Sep 10, 2013

The influence of direct democracy on the shadow economy

In this paper we have analyzed the influence of direct democratic institutions on the size and development of the shadow economies of 57 countries that have some direct democratic institutions. The main result of our theoretical analysis is that, ceteris paribus, direct democratic institutions have a negative effect on the shadow economy’s size. Our model also predicts that this effect should be nonlinear and should interact with other features of the political system (e.g., district magnitude). The empirical investigation confirms these hypotheses. Our econometric results demonstrate that the effect of direct democratic institutions on the shadow economy is negative, nonlinear, and economically meaningful; these results are robust to the inclusion of a wide variety of control variables yet are sensitive to the interaction of direct democracy with other political institutions (here, district magnitude). 
What are the policy implications of this work? We believe that the results reported here confirm that direct democratic institutions play an important role in reducing the size and development of the shadow economy by favoring good governance; this should be taken into account in the design of institutions. They also confirm that different institutional features are likely to interact with one another in shaping fiscal policies and economic outcomes. The fact that some political institutions may be substitutes (as in our framework) or complements is an important aspect that should be taken into account when designing an institutional framework.
Data on the informal sector are drawn from the dataset of Schneider (2005), which gives the size of the shadow economy as a proportion of official gross domestic product (GDP) for 145 countries over the 1999–2003 period. Our dependent variable is an average of the three available observations for the period indicated; this allows us to cover up to 73 of the countries included in the original sample. 
The direct democracy index (DDI) is that described in Fiorino and Ricciuti (2007). They derive it from three different sources: Kaufmann (2004) for 43 European countries, Hwang (2005) for 33 Asian countries, and Madroñal (2005) for 17 Latin American countries. Thus there are 57 countries for which we have both the size of the shadow economy and the index of direct democracy (see Table 1). The DDI ranges in value from 1 to 7, with 7 corresponding to countries rated as radical democrat and 1 to countries with the least direct democracy. As pointed out by Fiorino and Ricciuti, the main advantage of using this index is that it provides both a qualitative and a quantitative assessment of direct democracy. In fact, this index reflects both the quality and performance of direct democracy in that it focuses on the two most important and widely used processes (initiatives and referendums) as well as on the integrity of the processes themselves. The disadvantages of the DDI are that it is a subjective measure and that it does not identify the issues addressed by referendums and initiatives.

Note that Bolivia is the country with the largest shadow economy in the sample (68%), and Switzerland the only country, in the sample, under 10%. Switzerland is also the country with the highest score in the Direct Democracy Index, and Bolivia is at the bottom. Surprisingly Costa Rica and Singapore, are at the bottom too. 

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