Fiscal Decentralization, Corruption, and the Shadow Economy

We analyze the implications of fiscal decentralization for the size of the shadow economy, local government corruption, and the provision productivity enhancing local public goods. Most important, we show that an increase in the share of locally raised tax revenue left with the local government brings more entrepreneurs from the shadow and into the official economy. In addition, corruption, measured by the size of bribes that local government imposes on entrepreneurs for letting them use official public goods fully, may increase or decrease, depending on the extent to which public goods enhance the entrepreneur's productivity. We test the model's implication with respect to the size of shadow economy using cross-sectional country-level data and find strong support for our results.