Corruption and shadow economy: Examination of economic, social, and spatial links

The relationship between corruption and the shadow economy is one of most challenging topics in Economic Literature. Theoretically, they either substitute or complement each other – exhibiting either a negative or positive relationship (Buehn and Schneider, 2009). The latter argument emphasizes that the empirical and theoretical area of research in the suggested field is one of the most puzzling fields. The current paper aims to approximate the topic by focusing on a variety of potential factors/links which determine the level of corruption and the existence of a shadow economy. The level of capital taxes are one of the key factors that influence the correlation among corruption and shadow economy. This paper uses a modification of Keen and Kotsogiannis (2002) model so as to capture tax compliance effects. In order to keep our framework as simple as possible, and given that our main objective is to derive the corresponding theoretical relations and empirically test the impact of tax compliance (and consequently shadow economy) on the fiscal interdependencies between horizontally related regions (countries), the existence of any federal tax and equalization entitlements (giving rise to the so-called vertical externalities) is ignored. The post tax return of capital ‑, is the same in each country due to the fact that capital is costlessly and freely mobile across countries. The government of each country levies a specific capital tax. However, the welfare loss due to the imposition of capital tax is realized by the tax payers and gives them an incentive for tax evasion. The magnitude of tax evasion in each country is incorporated in our analysis by the introduction of a tax compliance rate (proportion of capital tax paid). The correct specification of empirical model, presupposes the consideration of a number of issues. More specifically, when it comes to estimating, the endogeneity of tax rates due to their joint determination in Nash equilibrium and the functional dependence between them should be taken under consideration. As far as it concerns the latter case, it is assumed that the variables under examination are characterized by the typical linear dependence (see e.g., Brueckner 2003; Revelli 2005). Moreover, an issue which should be tackled, is that of the intertemporal dependence between national corporate taxes and the dynamic impact of shadow economy culture on own tax rates. The aforementioned dynamic character of fiscal interdependencies is captured by the appropriate modification of empirical model so as to involve the element of time.