U.S. Shadow Economies, Corruption, and Entrepreneurship: State-level Spatial Relations

Abstract

(ProQuest: ... denotes formulae omitted.)1.IntroductionWhat is the link between shadow economy size and public official corruption? This question lacks a clear answer in the current literature. The existing evidence points to corruption and the shadow economy sometimes acting as complements and at other times substitutes. The shadow economy and corruption literatures are explored here to address previous findings and to highlight the absence of clarity in the corruption-shadow economy relationship. The designations complement and substitute often mask the underlying relationship between corrupt officials and shadow economy participants. The empirical analysis in this study focuses on corruption and shadow economy size across the U.S. states, but the theory presented might be applied more broadly. For example, in the U.S., like other high-income nations, a collusive relationship between corrupt public officials and firms is likely to result in more formal sector privileges for those firms party to the exchange (Dreher and Schneider, 2010). In this paper, such relationships are defined as cronyism. It is argued here that cronyism exists between public officials and firms primarily at two levels: highly visible officials with large firms and less visible officials with small firms. Additionally, cronyism creates barriers that drive otherwise legitimate firms, their workers, and entrepreneurs underground.This is different than conventional arguments in the literature. Dreher and Schneider (2010), for example, suggest that collusion between firms and corrupt officials in high-income countries result in a negative - substitutive - relationship between corruption and shadow economy size. That is, according to Dreher and Schneider, firms leave the underground in order to collude with corrupt officials for formal sector work. (The substitution is not between corruption and shadow economy size in this case, but the formal and informal sectors). However, a cursory glance at the data (Figure 1 below) shows a positive corruption-shadow economy relationship in the United States. In what follows, a new theory is presented for the corruption-shadow economy relationship in high-income countries. In brief, the theory posits that large (more visible) firms will operate primarily in the formal sector to begin with; only brief crony transactions will take place off-the-books, contributing positively, if at all, to shadow economy size. Public officials who face a high degree of public scrutiny - e.g., politicians - will not likely engage in corrupt acts with small firms and entrepreneurs. As utility maximizers along political lines, corrupt political actors will want to engage in low-risk, high-reward cronyism. Therefore, corrupt officials who are more visible to the public will likely focus their solicitations on a small number of large firms. However, public officials who are less visible to the public eye - e.g., law enforcement - will probably have more luck shaking down smaller firms and sole proprietors. Again, however, the relationship between less visible corrupt officials and small firms should reveal a positive corruption-shadow economy relationship.Moreover, some entrepreneurs and firms will flee all corruption and take their business underground. This, too, will be captured in a positive corruptionshadow economy relationship. Thus, the association between corrupt officials and shadow market participants addressed here is sometimes collusive, sometimes non-collusive. The importance of this realization is discussed further in the next section.With this expectation in mind, both in-state and spatial aspects of the corruption and shadow economy relationship are investigated. First, the analysis looks at the association between corruption and shadow economy size within states' borders. Second, spatial contagion of both shadow economies and corruption are examined, followed by cross-contagion - the relationship between neighboring shadow economies (corruption) and home corruption (shadow economies). …