Shadow Economy, Rent-Seeking Activities and the Perils of Reinforcement of the Rule of Law

Abstract

An economy is considered where a possibility to seek rents (a particular case of this activity is corruption) exists along with production. A producer is able to hide part of his output from both bribery and taxation. It is shown that the presence of a shadow sector has di?erent e?ects in economies with high and low rent-seeking. As expected, in the economy with low corruption the direct law enforcement is bene- ficial for growth, and reduces the shadow sector. However, in the highly corrupt economy, combating the shadow economy reduces output and increases corruption, while combating corruption reduces the shadow economy.