Shadow Economy, Rent-Seeking Activities and the Perils of Reinforcement of the Rule of Law

An economy is considered where a possibility to seek rents (a particular case of this activity is corruption) exists along with production. A producer is able to hide part of his output from both bribery and taxation. It is shown that the presence of a shadow sector has different effects in economies with hight and low rent-seeking. As expected, in the economy with low corruption the direct law enforcement is beneficial for growth, and reduces the shadow setor. However, in the highly corrupt economy, combating the shadow economy reduces output and increases corruption, while combating corruption reduces the shadow economy.