WPS3623 THE IMPACT OF REGULATION ON GROWTH AND INFORMALITY CROSS-COUNTRY EVIDENCE * Norman V. Loayza Ana María Oviedo Luis Servén The World Bank University of Maryland The World Bank *This research has been supported by the World Bank's Latin America Regional Studies Program. We are very grateful to Basudeb Guha-Khasnobis, Patricia Macchi, Janis Vehmaan-Kreula, and participants in the EGDI-WIDER Conference on the Informal Sector (Helsinki, 2004) for useful comments. THE IMPACT OF REGULATION ON GROWTH AND INFORMALITY: CROSS-COUNTRY EVIDENCE May 2005 Abstract This paper studies the effects of regulation on economic growth and the relative size of the informal sector in a large sample of industrial and developing countries. Along with firm dynamics, informality is an important channel through which regulation affects macroeconomic performance and economic growth in particular. The paper concludes that a heavier regulatory burden --particularly in product and labor markets-- reduces growth and induces informality. These effects are, however, mitigated as the overall institutional framework improves. JEL classification: K20, K30, H11, O40, O17. Keywords: Regulation, government performance, economic growth, informal economy. Norman V. Loayza Ana María Oviedo Luis Servén The World Bank University of Maryland The World Bank nloayza@worldbank.org Oviedo@econ.umd.edu lserven@worldbank.org ii I. Introduction The enactment of regulation follows a process where valid social goals are combined with the objectives of particular interest groups (see Djankov, La Porta, López- de-Silanes, and Shleifer 2002). Whatever their justifications and objectives, regulations are bound to have an impact beyond their area of control and exert an effect on the overall economy. This effect has two basic channels: the dynamics of firm restructuring and the formation and evolution of the informal sector. Using a large sample of industrial and developing countries, this paper examines empirically the overall effect of business regulation on economic growth and on the relative size of the informal sector, thus starting an exploration of the informal-sector channel of regulation.1 The key to a healthy economy is the flexibility to manage negative shocks and take advantage of growth opportunities. Intentionally or not, regulation can impose rigidities and distort the incentives for factor reallocation, capital accumulation, competition, and innovation. For those firms that abide by the regulatory environment, this distorts the normal process of firm creation, growth, and disappearance ­the Schumpeterian process of "creative destruction." Through this firm-dynamics channel, regulation can have a macroeconomic impact by both worsening recessionary periods and reducing trend growth. This is not, however, the whole impact of regulation. In the absence of perfect monitoring and compliance, some firms will find it optimal ­or simply necessary--to evade regulations and work outside the strict legal regime. Avoidance of regulations, however, does not mean that they cease to have an effect. The informal sector ­the result of the loose aggregation of firms and activities outside the regulatory framework--is the second-best response of an economy facing shocks and trying to grow.2 The response is second-best because it entails losing, at least partially, the advantages of legality, such as police and judicial protection, access to formal credit institutions, and participation in international markets. Moreover, trying to escape the control of the state forces many informal firms to remain sub-optimally small, use 1We explore the firm-dynamics channel in a related paper (Loayza, Oviedo and Servén, 2005b). 2For an excellent review of the causes and consequences of the informal sector, see Schneider and Enste (2000). Drawing from a public-choice approach, Gerxhani (2004) provides an interesting discussion of the differences of the informal sector in developed and developing countries. The classic study of informality is, of course, De Soto (1989). 1 irregular procurement and distribution channels, and constantly divert resources to mask their activities or simply bribe officials. Therefore, as compared with a first-best response, the expansion of the informal sector often represents distorted and insufficient economic growth.3 In addition, the informal sector can generate a negative externality that compounds its adverse effect on growth: by avoiding taxes, informal activities use and congest public infrastructure without helping to replenish it. If public infrastructure complements private capital in the process of economic growth, a larger informal sector will imply smaller growth.4 The simple cross-country comparison presented in Figure 1 suggests that countries where the relative size of the informal sector is larger tend to grow at a slower pace. In assessing the impact of regulation, it is essential to consider that this impact is likely to depend not only on the quantity of regulation, but also on its quality. There are good reasons for this. On analytical grounds, certain types of regulation ­ such as those designed to enhance competition in goods or financial markets ­ should be expected to exert beneficial effects on economic performance, rather than adverse ones. More generally, countries with better institutions tend to create regulatory environments genuinely aimed to improve business conditions rather than privilege a few interest groups.5 They are also more likely to enforce regulation in a transparent and even-handed manner, limiting the regulator's margin for arbitrariness and corruption that can place many firms at a disadvantage. All these arguments suggest that the quality of regulation is likely to be closely related to overall governance quality, and thus in our experiments we use standard governance indicators to capture and examine the importance of regulatory quality. The rest of the paper is organized as follows. Section II describes the synthetic regulation indicators and presents some stylized facts concerning the patterns of regulation 3This does not necessarily mean that informal sector firms are not dynamic or lagging behind their formal counterparts (see Maloney 2004 for evidence on the dynamism of Latin American informal firms). In fact, in equilibrium the risk-adjusted returns in both sectors should be similar. The stagnation arguments presented in the text are relative to the first-best response and not with respect to a sclerotic economy unable to circumvent its regulation-induced rigidities. 4See Loayza (1996) for an endogenous-growth model highlighting the negative effect of informality through the congestion of public services. 5This is the argument in Claessens and Klapper (2002). 2 across countries. Section III reports estimates of the impact of regulation on economic growth and the size of the informal sector. Section IV offers some concluding remarks. II. Measuring Business Regulation In this section, we briefly describe our measures of regulation and their sources. We also discuss differences in regulation intensity across countries for different levels of economic development. We construct indices to measure business regulation in the following seven areas: firm entry, labor markets, fiscal burden, trade barriers, financial markets, contract enforcement, and bankruptcy regulation. Each index is obtained as an average of related components, normalized to vary within a unit interval with higher values representing heavier regulatory burden.6 The components used to construct the seven synthetic indices are obtained from the following data sources: Doing Business (The World Bank Group), Index of Economic Freedom (The Heritage Foundation), Economic Freedom of the World (The Fraser Institute), Labor Market Indicators Database (M. Rama and R. Artecona, 2000), The Corporate Tax Rates Survey (KPMG), and International Country Risk Guide (The PRS Group). These sources cover the largest number of countries and areas under regulation, and their measures use a clear methodology and are straightforward. Except for the Labor Market Indicators Database, all sources are public. Our sample covers 75 countries. In most cases, data are based on surveys conducted in a single year (in the late 1990s) in a large group of countries; for components with observations for more than one year, we use average values over the period. Therefore, our indices should be interpreted as average regulation levels in the late 1990s. We should note, however, that regulation tends to stay constant over long periods of time. Table 1 shows simple correlations between the seven regulation indices. The strongly positive correlations among all but the fiscal burden and labor indices suggest that regulation policy comes in "packages." Judging from these correlations, we can distinguish three regulation categories: fiscal, labor, and product-market regulations, where 6We refer the interested reader to Loayza, Oviedo and Servén (2005a) for details on the construction and components the business regulation indices. 3 the latter is a composite of the entry, trade, financial markets, bankruptcy, and contract enforcement indices. We obtain the product-market index by averaging the scores of the five components.7 We also compute an overall regulation index by averaging the scores of all seven components. We choose to give equal weights to all components despite the strong correlation among the first five because we don't have any priors about the importance of labor market or fiscal regulation relative to the others. Figure 2 depicts scatter plots of the overall, product-market, labor, and fiscal regulation indices against the (the log of) GDP per capita of all countries in the sample. The product-market regulation index is strongly negatively related to average income, and so is the overall regulation index, reflecting the fact that it loads heavily on product- market regulations. Labor regulation also has a negative correlation with average income, but it is smaller and not statistically significant. The relationship between fiscal regulation and income is strong but of the opposite sign as those of the other types of regulation: richer countries tend to have heavier fiscal regulation. Finally, we use a governance index in order to assess the quality of regulation itself and the general context that determines how regulation functions. We construct this index using three measures from the International Country Risk Guide: absence of corruption in the political system, prevalence of law and order, and level of democratic accountability. The last panel of Figure 2 shows the close connection between our governance index and per capita GDP. III. Regulation, Economic Growth, and Informality Having described how the regulatory environment varies across countries, our objective for this section is examining whether regulations have an impact on economic growth and the size of the informal sector. Establishing the connection between regulation and informality is a first step in understanding how regulation affects economic growth. In assessing the effect of the regulatory environment, it is important to consider that the quality of regulation is profoundly affected by the institutional context in which it is imposed. Thus, regulation's ultimate impact is likely to be affected by the country's level 7The term "product-market regulations" is taken from Nicoletti et al. (2000). 4 of institutional development. In order to explore the interaction between institutional progress and regulatory environment, we extend the basic empirical analysis by allowing the effects of regulation to vary with the measure of governance described above. Sample and specification Our empirical methodology is based on cross-country regression analysis. We conduct separate regressions for each dependent variable of interest, namely, economic growth and the size of the informal sector. In each case, we use as explanatory variables a measure of regulation and a set of basic control variables. Table 2 presents descriptive statistics of all variables used in the paper. The sample consists of 72 - 75 countries, depending on the regression exercise. In the largest sample, we have 22 developed and 53 developing countries, of which 21 belong to Latin America, 22 to Africa and the Middle East, and 10 to Asia. Country observations for each variable correspond to averages for the 1990s. We are constrained to this decade because internationally comparable regulation measures are available only for this period. The dependent variables are defined as follows. Regarding economic growth, its measure is standard in the literature and is given by the average annual growth rate of real GDP per capita. For our second dependent variable --the size of the informal sector-- there is no standard measure. To the contrary, there is much dispute as to what exactly the informal sector is, and this controversy naturally extends to all attempts to measure it (see Schneider and Enste, 2000). The definition we use in this paper identifies informality with regulation evasion. This definition is not only the most relevant given the focus of this paper, but it has also become the most popular since the seminal work by De Soto (1989). The informal sector thus defined is a shadow economy whose size is best represented as a latent variable. This is the approach taken by Schneider (2004) to provide estimates of the size of the informal sector --as production in percentage of GDP-- for 145 countries for the period 2000-2003.8 Schneider's study combines the DYMIMIC (dynamic multiple-indicators-multiple- causes) with currency-demand-based approaches to the estimation of the informal sector as a latent variable. More precisely, the informal sector comprises (non-criminal) economic activities that go undeclared specifically in order to avoid compliance with costly 8Loayza (1996) uses a similar approach for his estimates of the informal sector in Latin American countries. 5 regulation (in particular employment protection laws), tax payments, and social security contributions. It, therefore, excludes criminal activities and home-based production. We use Schneider's estimates because, first, they are the most comprehensive estimates obtained using a unified method, and, second, they are used by a number of other studies. However, as with the measurement of any other latent variable, these estimates of the size of the informal sector should be considered with caution. They are likely to pick up a large amount of measurement error; and in the particular case of the DYMIMIC procedure, the estimates depend largely on the theoretical relation between the variable of interest and the indicators, which may be subject to debate. Although highly important and interesting, a detailed discussion of the estimation of the informal sector is beyond the scope of this paper. As described in the previous section, our explanatory variables of interest in the growth and informality regressions are indices that quantify a country's regulatory burden. We consider, in turn, the overall regulation index and its three main components-- the product-market, labor, and fiscal regulation indices. In extensions to the basic specification, we interact the regulation index with a governance proxy, which as already noted is constructed from information on experts' perceptions on public accountability, absence of corruption, and rule of law, as reported by the International Country Risk Guide. The set of control variables for the growth regressions consists of the initial level of per capita real GDP (to account for convergence effects), the initial rate of secondary enrollment (as proxy for human capital investment), the initial ratio of private domestic credit to GDP (to account for financial depth), and a Sub-Saharan dummy variable (to control for the particular conditions of civil conflict, mismanagement, and disease affecting this region).9 For the regressions of the size of the informal sector, the control set is quite parsimonious consisting only of initial real GDP per capita. Despite its parsimony, this variable summarizes most elements of economic development and is crucially important as a control given its strong relationship with both informality and regulation (see, as illustration, the corresponding bivariate correlations in Table 2). 9The "Africa dummy" has a long tradition in empirical growth studies; see for example Easterly and Levine (1997). 6 Results and discussion We start with a visual exercise. Figures 3 and 4 show scatter plots that represent the simple relationship between the regulation indices and, respectively, economic growth and the size of the informal sector. The graphs using overall regulation consistently suggest that more heavily regulated economies tend to grow less and be more informal. Observations reflecting poor economic growth, large informality, and high overall regulatory burden belong mostly to developing countries, while developed economies tend to occupy the other end of the distribution. These links with overall regulation seem to be driven by product market regulation and, to a lesser extent, labor regulation. Conversely, the connection with fiscal regulation appears to go in the opposite direction, so that economies with larger fiscal regulation show somewhat better economic growth and smaller informal sector. We shall see if the opposite behavior of fiscal regulation survives the scrutiny of regression analysis. A more formal evaluation of the link between the regulation indices, growth, and informality requires multiple regression analysis, to which we turn now. The regression results are organized as follows. We first present the results on economic growth and then those on the relative size of the informal sector as dependent variables. For each of them we start with a basic specification where the effect of regulation is unrelated to governance. Then, we allow for the effects of regulation to vary with the quality of governance. Table 3.A presents the basic specification results on economic growth. The overall index of regulation has a negative and significant association with economic growth, and so do the product market and labor regulation indices, while the index of fiscal regulation has no significant relation. Table 3.B presents the estimation results when we allow for the effect of regulation on growth to vary with the quality of governance. The overall, product market, and labor regulation indices all carry significantly negative signs and their interaction terms with governance show a positive and significant coefficient. Thus, the negative association of these regulation indices with economic growth appears to be mitigated when the quality of governance rises. As to fiscal regulation, neither its direct coefficient nor the coefficient on the interaction term is statistically significant in the growth regression. 7 How large or economically important are the growth effects of regulation? Using the point estimates of the regression that accounts for governance interactions, we can perform some illustrative exercises. If a country's index of labor regulation were increased by one standard deviation in the cross-country sample (0.16) and its level of governance is equal to the world median (0.46), then its annual rate of per capita GDP growth would decrease by 0.3 percentage points. More remarkably, if a typical developing country were to decrease its product-market regulation to the median level of industrial countries (that is, from 0.51 to 0.17) while maintaining its level of governance (equal to the median of developing countries, 0.37), then its annual growth rate would rise by about 1.7 percentage points. The point estimates of the coefficients are such that if the quality of governance is sufficiently high, the negative growth effect of an increase in regulation can be nearly cancelled. For product-market regulations this threshold level is quite high and could only be approximated by countries like Switzerland, Sweden, or Canada. For labor market regulations, the threshold is somewhat smaller and comparable to that of Ireland or Portugal. We now turn to the regressions where the dependent variable is the relative size of the informal sector (in terms of informal production as percentage of GDP). Table 4.A presents the basic specification results. The product-market and labor regulation indices carry positive and significant coefficients, suggesting that these types of regulation lead to more extensive informality. The coefficient on overall regulation is also positive but fails to be statistically significant. This weakened effect is apparently due to the inclusion of fiscal regulation in the overall index; indeed, fiscal regulation by itself carries a significantly negative coefficient. This last result may seem rather puzzling, and we return to it below. Regarding the control variable, as expected, the level of income per capita carries a significantly negative coefficient. This indicates that, other things equal, informality is more prevalent in poorer countries. Table 4.B presents the results of the informality regressions when we include the interaction between regulation and governance as an additional explanatory variable. The coefficients on overall, product-market, and labor regulation indices are positive and statistically significant. Their corresponding interaction terms with the governance index 8 carry a statistically negative coefficient. Taken together, these results have a similar interpretation as those related to the growth regression: For low levels of governance (implying poor regulatory quality), an increase in product-market or labor regulation leads to an expansion of the informal sector. As governance improves, the amplifying effect of these types of regulation on informality diminishes until it disappears. This happens at moderately high levels of governance, the threshold value corresponding roughly to those of Greece, Spain, and Japan. Regarding fiscal regulation, its direct coefficient is positive, changing signs with respect to that in the basic specification; it, however, fails to be statistically significant, and now it's the interaction term with governance which carries a significantly negative coefficient. This indicates that for low levels of governance (up to those roughly corresponding to Colombia and Pakistan), the impact of fiscal regulation on the size of the informal sector is zero; but as governance improves, higher fiscal regulation actually leads to a reduction in informality. We can understand the puzzling negative relationship between fiscal regulation and informality by considering that the increase in fiscal burden not only makes evasion more attractive (which implies a positive relationship) but can also generate better public services and more resources for enforcing tax compliance (both of which make formality attractive). When governance is sufficiently good, the formality-inducing effect of fiscal regulation prevails. As in the case of growth, we can use the estimated coefficients to ascertain how economically important the informality effects of regulation are. Using the point estimates of the regression that accounts for governance interactions, let's consider the changes in the size of the informal sector brought about by changes in labor and product-market regulations. If a country's index of labor regulation were increased by one standard deviation in the cross-country sample and its level of governance is equal to the world median, then the size of the informal sector relative to GDP would increase by nearly 3 percentage points. If a typical developing country decreased its product-market regulation to the median of industrial countries while keeping its level of governance, then its informal sector would decrease by close to 7 percentage points of GDP. 9 IV. Concluding Remarks Regulation is becoming a core policy factor to explain the bottlenecks to economic growth in many countries around the world. Using a large sample of industrial and developing countries, this paper provides an evaluation of the impact of business regulation on economic growth and informality. Our regression analysis suggests that high levels of regulation are associated with lower growth. This is clearly the case for product and labor market regulation. However, the quality of regulation ­ as captured by the overall institutional framework ­ makes a big difference: in most instances we find that better institutions help mitigate, and even eliminate, the adverse impact of regulation on economic growth. The literature indicates two main channels through which regulation can have a negative impact on economic growth. The first ­and most popular--is the distortionary effect of regulation on the Schumpeterian process of firm dynamics. The second ­to which we devote our attention in this paper--is the incentive that regulation may create for firms to work outside the legal framework. We start an exploration of the informality channel by assessing the effect of regulation on the size of the informal sector relative to GDP. We find that an increase in either product-market or labor regulation leads to an expansion of informality. As in the case of growth, this pernicious effect is gradually mitigated as governance --and thus regulatory quality-- improves. Fiscal regulation has a different effect on informality (which may explain why we do not find a clearly negative impact of fiscal regulation on economic growth): when governance is not too low, an increase in fiscal regulation brings about a decrease in informality. This can be explained by considering that an increase in fiscal regulation not only makes evasion more attractive but can also generate better public services and more resources for enforcing tax compliance. Theoretically, analogous positive effects could also apply to other product-market and labor regulation, but they are not discernible in the cross-country sample we study. Does the negative growth effect of regulations imply that they should be eliminated altogether? This paper does not intend to assess the impact of regulation on social goals that could be beyond the strict sphere of economic growth ­ broad goals such as social equity and peace, or narrow ones such as worker safety, environmental conservation, and 10 civil security, which typically motivate specific regulations. Thus, our conclusions on the role of regulation must necessarily be evaluated in a more comprehensive context before drawing definitive social welfare implications. At any rate, to the extent that economic growth is quite an important goal, our findings imply that streamlining regulation and strengthening governance in highly regulated countries could have a significant payoff. 11 References [1] Claessens, Stijn and Leora Klapper, "Bankruptcy Around the World: Explanations of its Relative Use," World Bank Working Paper No. 2865, The World Bank, Washington DC (2002). [2] De Soto, Hernando, The Other Path: The Invisible Revolution in the Third World, (HarperCollins, 1989). [3] Doing Business, The World Bank, Washington DC. http://rru.worldbank.org/doingbusiness [4] Easterly, William and Ross Levine, "Africa's Growth Tragedy," Quarterly Journal of Economics, 112 (1997) 1203-1250. [5] Gerxhani, Klarita, "The Informal Sector in Developed and Less Developed Countries: A Literature Survey," Public Choice, 120, 267-300 (2004). [6] Gwartney, James and Robert Lawson, "Economic Freedom of the World - 2002 Annual Report," The Fraser Institute (2002). [7] International Country Risk Guide ­ ICRG, Brief guide to the rating system, ICRG (1999) http://www.icrgonline.com [8] KPMG, Corporate Tax Rate Survey, March 1998 ­ January 2003. [9] Loayza, Norman, "The Economics of the Informal Sector: A Simple Model and Some Empirical Evidence from Latin America," Carnegie-Rochester Conference Series on Public Policy, 45, 129-62 (1996). [10] Loayza, Norman, Ana María Oviedo, and Luis Servén, "Regulation and Macroeconomic Performance," World Bank Policy Research Working Paper No. 3469 (2005a). [11] Loayza, Norman, Ana María Oviedo, and Luis Servén, "Regulation and Firm Dynamics," mimeo, The World Bank (2005b). [12] Maloney, William, "Informality Revisited," World Development, 32(7), 1159-78 (2004). [13] Nicoletti, Guiseppe, Stefano Scarpetta and Olivier Boylaud, "Summary Indicators of Product Market Regulation With an Extension to Employment Protection Legislation," Economics Department Working Paper No. 226, Organisation for Economic Co-operation and Development (2000). [14] O'Driscoll, Gerald, Edwin Feulner and Mary O'Grady, 2003 Index of Economic Freedom, The Heritage Foundation and The Wall Street Journal (2003). [15] Rama, Martin and Raquel Artecona, "A Database of Labor Market Indicators Across Countries", unpublished, The World Bank, Washington DC (2002). [16] Schneider, Friedrich, "The Size of the Shadow Economies of 145 Countries all over the World: First Results over the Period 1999 to 2003," IZA DP No. 1431 (2004). [17] Schneider, Friedrich and Dominik H. Enste, "Shadow Economies: Size, Causes, and Consequences," Journal of Economic Literature, 38, 77-114 (2000). 12 Tables and Graphs Table 1: Correlation Coefficients Between Regulation Indices Financial Contract Entry Trade Bankruptcy Labor Fiscal Governance Markets Enforcement Entry 1 Financial Markets 0.66*** 1 Contract Enforcement 0.66*** 0.58*** 1 Trade 0.63*** 0.73*** 0.62*** 1 Bankruptcy 0.52*** 0.44*** 0.53*** 0.51*** 1 Labor 0.39*** 0.1 0.44*** 0.05 0.14 1 Fiscal -0.50*** -0.27** -0.57*** -0.33*** -0.38*** -0.16 1 Governance -0.70*** -0.64*** -0.79*** -0.79*** -0.57*** -0.14 0.51*** 1 Product Labor Fiscal Overall Governance Market Product Market 1 Labor 1 0.26** Fiscal 1 -0.49*** -0.16 Overall 1 0.97*** 0.42*** -0.31*** Governance -0.86*** -0.18 0.52** -0.80*** 1 Notes: *,**, and *** denote significance at the 10%, 5%, and 1% level, respectively. Source: Authors' estimation 13 Table 2: Descriptive Statistics Years: 1990-2003, 72-75 countries (a) Univariate statistics Variable Mean Median Standard Dev. Minimum Maximum Growth rate of GDP per capita (%) 1.53 1.78 1.67 -2.71 6.22 Informal sector output (% of GDP) 33.64 34.55 14.69 8.60 67.83 Log of GDP per capita in logs in 1990 7.83 7.60 1.61 4.98 10.74 Log of secondary enrollment rate in 1990 3.86 3.97 0.69 1.89 4.78 Log of private domestic credit / GDP in 1990 3.42 3.35 0.93 0.68 5.29 Overall regulation index 0.44 0.46 0.12 0.16 0.69 Product market regulation index 0.42 0.45 0.18 0.08 0.77 Fiscal regulation index 0.53 0.52 0.19 0.10 0.92 Labor regulation index 0.47 0.48 0.16 0.13 0.78 Governance index 0.52 0.46 0.26 0.05 1.00 (b) Correlation coefficients between dependent variables, control variables, and regulation indices Log of GDP per Log of secondary Log of private Growth rate of Informal sector Overall regulation Product market Fiscal regulation Labor regulation capita in logs enrollment rate in domestic credit / GDP per capita output (% of GDP) index regulation index index index in 1990 1990 GDP in 1990 Growth rate of GDP per capita 1 Informal sector output (% of GDP) -0.32*** 1 Log of GDP per capita in logs in 1990 0.33*** -0.69*** 1 Log of secondary enrollment rate in 1990 0.40*** -0.55*** 0.83*** 1 Log of private domestic credit / GDP in 1990 0.31*** -0.63*** 0.73*** 0.55*** 1 Overall regulation index -0.41*** 0.62*** -0.80*** -0.67*** -0.66*** 1 Product market regulation index -0.42*** 0.67*** -0.87*** -0.73*** -0.69*** 0.97*** 1 Fiscal regulation index 0.17 -0.51*** 0.49*** 0.49*** 0.41*** -0.31*** -0.49*** 1 Labor regulation index -0.14 0.24** -0.08 -0.11 -0.23** 0.42*** 0.26** -0.16 1 Governance index 0.35*** -0.78*** 0.86*** 0.68*** 0.65*** -0.80*** -0.86*** 0.51*** -0.14 Notes: *,**, and *** denote significance at the 10%, 5%, and 1% level, respectively. Source: Authors' estimation 14 Table 3. Economic Growth and Burden of Regulation Sample: 73-75 countries, 1990 - 2000 Method of estimation: Ordinary Least Squares Dependent variable: Economic growth: Average annual growth rate of GDP per capita, 1990-2000 A: Basic specification Type of regulation index: Overall Product Market Labor Fiscal [1] [2] [3] [4] Regulation -5.71 -5.37 -1.71 0.75 (index ranging from 0 to 1, higher meaning more regulated) -2.43 -2.67 -1.86 0.61 Control Variables: Initial GDP per capita -0.52 -0.67 -0.17 -0.26 (in logs) -2.22 -2.65 -0.78 -1.15 Initial education 0.53 0.46 0.47 0.52 (log of secondary enrollment rate in 1990) 1.23 1.14 1.02 1.03 Initial financial depth 0.22 0.22 0.24 0.34 (log of private domestic credit / GDP in 1990) 0.80 0.75 0.84 1.21 Sub-Saharan Africa dummy -1.71 -1.80 -1.80 -1.71 (1 if country belongs to Sub-Saharan Africa and 0 otherwise) -3.59 -3.86 -3.53 -3.12 Constant 5.70 6.91 1.44 0.34 2.78 3.03 1.06 0.24 No. of observations 75 75 73 75 R-squared 0.34 0.36 0.29 0.28 B: With governance interactions Type of regulation index: Overall Product Market Labor Fiscal [1] [2] [3] [4] Regulation -7.68 -7.70 -4.14 0.63 (index ranging from 0 to 1, higher meaning more regulated) 2.13 -3.69 -2.79 0.39 Governance-Regulation interaction 6.80 7.45 5.02 0.21 (Governance index * Regulation index) 2.13 2.64 2.31 0.12 (Gov. index ranges from 0 to 1, higher meaning better governance) Control Variables: Initial GDP per capita -0.81 -0.87 -0.47 -0.28 (in logs) -3.11 -3.51 -1.95 -0.92 Initial education 0.57 0.47 0.44 0.53 (log of secondary enrollment rate in 1990) 1.51 1.33 1.09 1.07 Initial financial depth 0.27 0.29 0.22 0.34 (log of private domestic credit / GDP in 1990) 0.86 0.90 0.68 1.20 Sub-Saharan Africa dummy -1.71 -1.72 -1.94 -1.71 (1 if country belongs to Sub-Saharan Africa and 0 otherwise) -3.75 -3.78 -4.31 -3.09 Constant 7.10 7.83 3.98 0.46 3.26 3.32 2.57 0.22 No. of observations 75 75 73 75 R-squared 0.39 0.43 0.35 0.28 P-value of Ho: sum of regulation coefficients = 0 0.79 0.92 0.52 0.57 Notes: a) Standard errors are robust to heteroscedasticity (Newey-West). b) t-Statistics are presented below the corresponding coefficient. Source: Authors' estimation 15 Table 4. Informality and Burden of Regulation Sample: 72 countries, 1990-2003 Method of estimation: Ordinary Least Squares Dependent variable: Informal sector output (% of GDP), 2000-2003 A: Basic specification Type of regulation index: Overall Product Market Labor Fiscal [1] [2] [3] [5] Regulation 21.67 21.61 17.03 -16.62 (index ranging from 0 to 1, higher meaning more regulated) 1.39 1.74 2.10 -1.96 Initial GDP per capita -5.04 -4.28 -6.25 -5.40 (in logs) -4.65 -3.20 -10.08 -6.10 Constant 63.49 58.07 74.45 84.69 4.32 3.80 10.37 15.83 No. of observations 72 72 72 72 R-squared 0.49 0.50 0.52 0.52 B: With governance interactions Type of regulation index: Overall Product Market Labor Fiscal [1] [2] [3] [4] Regulation 41.21 37.87 39.39 7.73 (index ranging from 0 to 1, higher meaning more regulated) 2.55 2.87 3.51 0.63 Governance-Regulation interaction -65.84 -50.16 -48.76 -42.91 (Governance index * Regulation index) -3.37 -3.03 -3.74 -3.03 (Gov. index ranges from 0 to 1, higher meaning better governance) Control Variables: Initial GDP per capita -2.52 -3.01 -3.31 -1.93 (in logs) -1.93 -2.22 -3.09 -1.33 Constant 48.41 50.18 52.45 57.50 3.28 3.38 5.13 5.53 No. of observations 72 72 72 72 R-squared 0.56 0.54 0.59 0.57 P-value of Ho: sum of regulation coefficients = 0 0.22 0.44 0.25 0.00 Notes: a) Standard errors are robust to heteroscedasticity (Newey-West). b) t-Statistics are presented below the corresponding coefficient. Source: Authors' estimation 16 Figure 1: The Informal Economy and Growth IRL 6 Correlation: -0.32*** KOR CHL MYS 4 DOM LKA capita IND THA ARG per CRI BGDTUN NORIDN PAN IRNPRT BWA SLV NLD AUS EGY URY SYRISR ESP PNG BFA PER GDP 2 USAGBR GRCMEX TUR AUT DNK BEL CANFIN GHA of FRA MWI SWE ITA PAK GTM BRA BOL JPN COL rate JOR SEN ZWE MAR PHL HND 0 CHE NIC ZAF VEN NGA ECU JAM CIV PRY Growth KEN MDG TGO COG NER ZMB -2 HTI 0 20 40 60 80 Informal sector in percent of GDP Note: *** denotes significance at the 1% level. 17 Figure 2: GDP per Capita vs. Regulation Indices Overall Regulation and GDP Product Market Regulation and GDP 12 Correlation: -0.81*** 12 Correlation: -0.87*** CHE JPN CHE JPN DNK NOR DNK NOR USA NLD SWEAUT ISLFIN BEL FRA NLD SWE USA FIN BEL ISL AUT FRA 10 GBR CAN AUS IRL ITA 10 GBRAUS CANIRL ITA ESPISR ta at ESP ISR KOR PRT GRC PRT GRCKOR capi ARG apic ARG URY URY MYS CHL TTO BRA CHLMYS TTO BRA per ZAF ZAF 8 BWA CRI MEX VEN per BWA MEX CRI VEN TUR PAN 8 PAN THA TUR JAM COLPER TUN JAMTHACOL PER TUN PRY SLV PRY SLV DOM GTM DOMJOR ECU IRN GTM JOR GDP IRNECU MAR GDP MAR PHL PHLPNG EGY PNG IDN EGY IDN BOL BOL LKA CIV COG LKA HND CIV SYR COG HND SYR Log ZWE Log ZWE SEN SEN PAK PAK 6 ZMB 6 ZMB NIC GHA IND NIC HTI GHA IND GMB HTI KEN BGD GMB TGO KEN BGD TGO NGA NGA NERMDG MDG BFA NER BFA MWI MWI 4 4 .2 .3 .4 .5 .6 .7 0 .2 .4 .6 .8 Overall regulation index Product market regulation index Labor Regulation and GDP Fiscal Regulation and GDP 12 Correlation: -0.09 12 Correlation: 0.49*** JPN CHE CHE JPN DNK NOR NOR DNK USA AUT FRA NLDBELSWE FIN ISL USA SWENLD FRA AUT FIN BEL 10 GBR CANAUS IRL ITA 10 IRLGBR AUS CAN ITA ta ISR ESP at ESP ISR KOR GRC PRT KOR GRC PRT ARG capi apic ARG URY URY MYS TTO CHL BRA CHL MYS TTO BRA per ZAF ZAF 8 BWA CRI VEN MEX per CRI VEN BWA MEX TUR PAN 8 PAN THA THA TUR JAM TUN COL PER JAMPER COL TUN IRN DOM SLVPRY PRYSLV JOR GDP ECU JOR DOMGTM ECU IRN MAR GTM GDP MAR PHL PHL EGY PNG IDN EGY IDN PNG BOL BOL SYR COG LKA CIV COG LKA CIV SYR Log HND HND ZWE Log ZWE SEN SEN PAK PAK 6 NIC 6 NICZMB GHA ZMB IND HTI HTI IND KEN BGD TGO BGDGMBTGO KENGHA NGA MDG NGA BFA NER BFA MDG NER MWI MWI 4 4 0 .2 .4 .6 .8 0 .2 .4 .6 .8 1 Labor regulation index Fiscal regulation index Governance and GDP 12 Correlation: 0.87*** JPN CHE NORDNK BEL FRA AUT USA NLD SWE ISL FIN 10 ITA IRL GBRAUS CAN at ISR ESP KOR GRC PRT capi ARG URY BRA TTOMYS CHL per ZAF 8 MEX BWA VEN CRI PAN TUR P THA COL PER JAM D TUN PRY DOM GTM SLV ECUIRNJOR G MAR IDN EGY PHL BOL PNG COG CIVSYR LKA Log HND ZWE SEN PAK 6 HTI NIC GHA ZMB IND TGO BGD KEN GMB NGA MDG NER BFA MWI 4 0 .2 .4 .6 .8 1 Governance quality index Note: *, **, and *** denote significance at the 10%, 5%, and 1% level respectively. 18 Figure 3: Growth of GDP per Capita vs. Regulation Indices Overall Regulation and Growth Product Market Regulation and Growth 6 IRL Correlation: -0.41*** 6 IRL Correlation: -0.42*** KOR KOR CHL CHL MYS MYS 4 DOM 4 DOM capita LKA capita LKA THA IND THA IND ARG ARG per TUN TUN CRI BGD per CRI BGD NOR IDN PAN NOR P TTOPAN IDN BWA IRN P PRT BWA IRN AUSNLD PRTTTOSLV SLV ESP ISR URY PNG EGY URY EGY BFA SYR NLD AUS ESP ISR PNG SYR BFA USA GBR PER GBR PER GD 2 2 DNK USA DNK GRC TUR CAN BEL TUR GRC BEL FIN AUT GHA MEX GD CAN FIN AUT MEXGHA ISL ISL of SWE ITA FRA GTM PAK MWI FRA MWI BOL of SWE ITA GTM PAK BRA BRA BOL JPN JPN COL JORSEN ZWE COL ZWE SEN rate PHLHND MAR rate JORPHL MAR HND th 0 CHE CHE NIC GMB th 0 NIC ZAF NGA VEN ZAF NGA VENGMB JAM ECU JAM ECU CIV CIV PRY PRY Grow KEN Grow KEN MDG MDG COG COG NER TGO TGO NER -2 ZMB -2 ZMB HTI HTI .2 .3 .4 .5 .6 .7 0 .2 .4 .6 .8 Overall regulation index Product market regulation index Labor Regulation and Growth Fiscal Regulation and Growth 6 IRL Correlation: -0.14 6 IRL Correlation: 0.17 KOR KOR CHL CHL MYS MYS 4 DOM 4 DOM capita LKA capita LKA IND THA THA IND ARG ARG per BGD TUN TUN CRI per BGD CRI NOR NOR P TTO IDN PAN IDN PAN TTO BWA IRN PRT PRT SLV P SLV BWA IRN ISR SYR URY AUS PNG NLD EGY ESP URY AUSESP GBR BFA PER PER PNG GBR EGYNLDISR SYR GD 2 USA TUR 2 BFAUSA AUT DNK GRC TURGRC AUT DNK GHACAN BEL BEL FIN MEX GD MEX GHA FIN CAN ISL of FRA PAK MWIGTM SWE FRA BOL ITA of BOL GTM PAKMWI SWE ITA BRA BRA JPN JPN SEN COL COL SEN rate ZWE JOR JOR ZWE MAR PHL rate HND HNDPHL MAR th 0 CHE CHE NIC th 0 GMB NIC JAMZAF NGA VEN VEN ECU ECUNGA ZAF JAM CIV CIV PRY PRY Grow KEN Grow KEN MDG MDG NER TGO COG TGO COG NER -2 ZMB -2 ZMB HTI HTI 0 .2 .4 .6 .8 0 .2 .4 .6 .8 1 Labor regulation index Fiscal regulation index Governance and Growth Correlation: 0.35*** IRL 6 KOR CHL taipacrep MYS 4 DOM LKA INDTHA BGD TUN ARG CRI NOR P IDN PAN PRT SLV TTOIRNBWA D EGY URY AUS ESP NLD PER SYR BFA PNG ISR USA GBR Gfo 2 TUR GRC BEL DNK GHA MEX AUT CAN FIN ISL PAK GTMMWIBRA FRA BOL ITA SWE JPN te COL ZWE SEN ra PHL JOR HND MAR th 0 CHE GMB NIC wor NGA JAM ECUZAF VEN CIV PRYKEN G MDG COG NER TGO -2 ZMB HTI 0 .2 .4 .6 .8 1 Governance quality index Note: *, **, and *** denote significance at the 10%, 5%, and 1% level respectively. 19 Figure 4: Informality vs. Regulation Indices Overall Regulation and Informality Product Market Regulation and Informality 80 Correlation: 0.62*** 80 Correlation: 0.66*** ) ) BOL P P BOL PAN PAN GD ZWE ZWE 60 PER GD PER NGA 60 NGA of HTI of HTI THA THA (% URY GTM URY GTM ZMB HND (% HND COG ZMB COG SLV SLV LKA NIC SEN LKA NIC SEN PHL CIV PHL CIV GHA NER BFA GHA NER BFA COL MWI BRA COL MWI BRA output 40 MDG MDG TUN output 40 TUN JAM PNGBGDPAK TGO TGO MAR JAM PAK MARPNG EGY BGD KEN EGYECU VEN KEN VENECU BWATUR DOM TUR BWA DOM MYS MEX MYS MEX PRY KOR ZAF GRC PRY sector GRCKORZAF ITA ARG CRI sector ITA ARG CRI IND IND ISR BEL ESP ISRPRT BEL ESP PRT CHL IDN JOR IDN 20 20 CHL JOR IRN SYR FIN SWENOR IRN SYR FINSWE NOR DNK DNK CAN IRL FRA CANIRL FRA Informal GBR AUSNLD Informal GBR NLD AUS AUT JPN AUTJPN USA CHE USA CHE 0 0 .2 .3 .4 .5 .6 .7 0 .2 .4 .6 .8 Overall regulation index Product market regulation index Labor Regulation and Informality Fiscal Regulation and Informality 80 Correlation: 0.24** 80 Correlation: -0.51*** ) ) BOL P P BOL PAN PAN GD ZWE PER 60 GD PER ZWE NGA 60 NGA of HTI of HTI THA THA (% URY GTM GTM URY ZMB HND (% HND COG ZMB COG SLV SLV LKA SEN NIC NICLKA SEN CIV PHL PHL CIV GHA NER COL MWIBFA NER GHA BRA COL BFABRAMWI output 40 MDG MDG TUN output 40 TUN PNG JAM MAR PAK TGO PAK BGD BGD JAMTGO PNG MAR KENBWA ECU EGY VEN ECU VEN KEN EGY DOM TUR DOM BWA TUR MYS MEX MYS MEX PRY PRY sector ZAF KOR GRC KOR GRC ZAF CRI ITA ARG sector CRI ARG ITA IND IND ISR ESP PRT ESP PRT ISR IDN BEL IDN BEL 20 SYR IRNCHL JOR CHL JOR SYR NOR SWE 20 NORIRN DNK FIN FIN SWEDNK CAN IRL IRL CAN AUS FRA AUS FRA Informal GBR NLD Informal GBR NLD AUTJPN AUT JPN USA CHE CHE USA 0 0 0 .2 .4 .6 .8 0 .2 .4 .6 .8 1 Labor regulation index Fiscal regulation index Governance and Informality 80 Correlation: -0.78*** ) P BOL D PAN G PER ZWE 60 NGA of HTI %( THA GTM HND URY COG ZMB NIC put SLVSENLKA CIV PHL NER GHA BFA COL MWIBRA out 40 MDG TGO TUN PAK JAM BGD PNG MAR or KENEGY ECU VEN TURDOM BWA MEX MYS PRY ZAF sect KOR GRC ARG ITA CRI al IND ISR ESPBEL PRT m IDN 20 SYR IRNJOR CHL NORDNK SWE or FIN FRA IRL CAN nfI GBRAUS NLD JPN AUT USA CHE 0 0 .2 .4 .6 .8 1 Governance quality index Note: *, **, and *** denote significance at the 10%, 5%, and 1% level respectively. 20