Informal economic activity poses a substantial challenge to both developed and developing countries to the point that both academics and international institutions such as the IMF exert a great deal of time and resources studying its determinants and how to combat informality. Large informal economic activity can have important negative macroeconomic consequences for several reasons. First, informal firms tend to be both small and have low levels of productivity, often contributing a minimal amount, if anything, to the tax base. Consequently, countries and regions with high levels of informality thus grow well below their true potential. Additionally, the lack of revenue a country receives from the diminished tax base can hamper the ability of governments to provide goods and services to their populations, which reinforces people’s move into the informal economy. Lastly, high levels of informality are often associated with higher levels of poverty and inequality, especially gender inequality, with women often having a higher probability than men for informal work, as well as being in the most precarious and low-paying categories of informal employment. Estimates of the size of the worldwide informal economy have suggested that around 2 billion workers participate in the informal economy (Delechat and Medina, 2021).
This working paper investigates determinants of informality in non-OECD countries during the post-cold war era with special attention paid to the global financial crisis of 2007-2009. Previous scholars such as Elbahnasawy et al. (2016) show that higher levels of democracy are associated with lower levels of informality, however I argue that institutional policies such as the respect or abuse of private civil liberties, rather than levels of democracy itself, offers a better understanding of what contributes to informality, specifically in the event of an exogenous economic shock as experienced in the global financial crisis.
Tables 1 and 2 below shows preliminary results of models interacting democracy with a global financial crisis dummy variable (table 1) as well as private civil liberties interacted with the global financial crisis dummy variable (table 2). The results show that for developing countries, democratization had a null effect on levels of informality in the face of an exogenous financial shock, however countries that instituted policies protecting the private civil liberties of their citizens, regardless of levels of democracy, fared better and saw a negative effect on the size of the informal economy (measured as a percentage of GDP). The relationship holds both with and without the addition of democracy variables into the model (measured using the Polity 2 score for all models) as well as other economic determinants put forth by previous scholars. All models are run with country fixed effects to account for within country variation, as well as two-way clustering robust standard errors and a lagged dependent variable to account for heteroskedasticity and serial correlation.
Chris Gahagan is a PhD student in the Department of Political Science at Florida State University. His research interests include the social and political determinants of shadow (informal) economic activity throughout the world. You can learn more about Chris here.