Can corruption constrain the size of governments?

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, introduces 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.