Individualism, economic freedom, and the development of the shadow economy

To better understand the relationship between formal institutions, culture, and the size of the shadow economy, this paper considers the impact of pro-market institutions and cultures of individualism, and their interplay, on the size of the shadow economy. Using panel data for 64 countries from 1995 to 2017, the results show that economically free countries that value individualism over collectivism are, on average, associated with smaller shadow economies. Furthermore, the findings reveal that individualistic cultures amplify the effect of formal market-supporting institutions in reducing the size of the shadow economy, and vice versa. In terms of policy guidance, the results of this study suggest that policies would benefit from accounting for culture in promoting pro-market institutions to combat the shadow economy or in transitioning shadow participants to the formal sector.