Unofficial Economy and Corruption: Complements or Substitutes?

Fabio Klein (EAESP/FGV)

Abstract
Much empirical research has shown that corruption and unofficial economy are somehow
related, while only few theoretical models have been developed to explain how precisely
they do so. Thorough this paper, I try to approximate theory and practice by developing a
simple theoretical model that shows how corruption and unofficial economy relate to each
other as either substitutes or complements, depending on variables such as taxes, quality of
public goods and services and the institutional context. The main theoretical predictions is
supported by a data set comprising of 87 countries observed between 1998, 2000 and 2002.
The main conclusion is that the unofficial economy and corruption are complements when
(i) taxes are high and quality of public goods are low, and (ii) both taxes and quality of
public goods are high, with overall levels of corruption and unofficial economy being
higher on (i). Inversely, corruption and unofficial economy are substitutes when (iii) both
taxes and quality of public goods are low, and (iv) taxes are low and quality of public goods
are high, though the levels of corruption and unofficial economy should be greater in (iii).

JEL-class: D73, O17, H26, H41, K42

Key-words: Corruption, Unofficial Economy, Taxes, Public Goods, Rule of Law

Introduction

The unofficial economy literature has been experiencing a growing institutional focus. The
first studies usually adopted a labour market perspective, which then further evolved to a
greater concern over public finances and institutional variables, such as effective tax
burden, level of bureaucracy, corruption and rule of law. One of the first authors to make
this transition was Loyaza (1996), who studied the determinants and effects of the informal
sector on economic growth in Latin America. He found that the relative size of the informal
sector increases with higher tax burden, higher labour market restrictions and lower quality
of government institutions. Moreover, he shows that a higher informal sector is associated
with lower economic growth, because congestion over the use of public services by the
informal sector reduces their provision for all economy, reducing total factor productivity.
Worth mentioning is that he considers quality of bureaucracy, corruption and rule of law as
the 3 proxies for the broader category of strength and efficiency of government institutions.

Johnson, Kaufmann and Shleifer (1997) – JKS – develop and test a simple theoretical
model of 3 possible equilibria between formality and informality (i.e. good, unstable and
bad). Their empirical results show that unofficial economy increases with corruption, weak
legal system and excessive regulations and tax burden. Additionally, a higher unofficial
economy is correlated with lower economic growth. JKS compare the differences in growth
rates and size of the unofficial economy between former Soviet Union and those of Eastern
Europe and conclude that the main explanation for those differences is the lower quality of
the institutions of the former.

1
The study by Johnson, Kaufmann and Zoido-Lobaton (1998) – JKZ – is very much an
extension of JKS, where a broader sample of countries (Transition, OECD and Latin
America countries) is considered, allowing group comparisons. Their new results point to a
less significant direct impact of regulations and taxes on unofficial economy. They suggest
that besides and perhaps more importantly then the formal taxes and regulations, is how
they are applied, collected and enforced, which ultimately depends on the level of
discretionary power (determined by the strength of the rule of law) and consequently on the
levels of corruption.

Johnson and Kaufmann (2001) summarize these findings affirming that firms go
underground not because of high statutory taxes, but because of inadequate institutions (e.g.
overregulation, corruption, weak legal system and lack of transparency of laws).

If the results in the literature are not conclusive as to how tax burden, tax rate and to a
lesser extent administrative bureaucracy affect unofficial economy, the majority of the
studies affirm that higher corruption, weaker rule of law and excessive regulations are the
main drivers for going underground. And within those, corruption has shown to be the most
robust, followed by rule of law (Friedman et al, 2000; Johnson, Kaufmann and Shleifer,
1997; Johnson, Kaufmann and Zoido-Lobaton, 1998, 1999; Johnson and Kaufmann, 2001;
Loyaza, 1996).

However, some studies differ slightly on these conclusions. Johnson et al (2000) for
example, working with firm-level data from more than 1000 companies in five transitional
economies do affirm that corruption increases unofficial economy, although they cannot say
in what direction the causality runs: if firms go underground to flee from bribes taken place
in the official sector or if they pay bribes to safely hide their activities. As for rule of law,
their results show that at the macro level (cross country), it is negatively associated with
unofficial economy (as predicted), but its statistical significance is weakened at the micro
level1.

The theoretical model of Choi and Thum (2005) provides a quite different proposition of
how corruption, shadow economy and law enforcement interact. If initially corruption at
the official sector drives firms underground, it is exactly the possibility of becoming
informal that will constrain public officials to exploit official activity, forcing a reduction in
the level of bribes, which consequently lowers the costs of operating formally and thus
promotes more official economic activity. Therefore, they claim that the unofficial
economy works as a complement to the official one, and not as a substitute 2. Moreover,
better law enforcement increases the risks of being caught in the unofficial sector, further
allowing public officials to increase the bribe levels in both sectors. This could lead to a
higher number of illegal activities, since the decision to operate formally or informally
would still be made on the basis of the expected bribery payment.

1
They suggest that this happens because most firms in the sample are only partially informal, so that previous
access to courts and legal system is not altered if a firm decides to underreport an extra portion of its output.
2
They show that these results hold even when the model is extended to allow for bribes in the informal sector.

2
Dreher and Schneider (2006) present a similar argument on substitutability and
complementarity between formal and informal sectors, although their results are sensitive
to the level of development. By dividing the countries in low and high income groups, they
suggest that in poorer countries, the unofficial economy tends to increase corruption (and
vice-versa), thus they act as complements, whereas in richer countries the shadow economy
acts as a substitute to corruption, promoting its reduction as firms go underground to avoid
bribes, which is aligned with the predictions of Choi and Thum (2005). Worth adding is that
Dreher and Schneider (2006) find that the effects of corruption on unofficial economy
become insignificant when interacted with institutional quality, which suggests that
corruption reflects poor institutions.

This paper focuses precisely on the debate over the complementarity and substitutability of
corruption and unofficial economy started by Choi and Thum (2005) and Dreher and
Schneider (2006) and hopes to contribute to a better understanding of how and when such
relationship takes place. While with their empirical findings Dreher and Schneider (2006)
have only began to scratch the surface of this concept, and Choi and Thum (2005) did not
go beyond their pure theoretical model, I try to fill this gap by putting theory and empirical
evidence together in a more systematic way. In the following section, a theoretical model is
presented. Data information is presented on the third section, while the estimation strategy
is presented on the fourth section. Preliminary results are introduced on the fifth section,
followed by the main conclusions.

Theoretical Model

The model hereby presented is a variation of Loyaza’s (1996), where the capital rate of
return depends on the available amount of public services relative to total production,
represented by the endogenous production function below:

α
G
(1) Yi = A  k i
Y 

where Yi and ki are the production of and capital owned by individual firm i; A = exogenous
productivity parameter; G = flow of public services; Y = total production in the economy
(national income); and α = elasticity of output Yi with respect to G/Y with 0 < α ≤ 1, which
measures the productivity of public services relative to private services.

The net expected incomes of firms in the official and unofficial economies are given by

α
G
(2) y iOE = (1 − [τ + E (C )] ) A  k i → “Corruption Without Theft”
Y 
or
α
G
(2’) y OE
i = (1 − E (τ ) ) A  k i → “Corruption With Theft”
Y 
and

3
 α
 δG 
(3) y = (1 − E (π ) ) A
UE
i  ki
 Y 
where (2) is the income of firm i in the official economy (OE) net of taxes τ3 and an
expected level of corruption E(C), (2’) is the income of firm i in the official economy (OE)
net of expected taxes E(τ) and (3) is the income of firm i in the unofficial economy (UE)
net of expected penalties E(π). The parameter δ expresses the fraction of G available to
informal firms. The higher is δ, the more unofficial firms can illegally use the available
public services and infra structure, leading to congestion of their use, which should reduce
the level and quality of public services available to official firms, who originally paid for
them in the form of taxes (G is mostly financed by τ and only marginally by π, the legal
penalty paid by the informal firm if caught operating underground).

Note that at (2), the net expected income from operating officially is given by tax τ to be
paid with certainty, plus an uncertain level of corruption C, reflecting something close to
the concept of “corruption without theft” as defined by Shleifer and Vishny (1993),meaning
that the government does not lose tax revenues due to corruption. This formulation assumes
that C enters as an extra and uncertain cost that does not substitute the official tax τ,
reflecting situations where a firm is not sure whether it will have to pay extra bribes to
“grease the wheel”4 to make its operations viable. But the net expected income of operating
officially could be formulated as something closer to the concept of “corruption with theft”
defined by these same authors. A suggestive formulation is shown in (2’), where C enters as
a substitute of taxes τ, so that the total expected costs would be E(τ) = pτ + (1 – p)C. For
the development of the mathematical arguments that follow, the assumption of corruption
without theft will be used for the sake of space saving.

Such dual formulation does not hold in the unofficial economy. Looking at the net income
from operating unofficially (equation 3), there is no tax to be paid with certainty, given the
very hidden nature of unofficial operations. Therefore, even the legal penalty π can only
occur with some probability p, depending on whether the illegal firm is caught and
punished. Even if it is caught, it can still avoid π by adhering to C. In this case, it makes
more sense to think of corruption as a substitute to π, since a fiscal official that has
uncovered an underground operation may still keep silence about it to his superiors and
benefit by entering in collusion with the firm’s manager. It is unrealistic to think of a case
where a firm pays the legal penalty π plus a certain amount of C: if it is brought to courts, it
pays π and nothing else. If it wants to escape from courts, then entering in a corruptive deal
is a possible alternative.

Based on the above discussion, the expected costs of corruption at OE and expected penalty
at UE are respectively given by

(4) E (C ) = p ⋅ 0 + (1 − p ) ⋅ C = (1 − p)C

and
3
Taxes τ include all monetary taxes required to run a business officially, such as income tax, social security
contributions, value added taxes and others.
4
See Huntington

4
(5) E (π ) = p ⋅ π + (1 − p ) ⋅ C
Assume that the penalty rate π is a linear function of the unofficial economy UE

(6) π = aUE

where UE = YUE/Y is the size of the unofficial economy relative to the national income Y,
and 0 < a ≤ 1 is a policy parameter determining the level of the penalty rate for a certain
size of UE. For simplification, assume a = τ + (1 – τ ) = 1. This means that a firm operating
underground, if caught and punished, would pay a fine equivalent to a 100% income tax.
The above equation suggests that if the government is active in fighting increasing levels of
UE, it would increase the penalty rate for higher levels of informality.

OE UE
After substituting (4) on (2), (5) on (3), setting the equilibrium condition y i = yi and
replacing the result using (6), we get

δ α − 1 + τ (1 − p ) (1 − δ α )
(7) UE = + C
pδ α pδ α

which can be rewriten as

UE =
(1 − p ) (1 − δ α ) C + 1 − 1
+
1
τ
(8) α α
pδ p pδ pδ α

Assume p = f(I), where I is a general measure of institutional quality with 0 < I ≤ 1,

capturing things such as the rule of law, quality of government bureaucracy and regulations,
important institutions that should work against UE. The maximum level of p = 1 would
resemble the best level of institutional quality. It can be seen from the above equation that
higher levels of p (better institutions) lead to a reduction in UE.

Let us go briefly over each of the terms in (8). The first term shows how corruption C
affects the unofficial economy UE, where higher levels of C promote higher levels of UE.
The second term expresses the impact of institutions p(I) alone over UE, where better
institutions lead to a higher probability of detection and punishment, thus reducing UE. But
it is worth noting that institutional quality is weighing all other terms, showing that their
impacts on UE are influenced by the current level of p(I). The third term can be interpreted
as the impact of public service delivery on unofficial economy given by δα, which measures
the accessibility (δ) of productive (α) public services by the unofficial sector. For a given
level of δ, if public services improve (α increases), UE is reduced (note the negative sign of
the term). For a given level of α, if unofficial firms have greater access to public services (δ
increases), UE is increased. Note that δα is present in all but one term in (8). Finally, the
fourth term expresses the impact of taxes τ on UE for given levels of p and δα, which should
be positive (higher taxes lead to higher unofficial economy).

5
The above model differs from Loyaza’s in two main aspects. First, corruption is explicitly
inserted in the model and separated from penalty π. In Loyaza, π reflects either the legal
sanctions imposed to unofficial firms or bribes paid to fiscal officials as an alternative for
escaping from law enforcement, which does not accurately captures the fact that C in the
unofficial economy is a substitute to π. In fact, in Loyaza’s theoretical model, corruption
occurs only within the unofficial economy. Second, the present model incorporates choice
under uncertainty, given that the net incomes of official and unofficial firms are expected
returns based on expected levels of corruption C and penalties π. Worth mentioning is that
if p = 1, the second term in (7) disappears and the above model becomes exactly the same
as the one suggested by Loyaza. This means that even under a perfect institutional setting,
there would still be some level of unofficial business operations depending on taxes τ,
productivity of public services α and accessibility to these services by unofficial firms
given by δ.

Corruption and Unofficial Economy: Complements or Substitutes?

The present model shows that a firm’s decision to operate in the official (OE) or unofficial
(UE) economy depends on the following variables: (i) the rate of official taxes (τ) and the
expected rate of penalty (π) for operating unofficially; (ii) the current expected level of
corruption (C) at both OE and UE; (iii) the level (G/Y) and productivity (α) of public
services and its availability (δ) to unofficial firms. Moreover, this decision is influenced by
the level of institutional quality p(I) that ultimately determines the probabilities given in (i)
and (ii). The equilibrium condition determines the equilibrium levels of C, τ and π for given
levels of p(I), α and δ. Let us now see the possible ways in which C and UE relate to each
other.

The decision to enter the Unofficial Economy UE

Model 1: Corruption Without Theft (equation 2)

Imagine a firm deciding to enter a new market or an existing firm deciding how to allocate
its investments in a given moment. Assume that initially it wants to operate officially,
agreeing to pay the current tax rates τ, which it perceives as being fairly low when there is
good provision of public goods and services (α is closer to 1). If the context is of complete
institutional quality (p = 1), the firm will not need to resort to corruption C to make its
operations viable. But if p < 1, there is a certain chance that it will face additional costs of
corruption given by (4), reducing the net income of operating officially. This would be
specially true for lower levels of α, since poor provision of public services would force
firms to corrupt public officials in order to overcome bureaucratic difficulties and expedite
their operations (or public official would condition their delivery on offside extra
payments). Given such conditions, the firm could decide to operate underground if yiOE <
yiUE. As the current expected level of corruption at OE increases, it also increases the firm’s
potential decision to migrate to UE, up to the point where yiOE = yiUE. This is the case where
UE is a substitute to C taking place at OE.

Model 2: Corruption With Theft (equation 2’)

6
Now assume that the official firm wants to evade from the official tax rate τ, which it
perceives as being unfairly high when there is low provision of public goods and services
(α is closer to 0). One way it could do so is by resorting to corruption C, “buying the
silence” of fiscal officials so that it would not have to pay the high official taxes. In such
case, C would work as a substitute to τ. Again, if p = 1, this would not be possible. But if p
< 1, it could resort to C and not pay τ, as long as (1 – p)C < pτ. In this case, the
government’s loss of tax revenues is directly reflected in higher levels of UE. Such
situation shows the case where C is a complement of UE, where C works as the channel
through which a firm hides part of its taxable output.

Note that the two models differ in relation to how taxes and public services affect a firm’s
decision. In the first, taxes are low and firms agree to pay them, but run the risk of paying
an additional expected corruption if doing so is necessary to keep its operations running (or
running faster). In the second model, taxes are high and firms want to run away from their
fiscal duties, even if public goods and services are fairly good. Imagine an extreme
situation where τ = 1, α = 1 and p = 1. This resembles a hypothetical country where there is
zero corruption and public goods are perfect, but all income is taxable, so that it would not
make sense to run a private business, thus making all entrepreneurship unofficial. In such
case, there is no complementarity between C and UE, because C = 0. But if the firm is
caught hiding, it will surely suffer the penalty π. But if p < 1, then C can work as a
protection mechanism for unofficial firms. In this case, C and UE become closely linked as
weapons against high τ. A similar, but worse situation would occur if p = 1, τ = 1, but α ≈
0: even if the firm agreed to pay the high taxes, it could not count on good public services.
This resembles a state that keeps all private resources to itself. Such situation forces firm to
hide, although with the great risk of being caught and punished due to the government’s
efficient detection mechanisms given by p = 1. Therefore, resorting to corruption is one of
the few alternatives left. Given high taxes, the fiscal official may well benefit by entering in
collusion with the firm, asking for a payment below τ to deliver public services and even
protection.

Comparing both models, we see that UE emerges from quite different causes. In the first
model, UE is caused by corruption C taking place in the official economy OE, so that UE is
a substitute to C. As suggested by Choi and Thum(2006), the fact that a firm has the option
to go underground should promote a reduction in C: the more firms enter UE in order to
avoid C, the lower are the expected bribes to be received by corrupt fiscal officials, forcing
them to reduce the level of C. In this case, they show that UE would be a complement to
OE. One could argue that fiscal officials could still extract bribes from unofficial firms after
detecting them, but that should bring these officials lower payoffs compared to extracting
bribes from official firms, due to the difficulties of detecting hidden operations. In the
second model, UE is caused by the firm’s attempt to escape from its fiscal duties, so that
taxes are the ultimate cause of UE. In such situation, C is the channel through which the
firm is able to hide its earnings and go underground. In this case, C is a complement to UE.

The decision to remain in the Unofficial Economy

Once inside the unofficial economy, the firm runs the risk of being caught. This risk should
increase as either p increases (improved institutions leading to greater detection capability),

7
yiUE increases (higher unofficial earnings and/or outputs leading to greater company size and
visibility), or a combination of both occurs. If caught, the firm may resort to C as an
strategy to avoid π, continuing to do so up to the point where yiUE = yiOE. Such situation
describes C working as a complement to UE. If the expected costs of maintaining its
operations underground becomes too high, then the firm may decide to become official.

Theoretical Predictions

The equilibrium matrix below resumes our main theoretical predictions:

Table 1 – Equilibrium Matrix

Public Goods and

Services

High Low
CT > CNT CT > CNT
High
C ↔ UE C ↔ UE
Taxes
CNT > CT CNT > CT
Low
C → UE C → UE

Based on the matrix, we have four possible equilibria5:

(a) (Low, Low): In countries with low official tax rates and low quality of public goods and
services, corruption without theft should be greater than corruption with theft (CNT > CT)
and most of the unofficial economy should be interpreted as a substitute to corruption
(C→UE).

This happens because the problem faced by firms here are not taxes, but the low quality of
public goods, for which they may have to pay an extra amount to get.

(b) (Low, High): In countries with low official tax rates and high quality of public goods
and services, corruption without theft should be greater than corruption with theft (C NT >
CT) and most of the unofficial economy should be interpreted as a substitute to corruption
(C→UE).

Though this constitutes the best equilibrium of the four, some level of C may occur for
reasons other than taxes and public services, like an public official favouring a firm in a
procurement process.

Compared to (a), (b) should bring lower overall levels of both corruption and unofficial
economy (given higher public goods and services, it is less necessary to resort to C “to
grease the well”), so that (b) brings greater welfare (w) than (a):
5
Note that in the four possible equilibria, we are assuming a given level of institutional quality p(I) < 1 so that
there will always be some level of corruption. Institutional quality is not explicitly inserted in these four
equilibria because it unnecessarily complicates the analysis, since it is highly related to C, UE, α and δ. In
simplified terms, higher p(I) should produce lower C, UE and δ, and higher α equally in all four cases.

8
C L , H < C L , L → UE L , H < UE L , L ⇒ ( Low, High ) >( Low, Low)
w

(c) (High, Low): In countries with high official tax rates and low quality of public goods
and services, corruption with theft should be greater than corruption without theft (CT >
CNT) and the unofficial economy should be interpreted as a complement to corruption
(C↔UE).

This is the worse equilibrium of all, because paying the high taxes is no guarantee of
getting the public service delivered, so that paying extra offside money may still be
required. In this case, both the high taxes and the “grease money” are a problem for the
firm.

(d) (High, High): In countries with high official tax rates and high quality of public goods
and services, corruption with theft should be greater than corruption without theft (CT >
CNT) and the unofficial economy should be interpreted as a complement to corruption
(C↔UE).

In this case, getting the service is not the problem, but paying for it might be too costly for
the firm, so that entering the unofficial economy becomes profitable.

Compared to (c), (d) should bring lower levels of both corruption and unofficial economy
(for the same reason as explained in b) , so that (d) brings greater welfare (w) than (c):

C H , H < C H , L → UE H , H < UE H , L ⇒ ( High, High ) >( High, Low)

w

It is worth pointing out that the above predictions are in quite contrast with the hypotheses
stated in Dreher and Schneider, who simply said that “…corruption and shadow economy
are substitutes in high income countries, while they are complements in low income
countries” (2006, page 1). The predictions above do not limit the correspondence of the
complementarity and substitutability of corruption and unofficial economy to poor and rich
countries respectively. This relationship does not depend on wealth, but on how taxes and
public services are related.

Data

Definitions and Sources

The data used in the present study comprises an unbalanced panel of 87 countries observed
in 3 years (1998, 2000 and 2002)6, containing information on variables related to economic
development, public finance and quality of governance, listed below7:
6
The number of countries for each year is: 87(1998), 86(2000) and 87(2002). There are 13 divergent
observations between 1998 and 2000, 12 between 1998 and 2002 and only 3 between 2000 and 2002.
7
Most data related to economic development and public finance were obtained from the World Bank
Development Indicators 2004 (World Bank, 2005). The exceptions are “mean years of schooling of labour
force”, taken from Barro and Lee (2000), and “unofficial economy (%GDP)”, taken from Schneider and Enste
(2000) and Schneider (2005). The governance indicators were obtained from Kaufmann, Kraay and Mastruzzi

9
Development indicators: Unofficial economy(%GDP, 1999/2000, 2001/2002 and
2002/2003), GDP per capita (purchasing power parity, $, all 3 years), Mean years of
schooling of labour force (age ≥ 25, 2000), Improved sanitation facilities (% of population
with access, 2002), Improved water source (% of population with access, 2002), Roads,
paved (% of total roads, all 3 years), Freedom of the Press (measures the degree of freedom
of the press and media, all 3 years).

Public Finance: Public health expenditure (% of GDP, 2002), Public spending on education
(% of GDP, 2000 and 2002), Highest marginal corporate tax rate (%, all 3 years), Highest
marginal individual tax rate (%, all 3 years), Tax revenue (% of GDP, all 3 years).

Quality of Governance: Control of Corruption (measures the exercise of public power for
private gain, including both petty and grand corruption and state capture), Government
Effectiveness (measures the competence of the bureaucracy and the quality of public
service delivery), Rule of Law (measures the quality of contract enforcement, the police,
and the courts, as well as the likelihood of crime and violence), Regulatory Burden
(measures the incidence of market-unfriendly policies), Voice and Accountability (measures
political, civil and human rights), Political Instability and Violence (measures the likelihood
of violent threats to, or changes in, government, including terrorism).

Data Treatment

Unofficial Economy: The definition is borrowed from Schneider and Enste (2000) and
Schneider (2005), from which the data was obtained, and is as follows: the unofficial
economy “…includes all market-based legal production of goods and services that are
deliberately concealed from public authorities…to avoid (i) payment of income, value
added or other taxes, and social security contributions, (ii) having to meet certain legal
labour market standards, such as minimum wages, maximum working hours, safety
standards, etc., and (4) to avoid complying with certain administrative procedures, such as
completing statistical questionnaires or other administrative forms” (Schneider and Enste,
2000). The estimates of unofficial economy provided are a combination of three different
methodologies8, and are available for the years 1999/2000, 2001/2002 and 2002/2003.

Because such periods do not perfectly match the years of the study (1998, 2000 and 2002),
it is not possible to estimate equation 8 using the same time t for the dependent and
independent variables. Therefore, the dependent variable UE will be measured at t + 1,
while the independent variables will all be measured at t. For example, the estimate of the
unofficial economy for Argentina is 25.4% for the period 1999/2000. This estimate is
plotted in the panel data set for the year 1998. Ideally, it would be desirable to have the
dependent and independent variables all at the same t, specially because the theoretical
model indicates a possible simultaneity between C and UE, where current expected levels
of corruption leads to the current decision to go underground. Although it might be
somewhat arbitrary to define an interval of one to two years as the required time lag for the
economy to adjust between formality and informality, it is still a reasonable assumption if
(2005).
8
The methods are MIMIC (Multiple Indicators, Multiple Causes), Currency Demand and Electricity
Differential. Please, refer to the papers for detailed information.

10
we think of fiscal years comprised of one year, which determine private and public agents
budget planning. This means that one to two fiscal years provide sufficient time and
information for economic agents to decide how much to invest, as well as where to do it: in
the official or unofficial economy. In this sense, the size of the unofficial economy in
Argentina in 1999/2000 can be thought as reflecting its public finances, services and
institutional conditions in 1998.

Productivity of Public Goods and Services: In the absence of an objective measure

capturing the productivity of public goods and services (α), one was created based on the
following formula:

ϕG 2
(9) αG = ⋅ε
(I G / Y )

where φG = performance of public good/service G, IG = total public investment/expenditure

on public good/service G, Y = national income, and ε = government effectiveness. This
provides a rough measure of the quality and efficacy of public investment that allows
country comparison. The squared term is used to reward those countries with overall higher
performance. If it were not used, than two very dissimilar countries could be ranked equally
in terms of α, provided that one of them had lower levels of both φG and IG/Y. For example,
imagine that country A had φG = 5 and IG/Y = 10, whereas country B had φG = 1 and IG/Y =
2, ignoring ε for the moment. Without the squared term, both would have equal productivity
of α = 0.5, while applying the quadratic form makes country A 5 times more productive
than B.

The public goods and services (G) hereby considered are Education, Health and Roads’
infra-structure. Government effectiveness (ε) is one of the six governance indicators present
in Kaufmann, Kraay and Mastruzzi (2005). Using this additional measure of overall
government effectiveness helps on calibrating the individual measure of productivity based
on only one policy dimension.

Based on the available information from the data as described above, the productivity of
Education and Health policies becomes:

α Education =
( Mean Years of Schooling ) 2 ⋅ε
(10)
Public Spending on Education (% GDP)

(11) α Health =
( Sanitation *
Water Access)
2
⋅ε
Public Spending on Health (% GDP)

Since the data used does not provide information on the percentage of public spending on
roads, the formula for this public good is just given by

(12) α Roads = Roads Paved ⋅ ε

11
The resulting numbers were all normalized so that 0 < α ≤ 1, where higher levels mean
higher productivity.

Corruption and other Governance Indicators: The governance indicators in Kaufmann,

Kraay and Mastruzzi (2005) all range from -2.5 to 2.5. This range was normalized to vary
between 0 and 1, where lower rates mean lower institutional quality. To make it coherent
with section 2 and avoid misinterpretations, the values in “control of corruption” were
subtracted from 1 so that the new variable “corruption” also ranges from 0 to 1, but now
having higher values associated with higher corruption.

Worth mentioning is that these governance indicators are mainly subjective, perceptions
based measures compiled from different surveys and polls applied to selected firms and
individuals. The intrinsic subjectivity of these indicators has been subject to critics,
suggesting that they are not very reliable proxies for objective indicators. Although
plausible, these critics are not strong enough to invalidate the efficacy of such indicators9.
But for the purpose of this article, such controversy is not even a problem, since the model
hereby developed is based on expected levels of corruption, so that using a perceptions
based measure of corruption is in fact preferred to any other objective measure, even if it
was available.

Descriptive Statistics

Table 2 below resembles the equilibrium matrix from section 2, using αHealth. Similar tables
for Education and Roads are provided in the Appendix.

They were constructed by grouping the countries according to the four possible equilibria
discussed in the preceding section. The threshold used to separate countries from high and
low values of both taxes τ (corporate tax rate) and public services productivity α was the
group average. For example, the average highest income corporate tax for the group below
(n = 60) was 29.2%. Countries with τ ≤ 29.2% were classified as having low tax, whereas
those with τ ≥ 29.2% were classified as having high tax. The same reasoning was applied
for α. For each group, the average corruption C, size of unofficial economy UE and
GDP/capita are provided. It can be seen from Table 2 that the evidence provides quite
strong support for the theoretical predictions with regards to the level of corruption and
unofficial economy in each equilibrium and its welfare consequences in terms of income
per capita.

Obviously, the resulting groups described in these three tables are far from being perfect for
a number or reasons, such as the variables chosen as proxies for τ and α, the formula
adopted to capture α, the threshold applied to separate countries from low and high values,
9
For arguments in favour of such indexes, see the authors’ self-defence at pages 27-31. For an argument in
favour of their corruption index as opposed to the popular index from Transparency International (TI), refer to
Kaufmann, Kraay and Mastruzzi (2003, pgs.32-39). Refer also to the interesting working paper by Fisman
and Miguel (2006), a natural experiment on parking tickets violations committed by diplomatic
representatives visiting New York during United Nations missions, where they show a high correlation
between their infractions ranking and the corruption index present in Kaufmann, Kraay and Mastruzzi (2005).

12
and data availability. These problems may lead to clusters that look strange, having outliers
in them. Nevertheless, the results provide us with a powerful picture of how the levels of
corruption and unofficial economy change in different equilibria, which in turn strongly
depend on the fairness of taxes and the quality of public goods and services.

Table A1 in the Appendix presents the statistical summaries of the main variables analyzed
in this study.

Estimation Strategy

Based on equation (8), the following linear regression model is tested:

(13)

UEi ,t +1 = αt + β1 ln ( Cit ⋅ I it ⋅ PSit ) + γ1 ln I it + γ 2 ln( I it ⋅ PSit ) + γ 3 ln(τ it ⋅ I it ⋅ PSit ) + uit

with t = 1,2 and 3

where C stands for Corruption, I for Institutional Quality, PS for Public Services
Productivity and τ for Taxes. The first three of these are transformed into their natural
logarithmic form so that we can interpret their respective coefficients as the unit change in
UE given a percentage change in their related variable. The symbols α and u are the usual
constant and error terms. The fact that all independent variables are lagged one year in
relation to the dependent variable is explained in subsection “Data Treatment”.

Step 1
I begin estimating (13) without the interaction terms (columns 1 through 5) in Tables B-E,
while use both interacted and individual terms in a subsequent step (columns 6) and finally
check the exact specification given by equation 13 (columns 7). This procedure is applied
for each of the three proxies for PS, using αEducation, αHealth and αRoads (see equations 10, 11
and 12). For Education, the only available year is 2000, while for Health is 2002.
Information on Roads are available for all three years, but 1998 is be used given its higher
number of observations10. For the variable I, Rule of Law is used in all specifications. For
the variable τ, highest marginal corporate tax rate is used. These same procedures are
applied using the overall indicator of Government Effectiveness as a proxy for PS. Since
data on this variable is available for all years, I combine the observations in one pooled
cross-section. The results are shown in Tables B through E in the Appendix.

10
For 1998, information on Roads are available for 72 observations. For the years 2000 and 2002, there are 36
and 40 observations respectively.

13
 Table 2 - Equilibrium Matrix using Health (2002)

Public Goods and Services (α) - Health * Government Effectiveness (2002)

High (α > 0.22) Low (α ≤ 0.22)

Avg = 0.38 SD = 0.10 Max = 0.56 Min = 0.24 n = 15 Avg = 0.10 SD = 0.07 Max = 0.22 Min = 0.00 n = 25
n = 60
Cameroon, China, Colombia, Congo
High (τ > 29.2%) High (τ > 29.2%)
Australia, Austria, Canada, Costa Rica Cote d'Ivoire, Ghana, Guatemala
Avg = 32.8% Avg = 32.7%
Jamaica, Japan, Mexico, Netherlands India, Indonesia, Kazakhstan, Kenya
SD = 2.65% SD = 3%
Philippines, Russian Federation Morocco, Mozambique, Namibia
Max = 38% Max = 40%
Sri Lanka, Thailand, Ukraine Nigeria, Panama, Paraguay, Senegal
Min = 30% Min = 30%
United States, Uruguay South Africa, Tanzania, Turkey, Uganda
n = 15 n = 25
Venezuela, Zambia, Zimbabwe

Taxes C = 0.37 UE = 31.5% GDP/cap = $15,248 C = 0.62 UE = 43.2% GDP/cap = $3,372 Taxes
(τ) (τ)
Low ( τ ≤ 29.2%) Low ( τ ≤ 29.2%)
Avg = 21% Avg = 23.2%
Azerbaijan, Bolivia, Botswana, Brazil, Cambodia
SD = 6.5% Bulgaria, Chile, Finland SD = 4.2%
Dominican Republic, Ecuador,Nicaragua,
Max = 29% Hungary, Iran, Oman, Slovak Republic, Sweden Max = 27%
Papua New Guinea, Peru, Romania, Uzbekistan
Min = 12% Min = 15%
n=8 n = 12

C = 0.31 UE = 22.6% GDP/cap = $14,288 C = 0.60 UE = 46% GDP/cap = $4,353

High (α > 0.22) Low (α ≤ 0.22)
Avg = 0.37 SD = 0.09 Max = 0.56 Min = 0.31 n = 8 Avg = 0.10 SD = 0.07 Max = 0.21 Min = 0.00 n = 12
Public Goods and Services (α) - Health * Government Effectiveness (2002)

14
Step 2
I run a panel data estimation using fixed-effects (FE) method in order to eliminate time-
constant effects that may be related to the independent variables and that also affects the
dependent variable. The results are shown in Table F. Columns 1 through 3 refer the whole
period (1998, 2000 and 2002), while in columns 4 and 5 only the years 2000 and 2002 were
considered, since this period provides us with an almost complete balanced panel. As in the
case of the pooled regression, the unavailability of data forces me to use Government
Effectiveness (ε) only as a proxy for PS.

Step 3
Motivated by the equilibrium matrix of section 2, I ran a clustered regression for four
different clusters of countries for both the cross-sectional and panel models. The thresholds
applied to divide countries between low and high taxes and public services productivity are
their respective sample average for 2000 and 2002.

Step 4
There is some reason to suspect that I and C are closely related to each other (higher/lower
institutional quality leading to lower/higher corruption)11, creating endogeneity biases in the
results. Additionally, even though the dependent variables are all lagged in our model, there
may still be some degree of simultaneity between C and UE when the explanatory variables
are measured at t = 2002, because the estimated size of UE for such cases is for the period
2002/200312. In order to address these problems of endogeneity, the most significant
specifications obtained in the previous procedures were selected and tested using
instrumental variables (IV) estimation. The following variables were used as instruments
for C and I: Press Freedom and Voice & Accountability.The assumption is that once all the
required controls had been accounted for in the estimation of UE, these instruments should
not be correlated with the error term, but only correlated with C and I.

Econometric Results

Step 1
Looking at columns 1 through 3 in Tables B through D, we see that corruption is significant
and presents the expected negative signs. Take column 1 from Table B for example: an
increase of 1 percentage point in C reduces UE in 0.119% points. But C is very sensitive to
the inclusion of Law (stands for Rule of Law, the proxy used for institutional quality). But
this is fairly straightforward to interpret: as Law increases, it is expected that C decreases,
since Law captures the government’s capacity to detect and punish illegal activities.

It is also notable that Rule of Law is very sensitive to the inclusion of the variable income
per capita. This probably happens because there is a quite substantive variation of income
per capita among countries with similar levels of institutional quality. This can be seen by
observing the countries grouped in the equilibrium matrixes discussed in section 3. But the
interesting point is that even though there is variation of income level among countries
11
In fact, the correlation between corruption and rule of law (the measure to be used as proxy for institutional
quality) for the whole sample (260 country-years) is -0.972.
12
This simultaneity problem does not happen for t = 1998 and 2000, since for these years, the estimates of UE
are for the periods 1999/2000 and 2001/2002 respectively.

15
grouped under similar institutional and fiscal conditions, there is still some relationship
between income level, corruption and unofficial economy, where lower income is generally
associated with higher corruption and unofficial economy.

Tables D and E show interesting results regarding the interaction terms suggested by the
theoretical model. Column 6 in Table E suggests that the coefficient of corruption alone is
positively correlated with unofficial economy (as expected), but when interacted with a
given level of institutional quality (rule of law in our case) and quality of public goods and
services, it is negatively correlated with UE. Note that combining both still makes C to be
positive on UE.

A comment on the effects of taxes on unofficial economy is important. First, in most cases
taxes were not statistically significant, and when they were, in all but one case it had
negative signs, indicating that taxes alone do not seem to impact much on UE. As our
model suggests, its effects can only be understood when public goods and services, as well
as institutional quality, are taken into account. It is worth noting that I also tested highest
marginal individual tax rate instead of corporate tax rate in order to capture cases where the
legal constitution of a company confounds itself with that of the owner, making the
individual to be the firm and vice-versa. This is often observed in smaller and informal
businesses, which can constitute an important portion of the unofficial economy. But the
statistical results were even less significant than those for corporate tax.

Step 2
The results obtained from the panel estimation using FE also shows that C and UE are
related. Such relationship seems to be even stronger when C is interacted with institutional
quality (Rule of Law) and Government Effectiveness. The surprising result is its negative
sign. This is probably caused by the fact that the growth rates of C and UE are different,
which is emphasized in a panel estimation, since it reports changes in UE from changes in
C along time. As can be derived from information on Table A1 in the Appendix, the growth
rates of UE and C between 1998 and 2000 are quite similar on average (3.8% and 3.9%
respectively), but from 2000 to 2002, UE only grew 1.18% on average, while C grew 3.2%.

The results for steps 3 and 4 are not shown here because they ended up being weak in
virtually all cases. As mentioned, there is some potential endogeneity on the model, in part
confirmed by the results presented on the tables showing that Law many times captures the
effects of C on UE . I tried controlling for the endogeneity of C using Freedom of Press as
an instrument, based on the intuitive notion that a more active and strong press is able to
uncover and publish corruption scandals, but should not impact on a private agent’s
decision to operate inside or outside the unofficial economy. Unfortunately, in none of the
cases was the IV/2SLS fruitful, as it caused most of the coefficients to be statistically
insignificant. I also tried using Voice & Accountability as instrument, but results were still
weak, which were further confirmed by statistics of over and under-identifying restrictions.
This posits the challenge of controlling for the endogeneity bias in our estimates through
the use of adequate instruments, which is not a trivial task, specially because it requires a
precise specification of a model for corruption, something beyond the scope of this paper.

16
As for step 3, the results did not show any statistically meaningful correlation between the
explanatory variables and the dependent one when countries were grouped in clusters. This
is possibly caused by some degree of within-group variation in those variables, so that even
though they were grouped as similar according to the threshold specified, they still vary
considerably in their taxes and public services productivity. Also, dividing the sample of
countries into four groups creates weaker asymptotic properties, since there is a substantial
reduction in the number of observations.

Conclusions

This paper has presented a theoretical and empirical basis to help our understanding of how
corruption and unofficial economy are related to each other depending on variables such as
taxes, provision of public goods and services, and institutional quality. Based on the
theoretical predictions and preliminary empirical findings, it concludes that the unofficial
economy and corruption are complements when (i) taxes are high and quality of public
goods are low, and (ii) both taxes and quality of public goods are high, with overall levels
of corruption and unofficial economy being higher on (i). Inversely, corruption and
unofficial economy are substitutes when (iii) both taxes and quality of public goods are low,
and (iv) taxes are low and quality of public goods are high, though the levels of corruption
and unofficial economy should be greater in (iii).

This conclusion adds to the model suggested by Choi and Thum (2005) and differs from
Dreher and Schneider (2006), showing that different types of corruption (with or without
theft) take place under different fiscal and institutional contexts, which affect the expected
costs (and benefits) of corruption and operating in the unofficial economy. These two types
of corruption end up determining different links with the unofficial economy, and should
not at principle depend on a nations’ wealth, as suggested by Dreher and Schneider.

17
Appendix
Table A1 - Statistical Summary of the Main Variables

1998 2000 2002

Variable Obs Mean Std. Dev. Min Max Obs Mean Std. Dev. Min Max Obs Mean Std. Dev. Min Max
gdp_capita 87 11165.18 9372.772 497.567 32909.81 86 11207.98 9704.103 516.6046 34164.46 85 11768.32 10082.94 559.2109 35652.91
gov_effe 87 0.588723 0.2032374 0.233876 1.018764 86 0.567861 0.19259 0.1686 0.987857 87 0.5694 0.206076 0.142589 0.977318
law 87 0.592442 0.20235 0.240468 0.972047 86 0.568154 0.204112 0.261424 0.922135 87 0.549561 0.201421 0.220793 0.892403
corruption 87 0.417388 0.2259804 0.000878 0.722044 86 0.43328 0.223696 0.000731 0.711805 87 0.447852 0.220919 0.009772 0.763403
ue 87 31.61609 14.58275 8.6 67.1 86 32.86395 14.64801 8.7 68.1 87 33.25402 15.00524 8.4 68.3
tax_corp 87 30.28736 7.478509 6 45 86 29.33372 7.920571 0 54 87 28.24483 7.92718 0 40
edu 0 58 4.461804 1.524867 1.244017 8.387465 62 4.930938 1.56125 1.060274 8.512175
roads 72 57.06625 33.78509 3.5 100 36 57.69472 36.2149 5.5 100 40 59.9465 34.16588 6.67 100

Equilibrium Matrix using Education (2000)

Public Goods and Services (α) - Education*Government Effectiveness (2000)

High (α > 0.38) Avg Low (α ≤ 0.38)
n = 51 = 0.61 SD = 0.22 Max = 1.0 Min = 0.39 n = 10 Avg = 0.16 SD = 0.09 Max = 0.34 Min = 0.03 n = 11
High (τ > 30.8%) High (τ > 30.8%)
Avg = 34.4% Argentina, Australia, Canada Avg = 37.6%
Cameroon, Colombia, India, Iran,
SD = 2% Czech Republic, France, Greece SD = 5.8%
Italy, Jamaica, Malawi, Mexico
Max = 38% Israel, Philippines, Max = 54%
Min = 31% Portugal, Senegal, Zambia Min = 33% n
Russian Federation, Spain
n = 10 = 11
Taxes C = 0.33 UE = 25.7% GDP/cap = $18,018 C = 0.53 UE = 34.1% GDP/cap = $6,790 Taxes
(τ) Low ( τ ≤ 30.8%) Chile, Denmark, Ecuador, Finland Bolivia, Brazil, Costa Rica, Low ( τ ≤ 30.8%) (τ)
Avg = 26.7% Germany, Hungary, Indonesia Dominican Republic, Kenya, Malaysia, Avg = 27.7%
SD = 4.4% SD = 4.2%
Japan, Korea, Norway, Poland Nicaragua, Panama, Paraguay,
Max = 30% Max = 30%
Min = 15% Romania, Slovak Republic, Sweden South Africa, Thailand, Turkey, Min = 15% n=
n = 16 United Kingdom, Uruguay Uganda, Zimbabwe 14
C = 0.30 UE = 23.7% GDP/cap = $17,141 C = 0.56 UE = 42.7% GDP/cap = $5,376
High (α > 0.38) Avg Low (α ≤ 0.38)
= 0.61 SD = 0.16 Max = 0.94 Min = 0.39 n = 16 Avg = 0.16 SD = 0.08 Max = 0.33 Min = 0.04 n = 14
Public Goods and Services (α) - Education*Government Effectiveness (2000)

18
 Equilibrium Matrix using Roads (1998)

Public Goods and Services (α) - Roads * Government Effectiveness (1998)

High (α > 0.36) Avg = Low (α ≤ 0.36)
n = 72 0.65 SD = 0.18 Max = 0.97 Min = 0.39 n = 20 Avg = 0.16 SD = 0.09 Max = 0.32 Min = 0.00 n = 28
Argentina, Australia, Azerbaijan, Bulgaria
Austria, Belgium, Czech Republic Cameroon, Colombia, Costa Rica
High (τ > 28.8%) High (τ > 28.8%)
Avg = 34.1% Denmark, France, Greece, Ireland Cote d'Ivoire, Guatemala, India, Indonesia Avg = 33.4%
SD = 3.1% Israel, Italy, Japan, Kyrgyz Republic Jamaica, Kazakhstan, Kenya, Mexico SD = 3%
Max = 40% Lithuania, Netherlands, New Zealand Morocco, Namibia, Nicaragua, Oman Max = 40%
Min = 29% Poland, Slovak Republic, Spain Peru, Philippines, Romania, Russian Federation Min = 30% n=
n = 20 28
Thailand, United Kingdom, Uruguay Senegal, South Africa, Tanzania
Taxes Taxes
Ukraine, Zimbabwe
(τ) (τ)
C = 0.27 UE = 23.5% GDP/cap = $18,390 C = 0.55 UE = 38.4% GDP/cap = $5,435
Low ( τ ≤ 28.8%) Bolivia, Botswana, Brazil, Chile Low ( τ ≤ 28.8%)
Avg = 23% Finland, Kuwait, Malaysia, Norway Dominican Republic, Ecuador Avg = 20.4%
SD = 7.7% SD = 5.8%
Puerto Rico, Singapore, Sweden El Salvador, Estonia, Honduras
Max = 28% Max = 28%
Min = 6% n United Arab Emirates Hungary, Iran, Korea, Nigeria Min = 12% n=
=8 Panama, Papua New Guinea, Turkey 16
C = 0.15 UE = 22% GDP/cap = $20,842 C = 0.53 UE = 38.9% GDP/cap = $6,086
High (α > 0.36) Low (α ≤ 0.36)
Avg = 0.64 SD = 0.19 Max = 1.0 Min = 0.38 n = 8 Avg = 0.14 SD = 0.11 Max = 0.34 Min = 0.00 n = 16
Public Goods and Services (α) - Roads * Government Effectiveness (1998)

19
 Table B - Cross Sectional Regressions on Unofficial Economy using Health Services Productivity (2002)

Dependent Variable: Unofficial Economy (% GDP)

1 2 3 4 5 6 7
corruption 11.9464*** 5.2072** 5.3963** 5.5411* 3.3956 0
1.47 2.3 2.33 3.23 3.2 .
rule of law -17.8469*** -17.3154*** -14.8973** -5.2181 -4.6019 -6.4364
4.87 4.98 7.16 7.44 7.89 7.82
tax 0.083 0.0071 -0.1541 -1.9808
0.15 0.26 0.25 1.5
health productivity -0.9749 1.2543 0
1.54 1.64 .
gdp/capita -7.7824*** -8.1628*** -7.6307***
2.63 2.63 2.62
corrup*law*health 3.6337 3.5096
3.19 3.21
law*health -47.4388 0.2084
36.89 7.72
tax*law*health 45.15 -2.5116
36.58 6
Constant 45.5207*** 26.6319*** 24.8381*** 28.2332*** 109.1371*** 16.5873 111.7409***
1.94 5.47 6.34 10.11 28.43 80.14 35.33
R-squared 0.43 0.50 0.50 0.39 0.45 0.45 0.45
N 87 87 87 60 59 59 59
* p<0.10, ** p<0.05, *** p<0.01
standard errors are shown below the coefficients

Table C - Cross Sectional Regressions on Unofficial Economy using Education Services Productivity
(2002)

Dependent Variable: Unofficial Economy (% GDP)

1 2 3 4 5 6 7
corruption 6.4904*** 1.4721 1.4067 1.4152 1.179 50.2248
1.06 1.29 1.31 1.72 1.67 31.39 0
rule of law -24.0716*** -24.4033*** -13.9619** -7.0375 -4.3773 -6.4507
4.39 4.47 6.91 7.54 8.16 8.31
tax -0.0638 -0.4237* -0.4055* -2.0227*
0.15 0.25 0.24 1.08
edu productivity -4.2104* -1.0492
2.27 2.71
gdp/capita -5.5305* -5.3287* -5.6117*
2.77 2.74 2.81
corrup*law*edu -48.7986 1.128
31.19 1.7
law*edu 0 7.0908
. 7.37
tax*law*edu 47.131 -8.9968
30.67 6.9
Constant 40.5890*** 19.4199*** 21.0041*** 32.3437*** 89.3232*** -23.0627 108.3577***
1.83 4.17 5.57 9.27 29.95 78.86 37.18
R-squared 0.30 0.48 0.47 0.40 0.44 0.46 0.43
N 86 86 86 51 51 51 51
* p<0.10, ** p<0.05, *** p<0.01
standard errors are shown below the coefficients

20
Table D - Cross Sectional Regressions on Unofficial Economy using Roads Services Productivity
(2002)

Dependent Variable: Unofficial Economy (% GDP)

1 2 3 4 5 6 7
corruption 5.9239*** 2.1598* 2.0721* 1.3692 1.2669 0
0.89 1.16 1.17 0.94 0.91 .
rule of law -21.1166*** -21.1193*** -15.0228*** -5.4665 -1.3957 -2.7794
4.7 4.7 3.74 4.39 4.61 4.6
tax -0.1482 -0.0483 -0.103 -0.8483*
0.16 0.12 0.11 0.44
roads*gov -4.3271*** -2.4815**
0.95 1.05
gdp/capita -6.1232*** -6.1034*** -5.9301***
1.69 1.68 1.69
corrup*law*roads 1.6455* 1.3283
0.92 0.91
law*roads -19.5619** -1.6878
-9.74 -3.12
taxcorp*law*roads 15.4013 -2.2612
9.48 2.58
Constant 39.5236*** 22.1668*** 26.5377*** 19.1447*** 84.1822*** 55.8236** 86.9801***
1.75 4.17 6.21 4.54 18.34 25.74 20.28
R-squared 0.33 0.46 0.46 0.54 0.57 0.58 0.57
N 87 87 87 147 146 145 145
* p<0.10, ** p<0.05, *** p<0.01
standard errors are shown below the coefficients

21
Table E - Pooled Cross Section Regressions on Unofficial Economy using Goverment Effectiness
(1998, 2000, 2002)

Dependent Variable: Unofficial Economy (% GDP)

1 2 3 4 5 6 7
corruption 7.0920*** 2.1895*** 2.1443*** 1.9980** 1.4517* 25.5079***
0.63 0.78 0.79 0.81 0.74 9.18
rule of law -22.1789*** -22.3376*** -18.6463*** -6.955 -0.8431 -2.9985
2.53 2.55 4.64 4.53 8.26 8.37
tax -0.0421 -0.0336 -0.0933 -1.0365***
0.09 0.09 0.08 0.34
gov_effectiveness -4.4279 -1.0902
4.64 4.28
gdp/capita -6.8543*** -6.8561*** -6.7339***
0.93 0.92 0.93
corrup*law*gov -23.8050*** 1.5034**
9.13 0.74
law*gov dropped -1.3446
. 4.9
taxcorp*law*gov 20.7101*** -2.7449
7.86 2.08
d98 0.5467 0.958 1.0439 0.8579 -0.338 -0.2739 -0.6506
1.84 1.62 1.63 1.64 1.51 1.46 1.48
d00 0.7689 0.8406 0.8854 0.734 0.0315 0 0
1.84 1.61 1.62 1.63 1.49 . .
d02 0 0 0 0 0 -0.0057 -0.0402
. . . . . -1.49 -1.51
Constant 40.5362*** 20.6280*** 21.6652*** 20.9443*** 92.8009*** 52.4734*** 98.4561***
1.45 2.6 3.35 3.44 10.26 19.16 12.28
R-squared 0.33 0.48 0.48 0.48 0.57 0.58 0.57
N 260 260 260 260 258 254 254
* p<0.10, ** p<0.05, *** p<0.01
standard errors are shown below the coefficients

22
 Table F - Panel Data Estimation with Fixed Effects (1998, 2000 e 2002)

Dependent Variable: Unofficial Economy (% GDP)

1 2 3 4 5
corruption -0.4617*** -2.2696* -0.3953**
0.13 1.18 0.17
rule of law 0.6648 0.1782 0.24 1.3178 2.2891
1.00 1.28 1.29 1.21 1.72
tax 0.0021 0.0625 -0.034
0.01 0.05 0.03
gov_effectiveness 0.1586 -1.0221
0.62 0.95
gdp/capita -9.2579*** -9.2717*** -9.3347*** -9.6138*** -9.6165***
0.36 0.37 0.37 0.38 0.38
corrup*law*gov 1.7983 -0.4711*** -0.4024**
1.17 0.14 0.17
law*gov dropped 1.0264 0.2036
. 0.72 1.1
taxcorp*law*gov -1.6663 -0.364 -0.9423*
1.04 0.36 0.54
d00 1.2330*** 1.2490*** 1.2403*** -0.9839*** -0.9791***
0.13 0.13 0.13 0.12 0.12
d02 2.2529*** 2.2533*** 2.2485*** 0 0
0.15 0.15 0.15 . .
Constant 113.3422*** 117.1054*** 115.2710*** 119.4347*** 121.5961***
3.43 3.93 3.69 3.83 4.16
R-squared 0.73 0.73 0.73 0.78 0.79
N 258 254 254 171 167
* p<0.10, ** p<0.05, *** p<0.01
standard errors are shown below the coefficients

References

Bardhan, P. (1997) Corruption and development: A review of issues, Journal of Economic

Literature 3: 1320-1346.
Barro, R. and Lee, J. (2000) International data on educational attainment updates and
implications, NBER Working Paper, no. 7911.
Blackburn, K., Bose, N. and Haque, M.E. (2004) Endogenous corruption in economic
development, Research Paper 2004/16, GEP, University of Nottingham.
Blanchflower, D. and Oswald, A. (1995) The Wage Curve, Cambridge, MIT Press.
Bruegger, E. (2005) Endogenous Institutions and the Dynamics of Corruption, Bern
University Discussion Papers.
Burnside, C. and D, Dollar (2000) Aid, Policies, and Growth, American Economic
Review, 90:4, 847-868.
Chand, S.K. and Moene, K.O., (1999) Controlling Fiscal Corruption, World Development
Vol. 27, No. 7, pp. 1129-1140.

23
Choi, J. and M. Thum, (2005) Corruption and the shadow economy, International
Economic Review, Vol.46, n.3, 817-836.
Dreher, A., Kotsogiannis, C. and McCorristony, S. (2004) Corruption Around the World:
Evidence from a Structural Model, Exeter Working Paper
Dreher, A. and Schneider, F. (2006) Corruption and the Shadow Economy: An Empirical
Analysis, IZA Discussion Paper 1936.
Easterly, W., Kremer, M., Pritchett, L., and Summers, L.H., (1993) Good policy or good
luck? Country growth performance and temporary shocks, Journal of Monetary Economics,
32 (3), pp. 459-483.
Easterly, W., (2001) The lost decades: Developing countries’ stagnation in spite of policy
reform 1980-1998, Journal of Economic Growth, 6 (2), pp. 135-157
Fisman, R. and Miguel, E. (2006) Cultures of Corruption: Evidence from Diplomatic
Parking Tickets, NBER Working Paper 12312.
Friedman, E., Johnson, S., Kaufmann, D. and Zoido-Labton, P. (2000) Dodging the
grabbing hand: The determinants of unofficial activity in 69 countries, Journal of Public
Economics, 76/4, pp.459-493.
Gupta, M. (1993) Rural-Urban Migration, Informal Sector, and Development Policies: A
Theoretical Analysis, The Journal of Development Economics, 41: pp.137-151.
Gupta, S., Davoodi, H. and Alonso-Terme (1998) Does Corruption Affect Income
Inequality and Poverty?, IMF Working Paper 98/76, International Monetary Fund.
Hall, R and Jones, C (1999) Why do some countries produce so much more output per
workers than others?, Quarterly Journal of Economics, 114(1), 83-116.
Hellman, J. S., Jones, G., Kaufmann, D. (2000) Seize the State, Seize the Day: State
Capture, Corruption, and Influence in Transition, World Bank Working Paper 2444, World
Bank.
Huntington, Samuel P. (1968) Political Order in Changing Societies, New Haven, Yale
University Press.
Johnson, S. and Kaufmann, D. (2001) Institutions and the Underground Economy, pp.212-
228, in: O. Havrylyshyn and S. Nsouli (eds.): A Decade of Transition: Achievements and
Challenges, Washington D.C: IMF.
Johnson, S., Kaufmann, D. and Shleifer, A. (1997) The Unofficial Economy in Transition,
Brookings Papers on Economic Activity, 2, pp.159-239, Brookings Institution
Johnson, S., Kaufmann, D. and Zoido-Lobaton, P. (1998) Regulatory Discretion and the
Unofficial Economy, American Economic Review, Vol.88, N.2, pp.387-92
Johnson, S., Kaufmann, D. and Zoido-Lobaton, P. (1999) Corruption, Public Finances and
the Unofficial Economy, Policy Research Working Paper 2169, World Bank
Johnson, S., Kaufmann, D., McMillanc, J., Woodruff, C. (2000) Why do firms hide? Bribes
and unofficial activity after communism, Journal of Public Economics, vol. 76, 495–520.

24
Kaufmann, D., Kraay, A. and Mastruzzi, M. (2005) Governance Matters IV: Governance
Indicators for 1996-2004, World Bank.
Leff, N. H. (1964) Economic development through bureaucratic corruption, American
Behavioural Scientist 8: 8-14.
Loayza, N. V. (1996) The economics of the informal sector: a simple model and some
empirical evidence from Latin America, Carnegie-Rochester Conference Series on Public
Policy 45: 129-162.
Loayza, N., (1994) Labour Regulations and the Informal Sector, Policy Research Working
Paper 1335, World Bank.
Mauro, P. (1995) Corruption and growth, Quarterly Journal of Economics 110: 681-712.
Public Economics 76: 399-457.
Rauch, J. (1991) Modelling the Informal Sector Formally, Journal of Development
Economics, 35: pp. 33-47.
Rose-Ackerman, S. (1999) Corruption and Government: Causes, Consequences and
Reform, Cambridge University Press, Cambridge, UK.
Schneider, F. and D. H. Enste (2000) Shadow economies: size, causes and consequences,
Journal of Economic Literature, XXXVIII, 77-114.
Schneider, F. (2005) Shadow Economies of 145 countries all over the world: Estimation
results of the period 1999-2003, University of Linz: Department of Economics, Discussion
paper Linz, Austria.
Shapiro, C. and Stiglitz, J. (1984) Equilibrium unemployment as worker discipline device,
American Economic Review, vol. 74, pp. 433-44
Shleifer, A. and Vishny, R.W. (1993) Corruption, Quarterly Journal of Economics, CVIII:
599-618.
Tanzi, V. (1998) Corruption around the world-causes, consequences, scope and cures,
International Monetary Fund Staff Papers 45: 559-594.
Tanzi, V. and Davoodi, H. (1997) Corruption, Public Investment and Growth, IMF Working
Paper 97/139 (Washington: International Monetary Fund)
Treismann, D. (2000) The causes of corruption: a cross-national study, Journal of Public
Economics 76, 399–457.
World Bank (1998) Assessing Aid: What Works, What Doesn't and Why?, Oxford
University, Press for the World Bank (SLC).
World Bank (2005) World Development Indicators, World Bank.

25