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The influence of direct democracy on the shadow economy

Abstract

We analyze, both theoretically and empirically, the influence of direct democratic institutions on the size and development of shadow economies. Our model suggests that, as the extent of direct democracy increases, implemented fiscal policies more nearly reflect the preferences of citizens and so reduce their incentives to operate in the informal sector. This theory implies a negative relationship between the extent of direct democracy and the size of the country’s shadow economy. We also theorize that direct democracy has a greater effect in reducing the informal sector when the former is at low or intermediate values and when the electoral system is characterized by a larger district magnitude. An empirical investigation of a sample of 57 democracies confirms our model’s predictions.

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Notes

  1. Similarly, Pommerehne and Schneider (1978) and Frey (1994) show that popular referendums increase the likelihood that voters control the policy choices of governments.

  2. The analysis developed herein is close in spirit to the works on fiscal decentralization and the shadow economy (Torgler et al. 2010; Teobaldelli 2011) that demonstrate how federal institutions improve fiscal policies as well as government accountability to citizens, both of which end up reducing the informal sector’s size. Schneider and Enste (2002) were the first to recognize that proper elements of direct democracy, together with fiscal federalism, might strengthen public trust in political institutions and reduce the size of the shadow economy.

  3. See https://sites.google.com/a/uniurb.it/teobaldelli/.

  4. We refer to G as public goods and services, but it could also be interpreted as publicly provided private goods and services. One justification for hypothesizing that G does not enter the informal sector’s production function is that informal producers are unable to take full advantage of public services (e.g., social welfare, skill training programs) or government-sponsored credit facilities that could improve the production process. Moreover, according to Loayza (1996) and Johnson et al. (1997), the illegal status of informal agents prevents them from benefiting from government-provided goods and services. Examples of such benefits include being able to secure full enforceable property rights over their capital and output (through the legal and judicial system) and enjoying police protection from crimes committed against that property.

  5. The status quo policy is assumed to be chosen randomly by nature at the beginning of the period. In a dynamic setting, the status quo policy could be interpreted as the policy implemented in the previous period.

  6. Direct democracy identifies a variety of political processes that assign to ordinary citizens the right to decide directly on certain political issues through popular votes. All forms of direct democracy deal with the decision of citizens on substantive laws listed on the ballot, which are known as ballot measures or propositions. Ballot measures can concern either the proposal of a new law or the abolition of an old law. There are differences in how propositions are placed on the ballot. We can distinguish between an initiative, which allows citizens to propose new laws (constitutional or more ordinary legislation) of varying scopes, and a referendum, which is a vote on a law already approved by the legislature. Both forms of direct democracy allow citizens to control the agenda and typically require a predetermined number of signatures from eligible voters to qualify for the ballot. In order to simplify the analysis, we do not distinguish between these types and use the term “referendum” to signify any means of enabling citizens to intervene directly in the political process.

  7. In the standard model of retrospective voting, individuals coordinate on the same retrospective voting strategy; this leads to reelection of the incumbent when the policy provides a utility to voters that exceeds some endogenous threshold. Our setting of the voters’ reservation utility at the exogenous level of the status quo policy (rather than allowing it to be endogenous) does not affect the main results; it changes only the rents of the politician and voters. Our assumption that the incumbent’s punishment is associated with a strictly positive reelection probability (rather than zero) can be viewed as the reduced form of a more general model in which politicians differ along multiple dimensions (e.g., competence, ideology) and voters do not have the same preferences or information about the politician. Observe also that this assumption is relevant only to our analysis of the interaction between direct democracy and other institutional details.

  8. Persson and Tabellini (2000, 2003) explain the link between district magnitude and the electoral formula in terms of larger districts being associated with proportional electoral systems and smaller districts associated with majoritarian systems. Majoritarian elections reduce politicians’ rents because voters in marginal districts are more mobile and electoral competition is stiffer, which implies that citizens can punish politicians more severely for wasteful spending.

  9. Our approach recognizes that promotion of a referendum may be characterized by the standard collective action problems (Olson [1965] 1971) typical of rebellions (e.g., Tullock 1971; Silver 1974; Kurrild-Klitgaard 1997); for a review of this literature and open issues, see Kurrild-Klitgaard (2004). For this reason, we assume that the promotion of a referendum involves private costs and benefits related to the process itself. The positive effect of direct democracy on the probability that the referendum takes place can be explained by any framework under which such probability is increasing in number of citizens who mobilize relative to a required threshold. This means that the same result obtains also in a model where direct democracy reduces the number of individuals necessary for the promotion of the referendum. However, it seems reasonable to assume that higher levels of direct democracy are associated with lower thresholds required for a referendum to occur or with simpler and less costly procedures for the promoters.

  10. The next two lemmas are similar to Lemmas 1 and 3, respectively, in Teobaldelli (2011); their proofs, together with those of Lemmas 3–5 and Corollary 1, are given in Online Appendix.

  11. In writing the maximized net income of the individuals in (5), we have used the government’s budget constraint (2) and also that all individuals are identical.

  12. The only country ranked as high as 7 is Switzerland, and there are more countries (25) ranked 1 than any other value.

  13. In other words, it allows us to account for even the quality of procedures underlying popular initiatives and referendums intended to propose, approve, amend, or remove laws. In clarifying this point, Fiorino and Ricciuti cite the case of Belarus: even though nine referendums were held in this country from 1995 to 2004, Belarus still receives the lowest possible ranking; the reasons are that (a) the referendums were proposed and used by President Lukashenko to amplify his power at the legislature’s expense and (b) a positive outcome was secured thanks to arrests of political adversaries and pressure on citizens.

  14. District magnitude determines how many legislators are elected in a typical voting district. The index used here comes from Persson and Tabellini (2003) and is defined as the ratio of the number of districts to the number of seats in the country’s lower house; the index is thus an inverse measure of districts’ average size. It takes the value 1 in a UK-style system with (single-member districts) and a value slightly above 0 in an Israeli-style system (a single national district from which all legislators are elected). As discussed in Persson and Tabellini (2000, 2003), district magnitude is strongly correlated with the electoral system (this correlation is 0.84 in our sample): electoral districts tend to be large in proportional systems and small in majoritarian ones.

  15. According to Persson and Tabellini (2003), the age of a democracy may have important effects on the policies implemented in that mature democracies might adopt systematically different policies than young ones. For example: welfare-state programs are strongly associated with democracies, but the decision to establish these programs (e.g., public pension systems) may take a long time. Moreover, some important constitutional features may be correlated with the period during which a democratic form of governance was adopted.

  16. We use the GDP of 1960 in order to avoid possible endogeneity problems with respect to the dependent variable.

  17. It is worth emphasizing that the index of religious fractionalization measures a society’s religious heterogeneity and therefore captures different phenomena than do the variables used for the type of religion that is most diffused in the country.

  18. We remark that an absence of nonlinear effects resulting from direct democracy need not be at odds with our model’s predictions since the region in which the politician adopts a prevention strategy may simply be too small for such effects to manifest.

  19. Column 1 shows the estimate when we include only the indexes related to direct democracy and district magnitude; this estimate is reported as a robustness check.

  20. That the estimated marginal effects are positive for DDI values of 6 and 7 is due to the quadratic form used in the estimation; however, these coefficients are not statistically significantly different from zero. Recall that DDI=7 for only one country (Switzerland).

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Acknowledgements

For their helpful comments and suggestions we wish to thank the two anonymous referees and the Editor William F. Shughart II as well as Sascha Becker, Bruno Chiarini, Antonio Ciccone, Philipp Doerrenberg, and Mario Jametti. We also thank participants at the 68th Annual Congress of the IIPF in Dresden, the Bocconi University Workshop on Macroeconomic and Policy Implications of Underground Economy and Tax Evasion, the 2013 meeting of the European Public Choice Society, the Martin Paldam Workshop at Aarhus University, and the SIEP and SIE 2012 annual meetings.

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Correspondence to Désirée Teobaldelli.

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Appendix

Appendix

Proof of Proposition 1

Corollary 1 establishes a negative relationship between the maximized net income of the representative agent and the size of the shadow economy. Under prevention (δ>δ ), higher levels of δ do not change the reformed policy or the maximized net income of the agents; therefore, the size of the shadow economy becomes independent of δ and is related to the level of income under the status quo policy. That is, it’s size is \(x(\hat{y}(t_{0},\gamma_{0}))\) for all δ>δ because \(\hat{y}(t_{0},\gamma_{0}) = \hat{y}(t_{P},\gamma_{P})\) (see Lemma 3). Under nonprevention (δδ ), the policy implemented is the status quo (t 0,γ 0) with probability P(δ) and the reformed policy (t N ,γ N )=(t m ,γ m ) with probability 1−P(δ). Therefore, the expected size of the shadow economy is \({E}x(t_{N},\gamma {}_{N},\delta ) = P(\delta )x(\hat{y}(t_{0},\gamma_{0})) + [1 - P(\delta )]x(\hat{y}(t_{m},\gamma_{m}))\). From \(\hat{y}(t_{0},\gamma_{0}) > \hat{y}(t_{m},\gamma_{m})\) and Corollary 1 it follows that \(x(\hat{y}(t_{0},\gamma_{0})) < x(\hat{y}(t_{m},\gamma_{m}))\). Since dP(δ)/>0, the expected size of the shadow economy will be decreasing in δ; that is, dEx(t N ,γ N ,δ)/<0. It is also immediate that Ex(t N ,γ N ,δ)>x(t P ,γ P ) irrespective of the value of δ. □

Proof of Proposition 2

The threshold δ is implicitly defined (when it is interior) by \({E}V(t_{N},\gamma_{N},\phi ) | _{\delta = \delta^{*}} - V(t_{P},\gamma_{P}) = 0\), where the first term is given by (10) and the second term by (9). Applying the implicit function theorem to this expression yields

$$\frac{\partial \delta^*}{\partial m} = - \frac{\partial {E}V(t_{N},\gamma_{N},\phi ) / \partial \delta}{\partial {E}V(t_{N},\gamma_{N},\phi ) / \partial m}, $$

where ∂EV(t N ,γ N ,ϕ)/∂δ<0 by Lemma 4. Hence, from

$$\frac{\partial {E}V(t_{N},\gamma_{N},\phi )}{\partial m} = W\frac{\partial \phi}{\partial m} > 0 $$

it follows that ∂δ /∂m>0. The second part of the lemma is a consequence of higher levels of direct democracy having a greater effect under the nonprevention than under the prevention strategy—that is, when δδ (see Proposition 1). □

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Teobaldelli, D., Schneider, F. The influence of direct democracy on the shadow economy. Public Choice 157, 543–567 (2013). https://doi.org/10.1007/s11127-013-0098-2

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Keywords

  • Shadow economy
  • Direct democratic institutions
  • District magnitude
  • Good governance

JEL Classification

  • O17
  • P16
  • H11
  • H26