Digitalization and Institutional Quality in the EU Shadow Economy: Complementarity, Substitution, and Nonlinearity

This study examines how digitalization and institutional quality jointly influence the size and dynamics of the shadow economy across EU member states. It adopts an integrated framework in which digital capacity is treated as an operational extension of state capacity that can either complement strong institutions or compensate for institutional weaknesses. The empirical analysis is based on a two-dataset panel covering 27 EU countries over the periods 2013–2022 and 2017–2022. Institutional quality is measured using the Worldwide Governance Indicators, while digitalization is captured through detailed indicators from the Digital Economy and Society Index. Fixed-Effects models with Driscoll–Kraay standard errors are employed, alongside interaction and nonlinear specifications. Results show that institutional quality is consistently associated with lower levels of the shadow economy, but its effect exhibits diminishing returns at higher levels of governance, indicating institutional saturation. Digitalization effects are domain-specific. In isolation, both citizen- and business-oriented digital services show a positive association with the shadow economy, a finding termed the Digitalization Paradox, reflecting a phase where technological facilitation of informal activity outpaces regulatory adaptation. However, their interaction with institutional quality reveals divergent mechanisms. Citizen-oriented services tend to substitute for weaker governance, while business-oriented services complement strong institutional frameworks. The findings indicate that digitalization serves as an institutional amplifier whose final impact on the shadow economy, whether formalizing or facilitating, is dictated by the maturity of the host institution.