Exploring Informality: An Empirical Analysis of the Informal Economy

The informal economy often comprises a significant portion of a country's GDP. As this income is not, by definition, taxed or regulated by the government, informal activity presents obvious problems, such as loss of tax revenue, which leads to a lower provision of public goods. However, there is evidence suggesting that the informal economy may serve to promote growth within a country, allowing entrepreneurs a chance to test out their businesses before going through the long process of formal registration, essentially lowering the cost of entry. Many studies of informality focus on the relationship between informality and government intervention in the market (i.e. imposing high tax rates). I hypothesize that government activity is not the only variable which affects an individual’s decision to enter the informal sector. Through first-differenced regression analysis, I explore a range of causal variables. Measures of traditional legalist explanations of informality, such as the tax burden, regulations, corruption, and government effectiveness were found to be insignificant, while female labor force participation, GDP per capita (PPP), and dependency ratios were found highly significant. Using the rational legalist theory as a guide, I hypothesize that the informal economy consists of two parts – those evading formality and entrepreneurs seeking formality. Preliminary evidence is presented which suggests that the composition of an individual country’s informal economy is what determines informality’s effect on economic growth.