Regulatory Discretion and the Unofficial Economy

Abstract

Johnson, Kaufmann, and Shleifer (1997) find that the share of the unofficial economy in GDP is determined by the extent of control rights held by politicians and bureaucrats in post-communist economies. Exploring in more detail the role of bribes and using a broader data set from the OECD, Latin America, and transition economies, we find that the unofficial economy accounts for a larger share of GDP when there is more corruption and when the rule of law is weaker. While these findings are consistent with the earlier results for transition economies, in the larger country sample we find it is not necessarily the case that more regulation or higher taxes directly increases the size of the unofficial economy. The problem appears to be not regulation or taxation per se, but whether the state administrative system can operate without corruption. A high level of regulatory discretion helps create the potential for corruption and drive firms into the unofficial economy.