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32 Eur. J.L. & Econ. 1 (2011)

handle is hein.journals/eurjlwec32 and id is 1 raw text is: Eur J Law Econ (2011) 32:1-14 DOI 10.1007/s10657-010-9205-8 Can corruption constrain the size of governments? Francisco Azpitarte Published online: 16 December 2010 © Springer Science+Business Media, LLC 2010 Abstract This paper analyzes the relationship between government size and the level of corruption. We propose a theoretical model where production decisions and corrupt behavior are endogenously determined. We model corruption assuming production in the formal sector is regulated by public officials who can use their public power for private gain. In this context, the underground economy emerges as an outside option that allows entrepreneurs to avoid dealing with bureaucrats. The fact that investments in the informal sector may influence public finances, intro- duces the possibility of multiple equilibria with different levels of corruption. Consistent with previous theoretical works and recent empirical evidence, we find out that corruption and the shadow economy are complements as they positively correlate across equilibria, which implies that corruption may limit the size of the public sector. Keywords Tax revenue - Corruption - Underground economy JEL Classifications H20 - K42 1 Introduction This paper is concerned with the effect of corruption on production decisions and its consequences on the size of the public sector. We analyze how the perception of corruption by individuals can be crucial in determining the size of governments, measured as the fraction of output governments collect. We propose a theoretical model where production decisions and corrupt behavior are endogenously F. Azpitarte (E) STICERD-London School of Economics & Universidade de Vigo, London, England, UK e-mail: azpitarte@uvigo.es I_ Springer