Can innovation reduce the size of the informal economy? Evidence from panel data

A substantial body of literature has explored the determinants of the informal economy. However, this literature has predominantly focused on proximate causes such as taxation and unemployment, largely overlooking the role of innovation. This paper aims to fill this gap by examining the effect of innovation production on the size of the informal economy, utilizing a sample of 138 countries spanning the period from 2007 to 2018. We employ a two-step Generalized Method of Moments approach for a dynamic panel data model, addressing both the phenomenon of hysteresis in the development of informality and the endogeneity of innovation, along with several control variables. Estimations reveal that innovation reduces the size of the informal economy, emphasizing the significance of public innovation policies in addressing informality, with expected benefits in terms of tax revenue mobilization. This result remains robust across various controls, alternative estimation techniques, restricted samples, and different measures of both the informal economy and innovation. The study identifies economic development, domestic credit mobilization, and e-government as channels through which innovation influences the informal economy. We conclude by exploring possible public policies.