Shadow economy and environmental pollution

This thesis investigates the relationship between the size of the shadow economy and environmental pollution. To this end, an empirical analysis for various measures of environmental pollution is conducted first in a panel data setting for 152 countries over the period 1999-2007, and then in a time-series framework for Turkey over the period 1950-2009. The estimation results show support towards the existence of an inverted-U relationship between the size of the shadow economy and environmental pollution, that is small and large sizes of the shadow economy are associated with low levels of environmental pollution and medium levels of the size of the shadow economy are associated with higher levels of environmental pollution. Next, a two-sector dynamic general equilibrium model is built to account for this empirical observation. The model identifies two channels through which the informal economy might affect environmental pollution: first, the scale effect through which larger (smaller) informal sector size is associated with lower (higher) level of environmental pollution and the second, the deregulation effect through which larger (smaller) informal sector size is associated with higher (lower) level of environmental pollution . As these two effects work in opposite directions, the changing relative strength of one builds the inverted-U relationship between pollution indicators and informal sector size.