Journal of Business & Economic Policy

Country Morality and the Relative Size of the Shadow Economy
William R. DiPietro

Abstract
Using two different measures of national morality or national ethical character, this paper employs cross country regression analysis to test whether national morality reduces the relative size (relative to GDP) of the underground economy. The empirical analysis of the paper supports the contention that the relative size of the underground economy is negatively related to national morality, thereby suggesting that socializing individuals to internalize ethical behavior is one way to dampen the extent of the underground economy and potentially provide a more fertile environment for the growth and flourishing of the legitimate economy. Every country has limited resources that have to be used for the production of goods and services in order to provide a standard of living for the people of the country. Unfortunately, resources that are devoted to the shadow economy are not available for the legitimate economy. To the extent that the shadow economy absorbs resources and productive activity from legitimate activity, draining legitimate production, the tax base is lessened. This diminishes the ability of the government to collect taxes, taxes that are needed for the provision of essential collective goods, such as infrastructure, education, justice, defense, and other valuable services, thereby inhibiting the potential development of the national economy. Another major problem with the underground economy is that it is apt to undermine personal trust and cause a disintegration of social relationships. Trust is very foundation of exchange and provides the underpinning for the use of contracts in the legitimate economy. In the extreme, the breakdown in trust can even lead to a failed state. In the Mexican city of Juarez, in which the illegal drug trade dominates, people do not trust anyone, not the police, not the government, not the army, nor do they trust other individuals, as everyone is looking for drug money and using violence to get it. Thus, the controlling of the size of the underground economy is of real relevance for a nation in terms of a nation's current economic performance and for its future economic trajectory. In order to effectively curtail the size of the shadow economy, that is, to be able to design polices that keep the underground economy in check and within bounds, one must be able to identify the potential sources, causes, and reasons for the existence and thriving of the shadow economy. Although there are many other potential determinants of the size of the shadow economy, such as the level of economic development, one important potential determinant of the size of the shadow economy is the extent of national morality. Individuals face a choice of engaging in legitimate activity or of using their resources in the underground activity. Rationally, the higher costs of engaging in underground activity compared to the legitimate economy the lower will be the engagement in the shadow economy. Greater internalized national morality places a higher cost of engaging in underground activity, thereby lessening the chances of an individual deciding to engage in underground production. The remainder of the paper is broken down into five sections. The first section highlights some of the recent literature regarding the underground economy and its determinants. The second proposes a simple model of the underground economy highlighting national morality as a key determinant of the relative size of the underground economy. The third provides information on the sources of the variables used in the empirical analysis. The fourth section reports the findings of cross country regressions of the relative size of the underground economy on morality. Lastly, the fifth section concludes.

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