Regulatory Discretion and the Unofficial Economy

Previous work on transition economies suggests that, while formal rules may count in some instances, what really matters is how regulations and tax rules are actually implemented. If the rules are fine on paper but officials have a great deal of discretion in their interpretation and implementation, this leads to a higher effective burden on business, more corruption, and a greater incentive to move to the unofficial economy. This general idea leads to 3 specific propositions: 1. The share of the unofficial economy in GDP should be higher when there is more regulation and more discretion for officials regarding how the regulatory system operates. 2. The unofficial economy should be larger when there is a bigger tax burden on firms in the official sector. 3. A larger unofficial economy should be correlated with weaker publicly provided services, as measured by corruption and the "rule of law." A paper finds support for these propositions in a broad set of countries for which there exist at least roughly comparable estimates of the unofficial economy in the 1990s.