and property rights etc.;<sup>6</sup> unfair competition; overutilization of public goods and services by informal sector that does not contribute to public budgets. In a broad perspective, shadow economy might be a source of distortion to efficient allocation of resources, constrain economic growth and undermine social cohesion and legitimacy of state.<sup>7</sup> For a detailed overview of shadow economy consequences see for instance Schneider and Enste (2000) or Oviedo et al. (2009).

Besides these direct consequences, existence of informal economy might alter the effect of economic policy which might become less efficient, the magnitude of this effect depending on the size of shadow economy. Informal economy may intensify unfair competition between the states and social dumping. On the European level, for example, different size of shadow economies distorts the contributions to the EU budget that are based on the officially declared GDP. Some studies also point to link between illegal immigration and undeclared work (see for instance EC, 2007).

The European Union has been addressing the shadow economy phenomena with emphasis since late 1990s, developing a strategy to combat undeclared work (this even became one of the goals listed in the Lisbon agenda). In its study, European Commission (EC, 2004) puts a special attention to the group of new member states (hereafter ―NMS‖) and candidate countries, where informality has a slightly different character given the previous era of centralized economies and consequent transformation period connected with large institutional, economic and societal changes. Indeed, there exist marked differences between the size of shadow economies in old and new European Union member countries.<sup>8</sup> While the share of the shadow economy in GDP averaged 27.5% in new member states over the period 1999-2007, the respective share in the old member states stood at only 17.9%.

Shadow economy is a complex phenomenon, determined by numerous economic, institutional, regulatory, social and cultural factors. Generally, these are the factors affecting decision-making of individuals and firms whether to stay formal or turn informal, based on financial motives with potentially different moral evaluation of both situations. In our research, we focus on labor market institutions as these have been considered one of the main forces driving economic agents to informality in existing economic research (see e.g.. Schneider and Enste, 2000, OECD, 2004, Oviedo et al., 2009). Substantial differences in institutional frameworks exist across the European countries, although some convergence could be observed recently (see Fialová and Schneider, 2009).

In this paper, we present a multiple country, aggregate level econometric analysis of the impact of labor market institutions and institutional reforms on the size of shadow economies in European countries and various trends in their development in period 2000-2007. We analyze changes in labor market institutions and their impact on the share of the labor force in shadow employment and on the shadow economy production. Furthermore, we address the

> 6 In contrast, Schneider (2003) argues that informal sector exhibits higher level of productivity compared to the official economy. One of the reasons he mentions is stronger work effort of informal workers, whose pay is not burdened by huge taxes, social contributions and other regulations.

> 7 For a detailed survey of costs and benefits considered by individuals and firms in decision-making about turning informal, see Djankov et al. (2003).

> 8 For the purpose of this paper, we consider old EU countries group as Belgium, Denmark, Germany, Greece, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal, Finland, Sweden, United Kingdom and non-EU Norway (sixteen countries). New member states group (―NMS‖) consists of countries acceding to the EU in 2004 and 2007: Bulgaria, Czech Republic, Cyprus, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, Slovenia, Romania (twelve countries) unless indicated otherwise.

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