Researchers at Imperial College Business School in London found that a large number of shadow entrepreneurs are operating in India without registering their businesses with official authorities and eventually hampering economic growth.
The team created a league table based on a study of 68 countries and found Indonesia with the highest ratio of 130 shadow economy businesses to every business that is legally registered, followed closely by India at 127.
Shadow entrepreneurs are defined as individuals who manage a business that sells legitimate goods and services but they do not register their businesses.
This means that they do not pay tax, operating in a shadow economy where business activities are performed outside the reach of government authorities.
"Understanding shadow economy entrepreneurship is incredibly important for developing countries because it is a key factor affecting economic development," explains Professor Erkko Autio, co-author of the report, which attempts to analyse the number of entrepreneurs operating in the shadow economy for the first time.
"We found that government policies could play a big role in helping shadow economy entrepreneurs transition to the formal economy. This is important because shadow economy entrepreneurs are less likely to innovate, accumulate capital and invest in the economy, which hampers economic growth," he added.
In the study, Professior Autio and Dr Kun Fu estimate that business activities conducted by informal entrepreneurs can make up more than 80 per cent of the total economic activity in developing countries and the types of businesses include unlicensed taxicab services, roadside food stalls and small landscaping operations.
The researchers suggest that if India improved the quality of its democratic institutions to match that of Malaysia, it could boost its rate of formal economy entrepreneurs by up to 50 per cent, while cutting the rate of entrepreneurs working in the shadow economy by up to a third.
This would mean that the government could benefit from additional revenue from taxes.
"The shadow economy results in loss of tax revenue, unfair competition to registered businesses and also poor productivity factors which ultimately hinder economic development. As these businesses are not registered it takes them beyond the reach of the law and makes shadow economy entrepreneurs vulnerable to corrupt government officials," the report notes.
While the Philippines (126), Pakistan (109) and Egypt (103) make up the top 5 of the league table of shadow businesses, the UK exhibits the lowest rate of shadow entrepreneurship among the 68 countries surveyed, with a ratio of only one shadow economy entrepreneur to some 30 legally registered businesses.
The researchers concluded that where proper economic and political frameworks are in place, individuals are more likely to become formal entrepreneurs and register their business because doing so enables them to take advantage of laws and regulations that protect their company, such as trademarking legislation.
To create their league table, the UK researchers combined data from the Global Entrepreneurship Monitor (GEM) and the World Bank.