This study addresses one challenging problem that policy-makers are struggling with: how to tackle the income polarization and informal sector issues when they are interrelated and particular socio-cultural and institutional context moderate the relationship? We investigate the impact of shadow economy on income inequality by using a panel data set of 28-EU countries observed during the period 2005-2017. Our main findings from empirical estimations based on GMM estimator show one mixed evidence depending on which proxy of income inequality and shadow economy respectively is considered. The empirical outcomes conciliate prior opposite results and are explained by relating to different income groups, as the poor people and rich ones respectively engage in the shadow economy for different reasons, and create diverse impacts upon income distribution, both directly and indirectly. We also illustrate that the marginal impact of shadow economy on income inequality varies with key socio-cultural and economic conditions. The quality of institutions, like government effectiveness and domestic credit market performance, matters for the distributional impact of international tax evasion, while control of corruption counts for the broader sense of the informal economy’s implications. Cultural peculiarities are found to be relevant for the extent of redistributive effect of underground activities, bringing new and interesting insights in the researched area. Some policy implications derive from our empirical findings.
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