Spatial spillovers of pollution onto the underground sector

This paper examines the spatial spillovers of pollution onto the underground economy. The extant literature has considered the pollution-informal economy nexus to some extent, but the spillover effects across national borders have been ignored. Pollution can increase the underground sector when some formal sector production moves to the informal sector (scale effect), whereas greater pollution can reduce the underground sector when it invites tougher regulations (substitution effect). Results, based on a panel of more than 130 nations and allowing for reverse causality, show both own- and border pollution reduce the underground sector consistent with the substitution effect. In other results, we find opposite effects of economic and political freedom, and some differences in the influences of specific dimensions of economic freedom and the role of the government. Further, we find that while the size of government increases the underground sector, better institutional quality reduces it. Policy implications of these findings are discussed. The spillovers from neighboring nations are especially relevant for nations that are not islands, which is true for a majority of countries around the world.