Is the Devil in the Shadow? The Effect of Institutional Quality on Income

Abstract

The positive relationship between institutional quality and “official” income is well-documented. It is unclear, however, if this relationship holds once the “unofficial” economy is accounted for. An improvement in institutional quality tends to shift production out of the shadow and into the official sector, resulting in an increase in official income. However, this shift comes at the expense of the informal economy, potentially negating the perceived gains in output. This paper uses data from 5,506 Brazilian municipalities to explore the effects of institutional quality on total income per-person. We additionally estimate the effect of institutions on informal sector size. Our most robust finding suggests that higher quality institutions using our broadest measure are significantly related to development. While good institutions do decrease the size of the informal sector, the consequential switch to formality raises overall productivity.

Keywords: informal sector, shadow economy, institutions, development

JEL Classification: O1, O17, H11