Entrepreneurship, corruption, and the size of US underground economies
| Date | 02 November 2015 |
| Pages | 313-330 |
| Published date | 02 November 2015 |
| DOI | https://doi.org/10.1108/JEPP-04-2014-0018 |
| Author | Travis Wiseman |
| Subject Matter | Strategy,Entrepreneurship,Business climate/policy |
Entrepreneurship,
corruption, and the size
of US underground economies
Travis Wiseman
Department of Finance and Economics, College of Business,
Mississippi State University, Mississippi State, Mississippi, USA
Abstract
Purpose –Using state-level data on productive and unproductive entrepreneurship, shadow economy
size, and public official corruption, the purpose of this paper is to examine whether formal sector
productive (unproductive) entrepreneurial activity is associated with lower (higher) levels of informal
economic activity.
Design/methodology/approach –Additionally, the author aims to connect US state-level
entrepreneurship, shadow economy size, and corruption by asking whether corruption affects
entrepreneurial outcomes primarily through its effects on the shadow economy. The author contends
that if this is the case, then estimates of corruption should serve as a good instrument for shadow
economy size in regressions on formal sector entrepreneurial outcomes.
Findings –Results from OLS regressions suggest that shadow economy size shares a strong, negative
(positive), and statistically significant relationship with productive (unproductive) entrepreneurship.
These results are fairly robust to GMM estimation. Additionally, the author finds that corruption is a
strong instrument for shadow economy size; one for which validity cannot be rejected in regressions on
productive, and net entrepreneurship scores.
Research limitations/implications –However, the author cannot safely assert that the author
finds evidence of the shadow economy serving as a primary channel through which corruption
affects observed entrepreneurial outcomes. Failure to reject validity of the corruption instrument is,
at best, suggestive of the primacy of the entrepreneurial choice between formal and informal sector
participation.
Originality/value –This study, to the author’s knowledge, is the first to attempt “connecting the
dots”between entrepreneurship, corruption, and shadow economy size.
Keywords Corruption, Institutional quality, Productive entrepreneurship, Rent-seeking,
Shadow economy, Unproductive entrepreneurship
Paper type Research paper
1. Introduction
How do entrepreneurs behave in corrupt political environments? Entrepreneurs are
typically viewed in positive light, as innovators and arbitrageurs whose efforts
increase efficiency or expand the production possibilities frontier (see, e.g. Holcombe,
1998)[1]. Baumol (1990) offers an alternative perspective. In his view, entrepreneurs
channel their efforts in various ways: productive, unproductive, and destructive
activities. Though entrepreneurs still innovate and exploit profit opportunities, the
range of economic consequences differ between positive-, zero-, and negative-sum
Journal of Entrepreneurship and
Public Policy
Vol. 4 No. 3, 2015
pp. 313-330
©Emerald Group Publis hing Limited
2045-2101
DOI 10.1108/JEPP-04-2014-0018
Received 10 April 2014
Revised 30 October 2014
1November2014
Accepted 2 November 2014
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/2045-2101.htm
JEL Classification —H71, K1, K4, L26, O10, O18, O51, R11
The author gratefully acknowledge financial support from the Charles G. Koch Foundation
and the European Social Fund’s Doctoral Studies and Internationalisation Programme, DoRa. For
helpful comments and suggestions the author thank Andrew Young, Russell Sobel, Roger
Congleton, William Trumbull, Brian Cushing, Adam Pellillo, Josh Hall, and two anonymous
referees at the Journal of Entrepreneurship and Public Policy.
313
US
underground
economies
gains. Institutions are central to Baumol’s hypothesis. How entrepreneurial efforts are
channeled depends on the institutional framework under which entrepreneurs operate.
Institutions are “rules of the game,”formal and informal, that govern human action
and social interaction (North, 1991). Formal rules are those found in constitutions –
codified political and legal frameworks. Informal rules include social norms, customs,
and culture that are not codified or enforced by the formal structure. Baumol suggests
that productive entrepreneurs are guided by institutions that reward wealth creation;
unproductive entrepreneurs by institutions that reward zero- or negative-sum activities
–e.g., rent-seeking and frivolous law suits[2]. In this paper, I treat corruption as a proxy
for (poor quality) formal institutions which most closely align with Baumol’s
hypothesis concerning unproductive entrepreneurs.
A question that comes to mind concerning Baumol’s productive and unproductive
entrepreneurship hypothesis is: on the margin, how do productive entrepreneurs
respond to changes in the formal institutional environment that decrease the relative
rewards to productive activities? Productive entrepreneurs in the formal sector may of
course choose to bear the full cost of an unfavorable institutional adjustment; that is,
they do not alter their behavior. However, there are other plausible options. They may
migrate to more favorable institutional conditions; or re-focus their efforts toward legal ,
unproductive activity. Alternatively, entrepreneurs may move their efforts
underground to engage in productive, unproductive, and destructive –e.g., theft,
murder, etc. –activity. Furthermore, entrepreneurs may simply choose to give up
entrepreneurship entirely.
Existing empirical studies of productive and unproductive entrepreneurship focus
primarily on the formal economy (see, e.g. Sobel, 2008; Wiseman and Young, 2013,
2014), and for good reason. Informal economic activity is difficult to measure. The
shadow designation suggests activity deliberately undertaken in such a way that it
escapes detection by public officials[3]. This means that total entrepreneurial activity is
at all times unobservable.
Recently, Wiseman (2013) provides estimates of shadow economy size for 50 US
states over the period 1997 to 2008. I use these estimates here, along with measures of
productive and unproductive entrepreneurship from Wiseman and Young (2014), and
public official corruption convictions data from the US Department of Justice , to
explore the link between shadow economies, entrepreneurship, and corruption at the
US state-level. This study advances the existing literature in the following ways. First, I
establish a link between shadow economy size and the various ways entrepreneurs
channel their efforts. Second, I address the primacy of the shadow economy as a
channel through which corruption affects observed entrepreneurial outcomes. What I
mean by “shadow economy as a channel”is that entrepreneurs make choices between
formal and informal sector participation based on institutional change (in this case
changing levels of corruption). Shadow economy estimates serve as a proxy for that
choice. Entrepreneurs reveal their decisions in observed (formal sector) outcomes.
Therefore, the choice of going formal vs informal (proxied for by shadow economy size)
is a channel through which corruption affects formal entrepreneurial activity. I contend
that if this is the case, then estimates of state-level corruption should serve as a strong
and valid instrument for sha dow economy size in regres sions on observed
entrepreneurial outcomes. However, it is improbable that corruption affects observ ed
productive (unproductive) entrepreneurship only through the shadow economy. Some
entrepreneurs will not exploit the shadow economy at all. For example, it is possible
that entrepreneurs will respond to changes in levels of corruption with adjustments
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