Shadow Economy, Institutional Quality and Environmental Sustainability

The rapidly increasing degradation of the environment and the intensifying effects of climate change pose a pressing challenge for sustainable development. While the environmental impact of formal economic activity has been extensively studied, the influence of the shadow or informal economy remains underexplored. This paper reviews how informality shapes environmental outcomes, placing particular emphasis on the key role played by institutional quality. Countries with larger informal sectors often experience weaker environmental enforcement, greater reliance on pollution-intensive activities, and lower investment in sustainable infrastructure. At the same time, excessive regulation, taxation, and institutional failures can drive workers and firms into informality, especially when environmental rules increase compliance costs. The paper underscores that the environmental consequences of informality depend critically on the strength and credibility of institutions: where the rule of law, administrative capacity, and social protection are robust, incentives to operate informally are reduced and environmental regulations are more effectively enforced. Conversely, weak institutional settings allow environmentally harmful informal activities to proliferate and may also cause green transition measures to unintentionally push vulnerable workers into informality. At the same time, informal actors can also provide essential environmental services—such as waste management, recycling, and energy access in underserved areas. By synthesizing the existing literature, the paper argues that institutional quality is the key lever through which policymakers can align informality management with environmental objectives, calling for stronger state capacity, credible regulation, and more inclusive, community-based sustainability initiatives.