Corruption and the Shadow Economy*

This article develops a simple framework for analyzing the links between corruption and the unofficial economy and their implications for the official economy. In a model of self‐selection with heterogeneous entrepreneurs, we show that the entrepreneurs' option to flee to the underground economy constrains a corrupt official's ability to introduce distortions to the economy for private gains. The unofficial economy thus mitigates government‐induced distortions and, as a result, leads to enhanced economic activities in the official sector. In this sense, the presence of the unofficial sector acts as a complement to the official economy instead of as a substitute.