Informality and Long‐Run Growth

Date01 October 2017
DOIhttp://doi.org/10.1111/sjoe.12185
AuthorFrédéric Docquier,Joaquín Naval,Tobias Müller
Published date01 October 2017
Informality and Long-Run Growth
Fr´
ed´
eric Docquier
FNRS and IRES, Universit´
e catholique de Louvain, B-1348 Louvain-la-Neuve, Belgium
frederic.docquier@uclouvain.be
Tobias M¨
uller
Geneva School of Economics and Management, University of Geneva, 1211 Geneva 4,
Switzerland
tobias.mueller@unige.ch
Joaqu´
ın Naval
University of Girona, 17003 Girona, Spain
joaquin.naval@udg.edu
Abstract
One of the most salient features of developing economies is the existence of a large informal
sector. In this paper, we use quantitative theory to study the dynamic implications of infor-
mality on wage inequality, human capital accumulation, child labor, and long-run growth.
Our model can generate transitory informality equilibria or informality-induced poverty traps.
Its calibration reveals that the case for the poverty-trap hypothesis arises: although informal-
ity serves to protect low-skilled workers from extreme poverty in the short run, it prevents
income convergence between developed and developing nations in the long run. Then we
examine the effectiveness of different development policies to exit the poverty trap. Our
numerical experiments show that using means-tested education subsidies is the most cost-
effective single policy option. However, for longer time horizons, or as the economy gets
closer to the poverty trap threshold, combining means-tested education and wage subsidies
is even more effective.
Keywords: Child labor; development; education; inequality
JEL classification:O11; O15; O17
I. Introduction
In this paper, we develop a two-sector growth model to analyze the dy-
namic implications of informality for long-run growth. The model features
bidirectional causal links between informality and human capital accumu-
lation, our source of economic growth. On the one hand, the existence of
We thank Jordi Caball´
e and two anonymous referees for very helpful comments and sug-
gestions. This paper has also benefited from discussions at seminars at the Universitat
Aut`
onoma de Barcelona, IRES (Universit´
e catholique de Louvain) and CERDI (University
of Auvergne). F. Docquier acknowledges financial support from the ARC convention on
“Geographical Mobility of Workers and Firms” (convention 09/14-019).
©The editors of The Scandinavian Journal of Economics 2016.
Scand. J. of Economics 119(4), 1040–1085, 2017
DOI: 10.1111/sjoe.12185
an informal sector influences the incentive to accumulate human capital;
this is because informality lowers the skill premium and facilitates child
labor. On the other hand, human capital affects the size of the informal
sector; when the number of high-skilled workers is small, labor demand is
low in the formal economy and informality increases. First, we theoreti-
cally show that these interdependences between human capital accumula-
tion and informality can be the source of transitory informality equilibria
or informality-induced poverty traps. Second, we confront the data to the
model to obtain key parameters to match a set of stylized facts that de-
scribe the relationships between informality, human capital, child labor, and
growth. The calibrated model reveals that the case for the poverty trap is
strong. In this context, we explore different policies that could enable a
developing country to escape the poverty trap.
The informal economy is defined as the part of an economy that is not
taxed, monitored by any form of government, or included in gross national
product. Although it is difficult to measure precisely, informality is un-
doubtedly a widespread phenomenon in developing countries. For example,
Schneider et al. (2010) estimate the average size of the shadow economy as
a percentage of “official” gross domestic product (GDP), and they obtain
an average share of 38.4 percent in Sub-Saharan Africa, 34.7 percent in
Latin America and the Caribbean, and 25.1 percent in South Asia. It is
usually described as a heterogeneous sector that includes registered firms’
activities hidden from the state, wage employment or self-employment in
unregistered small-scale business units, and sometimes home production.
We make two clarifications about the concept of informality investigated
in this paper.
First, our model aims at capturing informal activities that lead to eco-
nomic transactions between economic agents, not home production. The
size of the informal market has been estimated using direct measurement
methods (i.e., household micro surveys) and indirect methods. The latter
exploit the correlation between economic activity and monetary indicators
(informal activities conduct more transactions in cash), electricity consump-
tion or indicators of aggregate expenditure (Schneider et al., 2010). Second,
the nature of the informal economy differs between rich and poor countries.
In developed countries, the informal sector is characterized by unreported
employment and sales. Informal activities are governed by the same pro-
duction technology as in the formal sector and are simply hidden from the
state for tax, social security, or labor law purposes.1The informal economy
is of a different nature in developing countries. Although tax evasion also
plays a role, developing countries show a dualistic system of production
1What we refer to as “fiscal informality” ranges from 10 to 20 percent of official GDP (an
average of 13.5 percent) in high-income countries (Schneider, 2005).
F. Docquier, T. M¨uller, and J. Naval 1041
©The editors of The Scandinavian Journal of Economics 2016.
with registered and unregistered firms. The latter are characterized by low-
skill intensive technology, and they provide a precious source of income to
many low-skilled individuals in countries where low-skilled wages would
fall below subsistence levels in the absence of an informal economy.2Our
model disregards fiscal informality and focuses on subsistence informality,
the overwhelming part of the informal economy in low-income countries.
Subsistence informality is the only way for many people in develop-
ing countries to escape extreme poverty and precarious living conditions
(G¨
erxhani, 2004). A large share of informality is tolerated by the state in
many developing countries. The reasons are multiple, such as the incapac-
ity of the state to develop or maintain social programs, its incapacity to
manage unemployment, the fear of a bankruptcy of the economy, the fear
of social tensions, etc. A report by the World Bank (2014, p. 23) states that
a third of developing economies do not have any social protection policy
or strategy, and the number of such countries has grown very recently,
meaning that the effects of many of these programs have yet to be seen. In
the absence of social protection, informality is widely tolerated because it
provides people with an alternative, in the absence of, for example, unem-
ployment insurance (as argued in Vodopivec, 2013; Robalino and Weber,
2013; Margolis et al., 2012; Charlot et al., 2016, among others) and/or a
minimum wage (as argued by, among others, Basu et al., 2012, 2015).
Informality can generate vicious circles through different channels. First,
de Paula and Scheinkman (2010, 2011), for example, emphasized the role
of value-added taxes in transmitting informality through chain effects – the
informality of a firm is cor related with the informality of firms from which
it buys or sells. Second, informality reduces the amount of fiscal revenues
that the government can allocate to social protection; in turn, this affects the
attractiveness of the formal economy through greater tax rates or smaller
social benefits (see Zenou, 2008; Leal Ordo ˜
nez, 2014). Third, Murphy
et al. (1989) or Krugman (1991) developed models of multiple equilibria,
in which firms can choose to operate in the informal sector (characterized
by low productivity and wages) or in the formal sector (characterized by
high productivity and wages, and fixed equipment costs). Each firm has
an incentive to move from informality to formality if the demand for
the goods produced is large enough. This occurs when the economy-wide
average income is high (i.e., when other firms industrialize and pay higher
wages).3For several reasons, the predominance of subsistence informality
can be seen as a result of a coordination failure, impeding the process of
industrialization and productivity growth.
2As G¨
erxhani (2004), we argue that the main difference is that some people need the informal
sector to survive in developing countries, which is not the case in developed countries.
3Hence, a firm’s decision whether to industrialize or not depends on its expectation of what
other firms will do.
1042 Informality and long-run growth
©The editors of The Scandinavian Journal of Economics 2016.

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