Corruption and Entrepreneurship: Cross‐Country Evidence from Formal and Informal Sectors

Abstract

While the impact of institutional quality on formal entrepreneurial activity has been well documented in the literature, whether and to what extent corruption influences entrepreneurship in the informal sector is less forthcoming. In this article, we analyze the effect of corruption on entrepreneurship in the formal and informal sectors. Using unique crosscountry data on formal and informal entrepreneurship, we find that corruption deters entrepreneurship in the formal sector and promotes informal entrepreneurship. These results remain robust even after conducting a series of sensitivity analyses.

Cross‐country Evidence of Corruption Spillovers to Formal and Informal Entrepreneurship

“…Using cross‐country data, we find that corruption decreases (increases) formal (informal) entrepreneurship consistent with the current literature (see, e.g., Berdiev and Saunoris ). In addition, the results show that increases in corruption in neighboring countries cause an increase in formal entrepreneurship in the home country.…”

“…In making this decision, entrepreneurs weigh the relative costs and benefits of participating in the formal versus the informal sector, where this cost–benefit differential is primarily a function of institutional quality . In this paper, we argue that corruption impairs institutional quality and therefore distorts this cost–benefit differential by reducing the benefits of operating in the formal sector (Autio and Fu ; Berdiev and Saunoris ). That is, corruption serves as an added “tax” on formal sector production (Berdiev, Goel, and Saunoris 2018; Buehn and Schneider ; Dreher and Siemers ), thereby increasing the costs of participating in the formal sector (Aidis, Estrin, and Mickiewicz ; Johnson et al ; Johnson, Kaufmann, and Shleifer ).…”

“…That is, corruption serves as an added “tax” on formal sector production (Berdiev, Goel, and Saunoris 2018; Buehn and Schneider ; Dreher and Siemers ), thereby increasing the costs of participating in the formal sector (Aidis, Estrin, and Mickiewicz ; Johnson et al ; Johnson, Kaufmann, and Shleifer ). Accordingly, entrepreneurs, in response to bribe demands, may choose to cease production completely if the corruption tax exceeds expected benefits, or alternatively they may decide to circumvent dealing with corrupt agents by moving their operations to the shadow sector (Berdiev and Saunoris ; Berdiev, Saunoris, and Schneider 2018; Friedman et al ; Hibbs and Piculescu ; Hindriks, Keen, and Muthoo ; Johnson et al ; Johnson, Kaufmann, and Shleifer ; Johnson, Kaufmann, and Zoido‐Lobaton )…”

“…As a result, many have argued that economic agents may be “voting with their feet” by migrating underground to escape corruption (see, e.g., Friedman et al ; Hibbs and Piculescu ; Hindriks, Keen, and Muthoo ; Johnson et al 2000; Johnson, Kaufmann, and Shleifer ; Johnson, Kaufmann, and Zoido‐Lobaton ) . Recent empirical results from Berdiev and Saunoris () confirm that entrepreneurs find refuge from corrupt public officials by retreating to the informal sector.…”

Corruption and the shadow economy: One‐way or two‐way street?

“…Specifically, our findings highlight that individuals immediately respond to the high costs associated with corruption by moving to the underground sector. In other words, the shadow economy offers entrepreneurs refuge from corrupt governments (Berdiev & Saunoris, ). This is also in line with the results by Williams and Round () and Williams, Shahid, and Martínez () for Ukraine and Pakistan, respectively.…”