The interrelationship between corruption and the shadow economy: a perspective on FDI and institutional quality

Purpose This study explores the relationship between corruption and shadow economy (SE) by examining the potential links and interactions between these two phenomena to see whether it is a one-way or two-way relationship and a complementarity or substitution linkage. Design/methodology/approach Using a dataset comprised of 145 countries all over the world between 1996 and 2015, the authors apply the simultaneous two-step system generalized method of moments approach to address the research question. Findings The study findings support a positive bidirectional relationship between corruption and SE. As such, this study has provided evidence supporting the complementarity association. In the authors' further analyses, they point out that several factors can moderate this positive bidirectional linkage. In particular, while Foreign Direct Investment (FDI) inflows strengthen it, it is weakened by other institutional factors such as civil liberties and political rights. Finally, by splitting the full sample into three different subsamples and then examining countries at varying stages of economic development, the authors can gain valuable insights into the evolving dynamics of the relationship between corruption and SE. Specifically, while the authors observe that the positive direction of corruption to SE remains unchanged across different nations, they observe that the positive influence of SE on corruption is strongest among developed economies only. Practical implications The study findings provide an important policy implication. This study highlights the synergistic relationship between SE and corruption, indicating that reducing corruption will reduce the size of the SE. Consequently, this reduction in the SE can mitigate the adverse effects of corruption on economic development. Originality/value This paper is among the first empirical studies that critically investigate the interrelationship between SE and corruption. It then explores how this two-way linkage is conditional on some factors, such as economic development levels and institutional quality indicators.