Accounting for Corruption: Taxes, the Shadow Economy, Endogenous Growth and Inflation

Modelling corruption explicitly in this paper produces changes in the predictions about how taxes affect the size of the "underground", non-market, or shadow, economy. Instead of inducing shifts towards the non-market good as in standard models without explicit corruption, here government tax increases raise the value of the corruption services and increase their use, without tending to cause an increase in the size of the shadow sector. These features conform to evidence on tax rates, corruption, and the size of the shadow economy, making a contribution relative to conventional models. Here a representative agent buys the corruption services and provides labor in the corruption sector. The agent acts within an endogenous growth neoclassical monetary model in which cash-only is used to buy the non-market good, while credit also can be used to buy the market good. An increase in inflation raises the price of the corruption service, reduces the non-market good consumption, and tends to lower the balanced-path growth rate by more than in conventional models. The effect of an increased preference for the non-market good, which is interpreted as in increase in corruption, has an ambiguous effect on the growth rate