Public Choice (2010) 144: 215–238
DOI 10.1007/s11127-009-9513-0
Corruption and the shadow economy: an empirical
analysis
Axel Dreher · Friedrich Schneider
Received: 18 October 2008 / Accepted: 16 September 2009 / Published online: 29 September 2009
' The Author(s) 2009. This article is published with open access at Springerlink.com
Abstract This paper analyzes the influence of the shadow economy on corruption and vice
versa. We hypothesize that corruption and the shadow economy are substitutes in high in-
come countries while they are complements in low income countries. The hypotheses are
tested for a cross-section of 98 countries. Our results show that there is no robust relationship
between corruption and the size of the shadow economy when perceptions-based indices of
corruption are used. Employing an index of corruption based on a structural model, how-
ever, corruption and the shadow economy are complements in countries with low income,
but not in high income countries.
Keywords Corruption · Shadow economy · Regulation · Tax burden
JEL Classification D73 · H26 · 017 · 05
A. Dreher ()
Center for European, Governance and Economic Development Research (cege), Georg-August
University Goettingen, Platz der Goettinger Sieben 3, 37073 Goettingen, Germany
e-mail: mail@axel-dreher.de
url: www.axel-dreher.de
A. Dreher
KOF Swiss Economic Institute, Zurich, Switzerland
A. Dreher
IZA, Bonn, Germany
A. Dreher
CESifo, Munich, Germany
F. Schneider
Department of Economics, University of Linz, Altenbergerstraße 69, 4040 Linz-Auhof, Austria
e-mail: friedrich.schneider@jku.at
url: www.econ.jku.at/schneider

216 Public Choice (2010) 144: 215–238
1 Introduction
In this paper we explore the relationship between the size of the shadow economy and cor-
ruption.
1
We thereby combine two important topics. The first deals with the impact of cor-
ruption on the shadow economy; the second with the influence of the shadow economy on
corruption. In both parts of the literature there are important gaps. Regarding the impact of
corruption on the shadow economy, first, previous studies employ rather small samples. For
example, Johnson et al. (1997) find that corruption affects the shadow economy positively
(and the official economy negatively)—in a cross section of, however, only 15 countries.
Similar results are presented in Johnson et al. (1998), with 39 countries in the relevant equa-
tion. Employing instrumental variables techniques and even reliable control variables was
thus infeasible.
Second, the few studies investigating the impact of corruption on the shadow economy
focus on rather heterogeneous country samples. There is no separation of high income and
low income countries, the exception being Friedman et al. (2000), distinguishing Latin
America, OECD and transition countries. However, Friedman et al. (2000) have only 15,
20 and, respectively, seven observations in their sample, so their results are far from re-
liable. Indeed, there is good reason to expect the relationship between corruption and the
shadow economy to differ in high and low income countries. In high income countries,
bribing government officials when detected engaging in the shadow market is rarely an op-
tion. Corruption might thus be independent of the size of the shadow economy. As Choi
and Thum (2005) and Dreher et al. (2008) show, however, the shadow economy can mit-
igate government-induced distortions, so that corruption and the shadow economy could
also be substitutes. Clearly, in high income countries entrepreneurs do not have to pay the
bribes demanded by officials as they could always bring the corrupt officials to court. Con-
sequently, they can choose by themselves whether to pay a bribe or operate underground. In
low income countries, to the contrary, entrepreneurs engaging in the shadow economy can
reasonably expect to escape prison when their illegal activity is detected. Officials collude
with entrepreneurs and taxpayers in exchange for a bribe (e.g., Hindriks et al. 1999). By col-
luding with firms, corrupt bureaucrats can allow them to exploit profitable opportunities in
the unofficial sector (Hibbs and Piculescu 2005). To what extent corruption and the shadow
economy are complements or substitutes is thus likely to vary between high and low income
countries.
Third, the existing evidence is contradictory and insufficient. Friedman et al. (2000) claim
“corruption is associated with more unofficial economy.” However, in the relevant instru-
mental variables regression, when controlling for the income level, this holds for only three
out of eight indices employed (ibid.: 480). Further investigation—with a larger sample of
countries—is needed.
Turning to the impact of the shadow economy on corruption, empirical evidence is virtu-
ally non-existent and the literature is not developed beyond the postulation of formal mod-
els. The exception is the recent analysis in Dreher et al. (2008), showing that corruption
decreases with the size of the shadow economy.
Finally, the use of perceptions-based indices of corruption has recently been challenged.
As one problem with these indices, it is not obvious what they actually measure. Arguably,
1
We define corruption as the abuse of public power for private gains. Arguably, corruption, in the common
usage of the word, can mean different things in different contexts. For a discussion of some of the alternative
denotations of the problem of corruption and its damaging consequences see the insightful survey by Bardhan
(1997). See also Klitgaard (1988), Rose-Ackerman (1999), and Otáhal (2007).