How Do Institutions Affect Corruption and the Shadow Economy?

This paper analyzes a simple model that captures the relationship between institutional quality, the shadow economy and corruption. It shows that an improvement in institutional quality reduces the shadow economy and affects the corruption market. The exact relationship between corruption and institutional quality is, however, ambiguous and depends on the relative effectiveness of the institutional quality in the shadow and corruption markets. The predictions of the model are empirically tested - by means of Structural Equation Modelling that treats the shadow economy and the corruption market as latent variables - using data from OECD countries. The results show that an improvement in institutional quality reduces the shadow economy directly and corruption both directly and indirectly (through its effect on the shadow market)