Government Decentralization and Prevalence of the Shadow Economy

Abstract

This article examines the effects of various types of decentralization of government functions on the cross-national prevalence of the shadow economy. Do countries with different prevalence of the shadow economy respond differently to government decentralization? We consider four dimensions of decentralization: (1) the tiers of government, (2) subnational government expenditures, (3) subnational government revenues, and (4) subnational government employment. While baseline results show decentralization to reduce the shadow economy, we uniquely find differences in the effectiveness across physical and fiscal decentralization -- greater physical decentralization is more effective at reducing widespread shadow economies, while fiscal decentralization is more effective with small shadow sectors.