the shadow economy, in some or all of these countries. The effects of such tax reductions on the extent of corruption in the same countries is less clear. To the extent that high taxation goes together with high degrees of corruption, however, gains could be had on this front as well.<sup>20</sup>

**Table 5.2: Relationships between indicies for the size of shadow economies and for corruption. HICs and LICs separately.**

|Region|Shadow eco|nomy on corru|ption|Corruption o|n shadow econ|omy|
|---|---|---|---|---|---|---|
||ICRG*<br>index, IV<br>(1)|ICRG*<br>index, IV<br>(2)|DKM**<br>index, IV<br>(1)|ICRG*<br>index, OLS|ICRG*<br>index, IV|ICRG*<br>index, panel|
|High-<br>income|-0.09|-0.11|-0.32|-0.84|-1.85*|0.09|
|Low-<br>income|-0.01|-0.01|0.10**|1.88|5.14|0.10|

Source: Dreher and Schneider (2006).\ Notes:

* = significant at level 90 percent

** = significant at level 95 percent ICRG = Based on International Country Risk Guide measure of corruption DKM = Corruption measure based on Dreher, Kotsigiannis and McCorriston (2005b)

# **5.3 Implications of extent of the shadow economy and tax evasion**

What is the implication of these results for climate finance? A key issue here is: what does the size of the shadow economy, and the level of rent seeking and corruption, imply for effectiveness and use of climate-related funds?

In this section we will discuss implications of extent of the shadow economy and of tax evasion. These two issues are closely related, in the sense that economic agents operating in the “shadow economy” engage in systematic tax evasion or avoidance. Tax evasion is usually taken to mean activity of individual agents (individuals or firms; within a frame where not entire sectors evade or seek to evade taxes).

One then first needs to remember that activity in the shadow economy is, quite generally, less efficient than activity in the formal economy, for a variety of reasons. One may perhaps argue that this fact in itself should not necessarily have implications for the effectiveness of climate-related finance and financial disbursements, insofar as the latter are made to individuals and firms that operate in the regular, tax-paying, part of the economy, report their activities and revenues, and actually pay their required taxes.

# **5.4 Implications of rent seeking and corruption**

Secondly, funds spent on corrupt activities (embezzled by local public officials, or paid as bribes to these or other actors) are can easily have even more perverse effects and can in many cases be viewed as “lost” at least from a wider social perspective.<sup>21</sup> Thirdly, a high level of rent seeking and corruption implies a generally high level at which any financial-fund value is dissipated through inefficient private- and public-sector behavior.

> 20 The evidence on relationships between corruption and tax levels is less compelling. One may, however, potentially visualize that the scope for corrupt activity by bureaucrats to be greater when private agents face greater tax and fee “hurdles”.

> 21 Such funds are of course not “lost” in the narrower sense that they, after all, accrue to somebody (after subtracting the transaction cost which of course can be hefty). But consumption of the individuals who depend on corrupt incomes often has, and probably ought to have, a low weight in society’s welfare function.

21