The effect of corruption on labour market outcomes Arusha Cooray a, b, * , Ratbek Dzhumashev c a School of Economics, University of New South Wales, Kensington, NSW, 2052, Australia b Centre for Poverty Analysis, Sri Lanka c Department of Economics, Monash University, Clayton, Victoria, 3800, Australia ARTICLE INFO JEL codes: O11 Keywords: Corruption Labour market ABSTRACT 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. 1. Introduction Studies show that corruption can be damaging for an economy. 1 In this study, we investigate how corruption affects labour supply. Labour supply is measured by the labour force participation rate (LFPR) and the employment to population ratio, 2 both directly and indirectly. Numerous papers have investigated the effect of corruption on labour supply and have found that corruption can affect labour supply through a number of channels. However, little has been done to establish a more general theoretical framework to investigate how corruption alters the LFPR and employment to population ratio through different channels. It is well known that low LFPRs and employment to population ratios affect productivity at the firm and country levels, reduce tax revenues, and retard economic growth and development. Thus, investigating this issue is important from a policy perspective. It is crucial for govern- ments to minimise the adverse effect of corruption on labour supply to promote growth. In light of this, we aim to develop a more general theoretical framework which links corruption to the labour market, and then we test the predictions stemming from the model, using panel data methods. * Corresponding author. School of Economics, University of New South Wales, Kensington, NSW, 2052, Australia. E-mail addresses: Arusha.Cooray@unsw.edu.au (A. Cooray), ratbek.dzhumashev@monash.edu (R. Dzhumashev). 1 The most commonly used definition of corruption is the abuse of public power for private gain (Mauro, 1998a, b). Corruption has been found to constrain growth (Rose-Ackerman, 1999; Tanzi and Davoodi, 2002; Mauro, 1995; Mo, 2001), discourage investment (Mauro, 1996; Brunetti et al., 1998; Campos et al., 1999), reduce foreign direct investment (Wei, 2000; Abed and Davoodi, 2002), and limit productivity (Lambsdorff, 2003) and reduce human capital accumulations through dis- tortions in the education system (Patrinos and Kagia, 2007). Studies also show that more corrupt countries face higher inflation (Al-Marhubi, 2000), larger shadow economies (Friedman et al., 2000; Johnson et al., 1997; Schneider et al., 2010), lower state bond ratings (Depken and Lafountain, 2006), and reduced expenditure on education and health (Mauro, 1998a, b). Shleifer and Vishny (1993) and Bardhan (1997) provide an extended review of different aspects of corruption and its economic effects. 2 The LFPR is defined as the proportion of the population aged 15 and older who is economically active, that is, all people who supply labour for the production of goods and services during a specified period as defined by the World Bank (2015) and the International Labour Organisation (ILO, 2015). The employment to population ratio is the proportion of a country's population who is employed (World Bank, 2015; ILO, 2015). Contents lists available at ScienceDirect Economic Modelling journal homepage: www.journals.elsevier.com/economic-modelling https://doi.org/10.1016/j.econmod.2018.05.015 Received 2 January 2018; Received in revised form 12 May 2018; Accepted 12 May 2018 Available online xxxx 0264-9993/© 2018 Published by Elsevier B.V. Economic Modelling xxx (2018) 1–12 Please cite this article in press as: Cooray, A., Dzhumashev, R., The effect of corruption on labour market outcomes, Economic Modelling (2018), https://doi.org/10.1016/j.econmod.2018.05.015