Shadow economy in Bosnia and Herzegovina: Coping strategy or economic threat?

A new econometric investigation has confirmed that Bosnia and Herzegovina’s shadow economy remains one of the largest in the Western Balkans, underpinned by structural institutional weaknesses, complex taxation, and systemic labor market rigidity. The study, titled “Shadow Economy Drivers in Bosnia and Herzegovina: A MIMIC and SEM Approach” and published in World, presents statistically robust estimates using the Multiple Indicators and Multiple Causes (MIMIC) model to trace the informal sector’s evolution from 1996 to 2022.

The research, conducted by economists from the University of Banja Luka, demonstrates that shadow economic activity in Bosnia and Herzegovina is not a transient byproduct of economic hardship but a deeply entrenched and responsive subsystem fueled by governance fragmentation, external shocks, and tax disincentives. Rather than benchmark the shadow economy as a percentage of GDP, often a source of methodological controversy, the study emphasizes relative movements and structural breakpoints, offering insight into how informality behaves during periods of crisis and institutional stagnation.

What fuels the shadow economy in Bosnia and Herzegovina?

Bosnia and Herzegovina’s post-conflict administrative structure, split between two autonomous entities and the Brčko District, creates a fragmented governance landscape. This institutional complexity has generated regulatory inconsistencies that enable and even incentivize informal economic behavior. According to the study, the most substantial drivers of the shadow economy include poor rule of law, inadequate control of corruption, high tax burdens, and sluggish employment growth.

Key sectors such as construction, agriculture, and retail, which account for large segments of employment and GDP, are especially vulnerable to informality. These sectors experience low levels of regulatory oversight, allowing unregistered transactions and cash-based earnings to proliferate.

The MIMIC model, which treats the shadow economy as a latent variable, combines macroeconomic causes (employment rates, GDP per capita, tax revenues) with institutional indicators (governance quality and corruption control) to construct a dynamic profile of informal activity. Employment growth and economic output are shown to correlate inversely with informality, while increased tax burden and institutional failure correspond to higher shadow activity.

The study further highlights that informal work often acts as a survival mechanism. In the absence of robust social protection systems, particularly for low-income households, informal labor offers financial relief but simultaneously undermines long-term economic resilience.

How has the informal sector responded to economic shocks?

Bosnia and Herzegovina’s shadow economy has not remained static; it has responded dynamically to global and local disruptions. Using structural break analysis, the study identifies key inflection points including the global financial crisis of 2008, the 2014 catastrophic floods, and the COVID-19 pandemic. These events pushed more individuals and firms outside the formal economy, either temporarily or permanently.

For example, the global crisis was found to have a delayed effect in Bosnia and Herzegovina due to the country’s limited integration into global financial flows. Yet once the downturn permeated the domestic economy, informal activity surged in response to declining formal employment and institutional inaction. Similarly, the 2014 floods disrupted physical and institutional infrastructure, triggering a short-term spike in shadow activity.

Interestingly, the COVID-19 pandemic had a paradoxical effect: government subsidies and formalization incentives led to the temporary declaration of previously hidden incomes. This unintended consequence of crisis-driven stimulus programs momentarily decreased the size of the informal sector, but researchers caution that such gains are likely reversible unless sustained policy reforms follow.

The research also notes that while some factors are endogenous, like tax policy and institutional quality, others are exogenous shocks that reveal systemic fragility. Thus, the shadow economy acts as an informal barometer of institutional resilience and public trust, expanding when the formal system fails and contracting when governance improves.

What policy measures can reduce informality?

The findings provide a detailed map for policymakers seeking to reduce the shadow economy in Bosnia and Herzegovina. Three central policy actions emerge from the analysis.

First, institutional strengthening is vital. Measures that enhance rule of law, streamline administrative processes, and combat corruption can improve public trust and reduce the perceived advantages of operating informally. The study confirms that stronger institutions are inversely related to shadow economic activity.

Second, tax system reform is essential. The research underscores the need to simplify tax codes, reduce fiscal pressure, especially on small and medium-sized enterprises, and improve enforcement consistency. These reforms can make formalization more appealing while narrowing the gap between legal compliance and economic survival.

Third, labor market interventions should target formal employment expansion. Improving job security, promoting decent work, and incentivizing businesses to hire through legal channels can shift the incentive structure away from informal labor. Additionally, targeted social policies should provide safety nets that reduce economic vulnerability without fostering long-term informality.

The study also urges caution with popular benchmarking practices in MIMIC-based shadow economy estimation. Instead of fixating on quantifying informality as a GDP percentage, the authors advocate for monitoring trend patterns and relative changes. This approach provides a more reliable basis for policymaking without the interpretive risks of arbitrary benchmarks.

Toward a more transparent and resilient economy

Despite data constraints and the country’s unique political-administrative setup, the study represents a significant empirical advancement in understanding Bosnia and Herzegovina’s shadow economy. It refines existing MIMIC methodologies by incorporating rigorous tests for stationarity, avoiding index benchmarking, and accounting for structural breaks caused by real-world shocks.

The findings highlight the need for context-specific, evidence-based strategies that go beyond generic policy blueprints. For Bosnia and Herzegovina, and similar post-conflict or transitional economies, the informal economy is not simply a statistical anomaly. It is a dynamic response to institutional and socio-economic shortcomings.