The effect of corruption on labour market outcomes

We develop a theoretical model to investigate the relation between corruption and labour supply. The theoretical model shows that corruption affects labour supply in the formal sector by reducing productivity, changing the supply of labour in the shadow economy, altering the tax burden, and distorting the saving-consumption trade-off. The predictions of the theoretical model are tested by using panel data methods for 132 countries. Using the labour force participation rate (LFPR) and employment to population ratio as proxies for labour supply, the estimated empirical results show that corruption has a statistically significant robust direct negative effect on the LFPR and employment to population ratio. Corruption also has an indirect effect on the LFPR and employment to population ratio through a higher tax burden and increase in size of the shadow economy. Higher wages, an increase in consumption, and better regulatory quality are found to reduce the negative impact of corruption on labour supply, however, the overall effect on labour supply is negative, suggesting that the negative effects of corruption outweigh the positive effects of improved regulatory quality, wages, and higher consumption. Our findings imply that in order to reduce the negative effect of corruption on labour supply, governments need to develop a comprehensive approach to not only combatting corruption itself but also working on improving regulation and promoting policies that decrease activities in the shadow economy.