The purpose of this paper is to examine the impact of corruption on the size of the shadow economy in countries that differ with respect to income level or geographical location. The underlying idea is that the primary manifestation of corruption might be associated with country characteristics and that different types of corruption might have different consequences.
IV regressions and bootstrapping are applied to a cross‐section of countries to show that geographical location of a country impacts on the relationship between corruption and the shadow economy. An interaction term of the level of corruption and geography is used to capture the differences in the types and consequences of corruption between countries.
Corruption does not seem to affect the size of the shadow economy outside the tropics. Instead, the higher the tropical area fraction of a country, the more a certain level of corruption enlarges the unofficial economy. Moreover, corruption and the shadow economy seem to be substitutes in the tropics.
Different types of corruption may have different consequences.
Unlike most of the previous literature, the paper accounts for the fact that some corrupt practices tend to be commonplace in some parts of the world, while other countries may be plagued by other types of corruption. Therefore, the consequences of corruption might also differ.
