Decentralization and the Shadow Economy: What Do We Really Know?

This paper empirically studies the impact of decentralization on the shadow economy. From a theoretical point of view, the impact of decentralization on the shadow economy is ambiguous. Decentralization may directly decrease activities in the unofficial economy e.g. through increased efficiency of public good provision, enhanced tax morale and/or higher probability of detection. In contrast decentralization may increase the shadow activities through the ambiguous effect on corruption. Using various measures of fiscal, political and public employee decentralization, we find evidence for the first effect. Our cross-section analysis reveals that the share of sub-national government employment in total government employment has a significant and robust negative impact on the size of the unofficial economy. This effect decreases with the degree of institutional quality, showing that public employee decentralization is not a feasible instrument to control the unofficial sector in all institutional settings.