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Official Regulations and the Shadow Economy: A Labour Market Approach

  • Maxim Bouev


This work revisits the role of regulations in emergence o f the shadow economy. In particular, it supplements the previous theoretical research that mainly ignored the fact that the decision to “go underground” is essentially a result of both employers and employees interacting in the labour market. We adapt a job search approach (see, e.g. Acemoglu 2001) to model a transitional economy with an informal sector. We apply and develop the idea first documented inter alia by Loayaza (1996) that there are two types of regulations that influence the size of the informal labour market through two different channels. Red tape and bureaucratic extortion (bribing) make starting a new business officially a not very attractive option and can lead new firms to the informal sector. On the other hand, taxes and redundancy pay make official firms offer lower wages which drives potential employees away into underground jobs. Depending on various combinations of policy parameters equilibria with different share of the informal economy are possible. The paper draws conclusions regarding the role of unemployment benefits in reducing the size of the informal economy. Policy implications are offered.

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Paper provided by William Davidson Institute at the University of Michigan in its series William Davidson Institute Working Papers Series with number 524.

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Length: 39 pages
Date of creation: 01 Dec 2002
Date of revision:
Handle: RePEc:wdi:papers:2002-524
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  1. Pierre-Daniel G. Sarte, 1999. "Informality and rent-seeking bureaucracies in a model of long-run growth," Working Paper 99-07, Federal Reserve Bank of Richmond.
  2. Daron Acemoglu, 1993. "Reward Structures and the Allocation of Talent," CEP Discussion Papers dp0143, Centre for Economic Performance, LSE.
  3. Dominik H. Enste & Friedrich Schneider, 2000. "Shadow Economies: Size, Causes, and Consequences," Journal of Economic Literature, American Economic Association, vol. 38(1), pages 77-114, March.
  4. Friedrich Schneider & Christopher Bajada, 2003. "The Size and Development of the Shadow Economies in the Asia-Pacific," Economics working papers 2003-01, Department of Economics, Johannes Kepler University Linz, Austria.
  5. Nash, John, 1950. "The Bargaining Problem," Econometrica, Econometric Society, vol. 18(2), pages 155-162, April.
  6. Pierre-Richard Agenor & Joshua Aizenman, 1994. "Macroeconomic Adjustment with Segmented Labor Markets," NBER Working Papers 4769, National Bureau of Economic Research, Inc.
  7. Daron Acemoglu & Robert Shimer, 1998. "Holdups and Efficiency with Search Frictions," Working papers 98-14, Massachusetts Institute of Technology (MIT), Department of Economics.
  8. Friedman, Eric & Johnson, Simon & Kaufmann, Daniel & Zoido-Lobaton, Pablo, 2000. "Dodging the grabbing hand: the determinants of unofficial activity in 69 countries," Journal of Public Economics, Elsevier, vol. 76(3), pages 459-493, June.
  9. Frye, Timothy & Zhuravskaya, Ekaterina, 2000. "Rackets, Regulation, and the Rule of Law," Journal of Law, Economics and Organization, Oxford University Press, vol. 16(2), pages 478-502, October.
  10. Kolev, Alexandre, 1998. "Labour Supply in the Informal Economy in Russia during Transition," CEPR Discussion Papers 2024, C.E.P.R. Discussion Papers.
  11. Murphy, Kevin M & Shleifer, Andrei & Vishny, Robert W, 1993. "Why Is Rent-Seeking So Costly to Growth?," American Economic Review, American Economic Association, vol. 83(2), pages 409-14, May.
  12. Acemoglu, D. & Verdier, T., 1996. "Property Rights, Corruption and the Allocation of Talent: A General Equilibrium Approach," DELTA Working Papers 96-12, DELTA (Ecole normale supérieure).
  13. Daron Acemoglu & Robert Shimer, 2000. "Wage and Technology Dispersion," Review of Economic Studies, Oxford University Press, vol. 67(4), pages 585-607.
  14. Loayza, Norman A., 1997. "The economics of the informal sector : a simple model and some empirical evidence from Latin America," Policy Research Working Paper Series 1727, The World Bank.
  15. R. Hirschowitz, 1989. "The Other Path: The Invisible Revolution in the Third World," South African Journal of Economics, Economic Society of South Africa, vol. 57(4), pages 266-272, December.
  16. Johnson, Simon & Kaufmann, Daniel & McMillan, John & Woodruff, Christopher, 2000. "Why do firms hide? Bribes and unofficial activity after communism," Journal of Public Economics, Elsevier, vol. 76(3), pages 495-520, June.
  17. Acemoglu, Daron, 2001. "Good Jobs versus Bad Jobs," Journal of Labor Economics, University of Chicago Press, vol. 19(1), pages 1-21, January.
  18. Daron Acemoglu & Robert Shimer, 1999. "Efficient Unemployment Insurance," Journal of Political Economy, University of Chicago Press, vol. 107(5), pages 893-928, October.
  19. Marimon, R. & Zilibotti, F., 1998. "Unemployment vs. Mismatch of Talents," Papers 661, Stockholm - International Economic Studies.
  20. Boeri, Tito & Garibaldi, Pietro, 2002. "Shadow Activity and Unemployment in a Depressed Labour Market," CEPR Discussion Papers 3433, C.E.P.R. Discussion Papers.
  21. Diamond, Peter A, 1981. "Mobility Costs, Frictional Unemployment, and Efficiency," Journal of Political Economy, University of Chicago Press, vol. 89(4), pages 798-812, August.
  22. Fugazza, Marco & Jacques, Jean-Francois, 2004. "Labor market institutions, taxation and the underground economy," Journal of Public Economics, Elsevier, vol. 88(1-2), pages 395-418, January.
  23. Lemieux, Thomas & Fortin, Bernard & Frechette, Pierre, 1994. "The Effect of Taxes on Labor Supply in the Underground Economy," American Economic Review, American Economic Association, vol. 84(1), pages 231-54, March.
  24. Fortin, Bernard & Marceau, Nicolas & Savard, Luc, 1997. "Taxation, wage controls and the informal sector," Journal of Public Economics, Elsevier, vol. 66(2), pages 293-312, November.
  25. Chander, Parkash & Wilde, Louis, 1992. "Corruption in tax administration," Journal of Public Economics, Elsevier, vol. 49(3), pages 333-349, December.
  26. Christopher A. Pissarides, 2000. "Equilibrium Unemployment Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262161877, June.
  27. Safavian, Mehnaz S. & Graham, Douglas H. & Gonzalez-Vega, Claudio, 2001. "Corruption and Microenterprises in Russia," World Development, Elsevier, vol. 29(7), pages 1215-1224, July.
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