy in Malta. Thus, it is recommended that any future research in the area of fiscal illusion and shadow economy in Malta includes these two variables in the estimation procedure.