Cracks in the Border: The Shadow Economy, Trade Openness, and Institutional Effectiveness in Sub-sahara Africa

Sub-Saharan Africa (SSA) continues to have the world’s largest shadow economy, even as countries work to liberalize trade and reform their institutions. This raises the question of whether opening trade always reduces informality or if it can sometimes make it worse. Our study examines how trade openness affects the size of the shadow economy in SSA. We look at exports, imports, and total trade openness separately, and also consider the influence of institutions and the wider economy. Using data from 31 SSA countries from 2000 to 2020, we apply the Dynamic System Generalized Method of Moments (System-GMM) to address endogeneity and differences between countries. We measure the shadow economy with an improved MIMIC-based index and break down trade into exports-to-GDP, imports-to-GDP, and total trade openness. Our findings show that trade affects informality in different ways. Exports and overall trade openness help reduce the shadow economy, likely because joining global markets encourages countries to follow international standards. In contrast, imports tend to increase informality, possibly because they create more competition for local businesses and make it harder for some firms and workers to stay formal. We also find that stronger institutions, higher literacy, and better tax systems are linked to less informality, while inflation makes it worse. These results suggest that trade openness alone is not enough to reduce informality. It should be combined with strong institutions, export-oriented policies, support for small businesses, and social safety nets. This study can help guide inclusive trade and formalization policies, especially for regional projects like the African Continental Free Trade Area (AfCFTA).