Official rules have always acted as the most important factor to manipulate freedom and choice of individuals and businesses working in the formal sector. The main objective of this article is to explain the link between institutional quality and size of underground economy of OIC member countries. For this purpose, three indicators of control of corruption (CC), political stability (PS) and rule of law (RL) are considered as the institutional indicators. Based on empirical evidence, we test three hypotheses of existence of significantly reverse linkages between control of corruption, rule of law and political stability and the size of underground economy. Utilizing a two stage dynamic panel data with GMM estimator of Arellano-Bond during 1999- 2008, we conclude a statically negative relationship between the mentioned institutional quality indicators and size of underground economy. The results also confirm that with larger size of formal economy and more freedom of individuals and firms, the smaller size of underground economy is expected.

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