Objective: Toward better understanding the political economy of illicit economy, we examine the impact that labor laws have on illicit economic activity. Specifically, we posit that labor regulations are one of the key prospective benefits associated with formal work, and thus incentivize firms and individuals to participate in the formal, rather than illicit, sector. We further argue that the possible negative effect of labor laws on shadow economies is conditioned by countries’ institutional strength. Methods: To test our hypotheses, we analyze time-series, cross-national data for over 100 countries from 1984 to 2012. Findings: Results suggest that labor regulations are negatively related to shadow economic activity and the suggested impact of labor laws is particularly germane to countries with stronger institutional capacity. Conclusion: Our argument and findings challenge the notion that regulations, particularly labor-related regulations, induce more illicit economic exchanges.