There is an interesting new paper by Johanna D’Hernoncourt and Pierre-Guillaume Méon (ungated older version here) investigating the relation between trust and the size of the shadow economy. From the abstract:

This paper reports a negative relationship between the size of the shadow economy and generalized trust, in a sample of countries, both developed and developing. That relationship is robust to controlling for a large set of economic, policy, and institutional variables, to changing the estimate of the shadow economy and the estimation period, and to controlling for endogeneity. It is independent from trust in institutions and from income inequality, and is mainly present in the sample of developing countries. Those findings suggest that the tax compliance effect of trust dominates its role as a substitute for the formal legal system.

The idea is that countries with a higher level of generalized trust have smaller shadow economies. The measure of trust is taken from the World Values Survey and it measures the number of people in each country who answer “yes” to the question “Generally speaking, would you say that most people can be trusted or that you need to be very careful when dealing with people?”.

Johanna D’Hernoncourta and Pierre-Guillaume Méon

I think that this is a very interesting piece of research, though it overlooks the inner dynamics of the informal economy. As legal systems are weak and property rights are not enforced by formal institutions, informal operators must rely on trust in all their transactions. In social capital theory, this is called a “club good”, meaning that trust is very strong within a group but small towards the general public (read this paper for a much better explanation).

We are seeing this everyday in our research in Kariobangi. One of the most common problems for entrepreneurs is that costumers cannot pay on time. Though, rarely entrepreneurs decide to cut the relationship with the insolvent clients, because this might reduce future business. Trust within groups, be they other entrepreneurs in local markets, informal associations or ethnic networks is very high because there is no alternative.

It would be very interesting to calculate a proxy for “social capital as a club good” in the World Value Survey and regress that against the size of the shadow economy. That would make a very interesting paper.