Abstract
This paper assesses the relationship between institutions, output, and productivity, when official output is corrected for the size of the shadow economy. Our results confirm the usual positive impact of institutional quality on official output and total factor productivity, and its negative impact on the size of the underground economy. However, once output is corrected for the shadow economy, the relationship between institutions and output becomes weaker. The impact of institutions on total (corrected) factor productivity even becomes insignificant. Differences in corrected output must then be attributed to differences in factor endowments. These results survive several tests for robustness.
Highlights
The consensus that institutions are a key determinant of economic development has led international organizations to devote a great deal of attention and resources to improving the institutional frameworks of developing countries
We compute the two measures of success with official output figures and output figures corrected for the shadow economy, respectively
These results confirm that the impact of institutional quality on total output runs through its effect on physical capital, human capital, and total factor productivity (TFP), and show that it is partly compensated by its impact on the shadow economy
Summary
The consensus that institutions are a key determinant of economic development has led international organizations to devote a great deal of attention and resources to improving the institutional frameworks of developing countries. Hall and Jones (1999) and Olson et al (2000) observed that the bulk of the relationship between institutions and income runs through the impact of institutions on total factor productivity. According to Schneider (2005a, 2005b), the shadow economy amounted to 39% of economic activity in developing countries, on average, and up to 40% in transition countries in 2002-2003 These figures call for caution in interpreting empirical results emphasizing the negative impact of defective institutions on income. To foreshadow our main results, we confirm the positive impact of institutional quality on official output and total factor productivity, and its negative impact on the size of the underground economy, reported in the previous literature. It is detailed and complemented in Hall and Jones (2009), Méon and Weill (2005), and Méon et al (2009)
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