Abstract

One school of thought associates the presence of hidden economy mainly with taxation. An alternative view underlines the importance of institutional failures, such as excessive regulations, inefficiency of the bureaucracy and corruption. A simple theoretical model is developed to analyse the joint behaviour of these variables. It suggests that a continuum of equilibria can emerge. Each equilibrium is characterised by different levels of underground economy. The optimal shares of shadow economy have a different nature as well, institutional-pushed vs. tax-pushed, and all of them are strictly positive. The former finding reconciles the alternative views about the main causes of the irregular economy; the latter calls for the presence of a natural rate of shadow economy. Empirical evidence for the OECD countries broadly supports the model.