__VP I7 2 `L POLICY RESEARCH WORKING PAPER 17-27 The Economics An increase in the size of the informal sector hurts growth of the Inform al Sector by reducing the availability for public services for everyone in . . . - - ~~~~~~~~~~~~the economy and increasing A Simple Model and Some Empirical tn the number of activities that Evidence from Latin America use spime existing public services less efficiently or not Norman A. Loayza at all. The World Bank Policy Research Department Macroeconomics and Growth Division February 1997 POLICY RESEARCH WORKING PAPER 1727 Summary findings Loayza presents the view that informal economies arise countries - identifying the size of the informal sector to when governments impose excessive taxes and latent variable for which multiple causes and indicators regulations that they are unable to enforce. exisr. Loayza studies the determinants and effects of the 'The results suggest that: informal sector using an endogenous growth model * The size of the informal sector depends positively whose production technology depends essentially on on proxies for tax burden and restrictions on the labor congestable public services. In this model, changes (in market. both policy parameters and the quality of government * It depends negatively on a proxy for the quality of institutions) that promote an increase in the relative size governiment institutions. of the informal economy will also generate a reduction in * An increase in the size of the informal sector hurts the rate of economic growth. growtlh by reducing the availability of public services for Using data from Latin American countries in the early everyone in tihe economy and by increasing the number 1990s, Loayza tests some of the model's implications and of activities that use some existing public services less estimates the size of the informal sector in these efficiently or not at all. This paper - a product of the Macroeconomics and Growth Division, Policy Research Department - is part of a larger effort in the department to examine the determinants of economic growth. Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington, DC, 20433. Please contact Rebecca Martin, room NI 1-059, telephone 202- 473-9026, fax 202-522-3518, Internet address rmartinl(@'worldhank.org. February 1997. (52 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quic kly, even if the presentations are less than fully polished. 'The papers carry the names of the authors and should be cited accordingly. T7hc findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily retnesent the Euiw of the World Bank, its Executive Directors, or the countries they represent. Produced by the Policy Rese;rch D)ssenmination C:enter THE ECONOMICS OF THE INFORMAL SECTOR A Simple Model and Some Empirical Evidence from Latin America Norman V. Loayza' The World Bank, Washington, D.C. 20433 'Excellent research assistance by Daniel Wolfenzon and Wanhong Hu is gratefully acknowledged. I am grateful for feedback provided by participants at the Carnegie-Rochester Conference on Public Policy in Pittsburgh, in November 1995. 1 specially acknowledge the comments from Patrick Asea, my discussant at the Carnegie-Rochester Conference, and Allan Meltzer, the Conference's organizer. I also benefited greatly from the comments of Pierre- Richard Agenor, Alberto Alesina, Cevdet Denizer, David Dollar, Edward Glaeser, Aart Kray, Philip Lane, Luis Serven, Klaus Schmidt-Hebbel, and participants at the World Bank Macroeconomics and Growth Seminar. INTRODUCTION The presence of large informal sectors is one of the most important characteristics of developing countries. The study of the informal economy is important inasmuch as it sheds light on how the state's regulatory and enforcement systems affect economic performance. There are a few different definitions and approaches to the study of the informal sector in the development economics literature.' This paper's approach follows the work by Hernando de Soto (1989)2, according to which the informal sector is defined as the set of economic units that do not comply with government-imposed taxes and regulations. As Portes, Castells, and Benton (1989, p. 12) put it, "The informal economy is ... a process of income-generation characterized by one central feature: it is unregulated by the institutions of society, in a legal and social environment in which similar activities are regulated. " The informal sector arises when excessive taxes and regulations are imposed by government that lack the capability to enforce compliance. An excessive regulatory system makes the formal economy unattractive by imposing high entry costs to legality -through license fees and registration requirements- and high costs to remain legal -through taxes, red tape, and, among others, labor and environmental regulations. However, escaping taxes and regulations is not costless. An informal status entails many disadvantages. Informal activities are subject to stiff penalties in the form of fines or capital confiscation. Furthermore, because of their illegal status, informal agents do not fully enjoy public services, particularly those that allow them full, enforceable property -1- rights over their capital and output. This has a number of negative consequences: First, informal producers are poorly protected by the police and the judicial courts from crimes committed against their property. Second, since they lack the capacity to enter into legally binding contractual obligations, their access to capital markets, for financial, insurance, and corporative purposes, is seriously impaired. Lastly, they find obstacles to use other public services such as social welfare, skill training programs, and government-sponsored credit facilities. The state, as the institution that both monitors the regulatory and enforcement systems and administers public services, plays a crucial role in the formation of informal economies. If state officials, or interest groups related to them, profit in some way from the presence of the informal sector, they will create an environment that makes informality attractive or simply unavoidable. To the extent that excessive regulations are created to benefit particular interest groups and not society in general, the presence of the informal sector is a result of the failure of political institutions to protect and promote an efficient market economy. This paper attempts to organize the current information on the determinants of the informal sector and its effect on economic growth through, first, a simple endogenous growth model and, second, empirical evidence from Latin America. The next section describes the main determinants and features of the informal sector.3 Then, the paper models the presence of the informal sector in the economy and its relationship to output growth within the framework of the endogenous growth literature,4 specifically, the work in which government's provision of public goods and services is considered explicitly, as -2- in Barro (1990) and Barro and Sala-i-Martin (1992). The empirical section of the paper uses data from Latin American countries to test some of the implications of the model and to provide estimates of the relative size of the informal sector throughout these countries. THE RATIONALITY OF BEING INFORMAL Economic units choose to be partially or completely informal by weighing the costs and benefits a legal status entails and considering their particular institutional and resource constraints. In this sense, the choice to be informal is a rational one, a fact which does not imply that some firms are not forced by their constraints to be either formal or informal. The costs and benefits of legality are now analyzed in detail. The presentation adopts de Soto's analytical framework as well as some of his reported evidence. De Soto studied the informal sector in Peru. Other researchers have applied his methodology to a variety of different countries. Chickering and Salahdine (1991) present evidence from selected underdeveloped Asian countries. Tokman (1992) offers evidence from Latin America and the Caribbean. These empirical findings also contribute to the following presentation. The Costs of Formality The costs of formality can be divided into costs to access the formal sector and costs to remain in the formal sector. Costs to access the formal sector. De Soto and his research group conducted various experiments to quantify the access costs. In one of them, they set up a small clothing factory in the outskirts of Lima and tried to register it legally. Four university -3- students were hired to do the necessary paperwork under the supervision of a lawyer specialized in Administrative Law. It was convened that no bribes would be offered unless there was no other means to proceed with the registration. During the months the experiment lasted, government officials asked for bribes ten times; in two cases, it was absolutely necessary to pay them. It took ten months to complete the registration procedure. Licenses and other requirements cost 195 dollars, and the loss in utilities caused by the ten-month waiting period was estimated at 1,037 dollars. In fact, the total cost of legal registration was equivalent to 32 times the minimum monthly salary. By way of comparison, Chickering and Salahdine (1991) report that a similar procedure takes three-and-a-half hours in Florida and four hours in New York. Tokman (1992) also finds high access costs to legality in other Latin American countries. Financial costs of entry, excluding required modifications in the business' premises, are estimated at an average of ten percent of annual profits; when modifications in the premises are required as part of the registration procedure, these financial costs rise significantly. Tokman finds that the average time to register a small firm in his group of Latin American countries is ten months, going from about one month (in Bolivia, Brazil, and Chile) to two years (in Guatemala). Given the long time involved in fulfilling business registration requirements, Tokman (1992, p.12) concludes that "... the combination of regulation inadequacy and bureaucratic inefficiency ... applies to most countries and particularly to [Ecuador, Guatemala, and Peru]." Costs to remain in the formal sector. Staying formal can also be very costly. De Soto finds that, in a sample of 50 small manufacturing firms, the costs of staying -4- formal represent an average of 348 percent of after-tax profits. De Soto reports that 22 percent of such costs are due to taxes, 5 percent due to higher public utility rates, and 73 percent due to regulations (mainly labor related) and bureaucratic requirements. The costs of staying formal can be divided into three broad categories: taxes, regulations, and bureaucratic requirements. Taxes on formal firms constitute a major source of government revenue, particular!y in developing countries. Since formal firms are registered with state organizations and, thus, can be audited with relative ease, they are attractive targets for taxation. This is especially true in countries that lack strong, well-equipped tax administrations to properly monitor individuals and informal firms. Burgess and Stern (1993) report that in developing countries, corporate income taxes represent 17.8 percent of total tax revenues, while individual income taxes, only 10.6 percent. In contrast, for industrial countries corporate income taxes account for only 7.6 percent of total tax revenues, while individual income taxes carry most of the weight with 27.7 percent. Confronted with a narrow base of formal firms, most underdeveloped countries have imposed, at least until recently, very high marginal tax rates. Regulations control the use of resources, the manner of production, and the distribution of output and profits. Common types of regulations are those related to environmental protection, allocation of imported inputs, consumer protection and quality control, financial capital availability, and workers' welfare. Of all types of regulations, those related to workers' welfare are the most restrictive and costly in underdeveloped countries (and in many developed countries as well). Regulations designed, in theory, to -5- improve workers' welfare appear in various forms, namely, minimum wages, fringe benefits (paid vacations and sick leave, indemnities, health insurance), social security, constraints on free hiring and dismissal, and protection to unions. Portes, Castells, and Benton (1989, p. 30) argue that "the best-known economic effect of the informalization process is to reduce the costs of labor substantially," costs which are mostly due to "indirect wages" such as benefits and social security contributions. Tokman writes that for small firms in Latin America, the additional costs related to labor regulations are the most important component of the permanency costs in the formal sector. Tokman (1992) reports that such regulations increase labor costs by an average of around 20 percent, which is about equally divided between benefits and social security contributions. Nipon (1991) estimates that informal firms in Thailand, by ignoring labor-protection laws, save about 13 to 22 percent of labor wages. Mazumdar (1976) cites the interesting example of the labor practices in the Bombay textile industry: Unions, enforcing government regulations, protected formal workers against salary decreases or dismissals and ensured social benefits for them. In response, textile companies kept the number of formal workers as low as possible; and when their business required a higher labor input, they would supplement the stable core of formal workers with casual day laborers, who were abundant in Bombay. Not surprisingly, these casual day workers, who constitute the informal labor force for the industry, were paid lower wages, had no job security, and enjoyed no fringe benefits. This example illustrates labor market conditions in many cities of the developing world. In most developing countries, capital is scarce relative to labor. This should -6- induce firms to choose labor-intensive technologies. However, because labor-employment regulations raise labor costs, formal firms in developing countries tend to be abnormally capital intensive. 5 Bureaucratic requirements (red tape and paper work) are also a significant cost of remaining formal. Alonzo (1991, pp. 48-49) reports that in the Philippines, "no matter how small the business, an owner needs an accountant and a lawyer to comply with all of the requirements." Chickering and Salahdine (1991, p. 191) write that in Egypt, "much of the country's entrepreneurial talent is consumed in circumventing the country's nightmare bureaucratic regulatory system." De Soto (1989) surveyed 37 formal firms operating in areas in which informal firms abound. He found that 40 percent of the administrative personnel working time is spent fulfilling the bureaucratic paper work imposed by the state. The Costs of Informality Informal enterprises face two kinds of costs: First, penalties when the informal activity is detected, and second, the inability to take full advantage of government- provided goods. Penalties for informal activities are usually stiff; very often, detected firms have to surrender a considerable part of their output or physical capital stock. De Soto (1989) finds that informal entrepreneurs pay between 10 to 15 percent of their gross income in bribes to corrupt government officials, whereas formal entrepreneurs pay an average of only 1 percent of gross income in bribes (without counting bribes used to become formal). In order to avoid being caught, firms scale down the size of their informal operations. In the case of purely informal firms, the efforts to avoid detection -7- prevent them from achieving economies of scale and from choosing an optimal capital- labor mix; this is so because larger and more physical capital-intensive firms are easier to detect. The second cost of informality is the inability to take full advantage of government- provided goods, in particular the legal and judicial system and the police. Since informal activities are illegal, informal businessmen cannot exercise full property rights over their capital and product. Therefore, contracts related to informal activities can not be enforced through the judicial system and, thus, their value and usefulness are greatly diminished. The inability to sign contracts enforceable through the courts creates uncertainty and increases the transaction and monitoring costs in all business dealings conducted by informal companies. This reduces investment that comes both from internal sources (retained earnings) and from capital markets. De Soto (1989) provides an interesting example of low investment from internal sources; he studies informal housing, that is, construction on land over which families have not yet secured a property title. De Soto finds that before obtaining their land titles, families invest as little as possible in building their houses and prefer investing in other durables; however, once the property titles are issued by the state, families shift their investment to build and improve their houses. Investment from capital markets is also severely affected by the lack of proper contracts. In fact, the inefficiency of capital markets is manifested in several ways: the high borrowing rates paid by informal firms, the relatively low value of informal physical capital, and the difficulty to transfer property and create common-stock corporations. De Soto (1989) points out that in Lima, in June 1985, the nominal borrowing rate for informal -8- firms was 22 percent monthly, whereas for formal firms of comparable size, it was 4.9 percent. Huq and Sultan (1991) report that in Bangladesh, in 1988, firms which depended on noninstitutional sources to meet their financial needs paid rates between 48 to 100 percent annually, whereas the borrowing rate from commercial banks was around 12 percent. The difficulty to transfer and mortgage property and create common-stock corporations limits the informal firms' ability to expand, manage their risk, and use more advanced technologies. The high cost of capital faced by informal firms coupled with their low cost of labor (due to their non-compliance with labor laws) induces them to be more labor intensive than their formal counterparts. As the costs of informality rise, the incentives for an enterprise to become formal become stronger. On the other hand, paradoxically, the higher these costs are, the more difficult it is for an informal enterprise to accumulate the wealth that would enable it to enter the formal sector. Credit constraints and the inability to form common-stock corporations prevent informal companies from growing and, thus, from being able to afford the access costs to the formal economy. A SIMPLE ENDOGENOUS GROWTH MODEL The following model attempts to organize some of the information presented in the previous section on the determinants of the informal sector and its effect on economic growth. To keep the model manageable, the paper ignores some aspects of informality that, although important, have been well studied in other papers, namely, the issues of capital-labor intensity, labor-market segmentation, and size of firms. These aspects of -9- informality have been examined by, among others, Chaudhuri (1989), Gupta (1993), Rauch (1991), and Loayza (1994). Setup6 The economy is populated by agents endowed with a (possibly different) starting level of a broad measure of capital, which is meant to include physical as well as human capital. They operate a technology that exhibits constant returns to capital (a la Rebelo 1991) to produce a single good, which can be either consumed or invested. Raw labor is not an input of production. We follow Barro and Sala-i-Martin (1992) in assuming that the capital rate of return depends on the available amount of public services relative to aggregate production. The basic production function is then given by Y. = A G k Oo, @n<, d2r8>0 aq ' ax axaq where ri(.) is the fraction of tax revenues available for the provision of public services. The fraction I-i(.) of tax revenues is in part wasted and in part used to finance the enforcement system. We assume that rj(.) is a positive function of the quality of government institutions (proxied by the parameter q). This captures the fact that higher- quality government institutions impose fewer wasteful regulations and administer fiscal resources more efficiently. Also, given that increasing enforcement effectiveness takes away fiscal resources, ri(.) is a negative function of enforcement strength (which, as explained below, is represented by the parameter A). The positive partial cross-derivative implies that the amount of resources it takes to raise enforcement strength decreases with the quality of government institutions. (The efficiency of governemnt institutions itself is assumed to be exogenous.) The ratio of public services to total production is then given by G 5 For given rl(.) and t, an increase in the relative size of the informal sector, I, lowers capital productivity for all agents in the economy. This is so because informal production congests public services but does not contribute to financing them. -12- We assume that the effective penalty rate, i, depends on both the strength of the enforcement system and the extent of public dissatisfaction with the informal sector (as argued below, this dissatisfaction is due to the fact that an increase in the relative size of the informal sector is most likely associated with a decrease in everyone's productivity.) The strength of the enforcement system affects the effective penalty rate because it determines the ability to detect and punish informal activities. As explained above, increasing enforcement effectiveness takes away fiscal resources, the more so the lower the quality of government institutions. The penalty rate is then given by it = T(X,I), O0, ->0 ax ai where X measures the strength of the enforcement system, and the relative size of the informal sector, I, measures public dissatisfaction with the effects of informality on capital's rate of return. Having the effective penalty rate partially depend on the size of the informal sector is a simple way to endogenize public policy in the face of informality (although there is no claim that such policy is optimal.) A simple functional form that conforms with equation (6), additionally presenting positive interaction between the parameters X and I, is the following: 11 = XI (7) -13- Equilibrium We restrict ourselves to the study of an interior solution, that is, one where the model's parameters are such that both sectors, formal and informal, coexist in the economy. Then, given that there is free mobility across sectors, in equilibrium the formal and informal rates of return must be equalized at all times. This condition determines the relative size of the informal sector in equilibrium. From equations (2) and (7), C(1 ,))8a =(1-T) (8) Therefore,7 (9) where the sign above each parameter indicates the sign of the partial derivative of I with respect to this parameter. The following results concerning the determination of the informal sector's relative size are obtained from equation (9). When the tax rate and, thus, the incentive to evade taxes rise, the informal sector expands. If in the composition of public services, a larger share corresponds to those services not available to informal agents (e.g., police, judicial, and legal systems), then the equilibrium size of I drops. The relative size of the informal sector also decreases when enforcement strength rises. Given that an improvement in the quality of government institutions allows strengthening -14- enforcement without higher drain on fiscal resources, an increase in q is also likely to lead to a smaller informal sector. Finally, when public services are more productive relative to private services, making public services forgone by informal activities more important in production, the relative size of the informal sector is smaller. Given the equilibrium value for 1, the economy's net capital rate of return, r, is given by, r = [A (I1 -i)T'] IXf oq) I - xj,ki6 a)!] (10) The expression in the first set of brackets corresponds to the case when there is no informal sector. The rate of return in such case is first increasing and then decreasing in the tax rate. The informal sector, through its detrimental impact on the availability of public services, creates an additional negative effect of the tax rate on the capital rate of return. Utility Optimization Agents in the economy maximize the value of discounted utility subject to their budget constraint: Max U =f e Pt dt 0 (11) subject to k1(t) = y1(t) - ci(t) = rki(t) - c,(t) -15- where p is the constant rate of time preference. We follow the common practice of assuming that the instantaneous utility function has a constant intertemporal elasticity of substitution, which is equal to 1/0 in equation (11). As in other Ak growth models, the rate of return, r, is independent of the path of capital accumulation. The first-order and transversality conditions imply the following constant rate of consumption growth: t ) = y = !(r-p) (12) Growth As in the Rebelo (1991) Ak growth model, there are no transitional dynamics in this model. The growth rates of aggregate capital (K), aggregate production (1), as well as formal (Y F) and informal (Y' ) production, are constant and equal to the consumption growth rate, y.8 The economy's long-run growth rate depends on the technology, preference, and policy parameters; in this sense, the model is one of "endogenous" growth. From equations (10) and (12), we obtain an expression for the economy's growth rate: y = > i[A(l_T)a] |rl|,q|1-(P (13) As the quality of government institutions improves (higher q), the growth rate rises because a larger share of tax revenues is allocated to finance public services. As explained -16- above, an improvement in the quality of government institutions can also lead to a stronger, less costly enforcement system and, therefore, to a smaller informal sector; this results in less congestion of public services and, thus, higher growth. A decrease in the amount of public services available to informal agents (lower 6) also improves growth by reducing congestion of public services due to informality. The effect of strengthening enforcement on the growth rate is ambiguous. On the one hand, it decreases congestion of public services due to informality; but on the other hand, it takes away fiscal resources that could be used to finance public services. However, given a standard cost function for enforcement (e.g., U-shaped average cost curve), strengthening enforcement when it is initially at a small level will produce a congestion-reduction effect that outweighs the resource-cost effect, thus increasing the economy's growth rate. The effect of an increase iri the tax rate on growth, discussed in the next section, can also be positive or negative: even though an increase in the tax rate both induces more public-service congestion due to informality and reduces the private net rate of return, it may also lead to a larger amount of public services. Optimal Tax Policy To examine optimal tax policy, we compare this model with the Barro and Sala-i- Martin, 1992 (henceforth B-SM) model, in which the informal sector is not present. The optimal tax rate when public services are subject to congestion in the B-SM model is given by -17- * a UB-S =I + a (14) It can be shown that in the present model, under certain parameter conditions9, the optimal tax rate involves some informality and is related to the other parameters of interest as follows,' + + r = (a,X,5) (15) t 0 (-I>0) (1-A)6a+t-l1< 0 (=I<1) 8. We assume that the technology, policy, and preference parameters are such that P >r> p 1-0 The second inequality ensures positive growth, and the first one ensures that attainable utility is bounded and the transversality condition holds (see Barro and Sala-i-Martin, 1995). 9. If 1-6 < a1/(a+X+aX), the growth-maximizing tax rate implies some informality. -33- Otherwise, that is, if 1-8" >aX/(a+Xl+aħ), the optimal tax rate brings about a fully formal economy. We assume that the first inequality holds. 10. In general, it is not possible to obtain an explicit solution for t+. However, for the case when X = 1 (maximum strength of the enforcement system), T* takes a simple form: t*=c/(1 +2a). The comparative statics results presented in equation (15) for the general case are obtained applying the implicit function theorem. 11. From 1993 to the present, a few countries (notably Peru) have undertaken an accelerated pace of market-oriented reforms. Given that the period of estimation considered in this paper is the early 1990's, the estimated results may not apply to the recent experience of such countries. 12. For a good survey on different approaches to the estimation of the informal sector, see Gupta and Gupta (1984). 13. It would have been preferable to use the average marginal corporate tax rate as the proxy for tax burden; unfortunately, data on tax revenue by rates was unavailable. Nevertheless, the highest tax rate is not only a good measure of the level of tax rates but also of their dispersion. 14. The appendix presents the data used in the paper and their sources. 15. In order to remove the indeterminacy of the structural coefficients, the coefficient on the VAT evasion rate was set equal to one; therefore, a t-test can not be applied to this coefficient. Setting the coefficient on the other indicator equal to one produced essentially the same results. 16. The average growth rate was calculated using the least-squares method, in order to -34- make use of the observations for all years in the period. -35- REF'ERENCE LIST Alonzo, R. (1991) The Informal Sector in the Philippines. The Silent Revolution. Eds. A. Chickering and M. Salahdine. International Center for Economic Growth, San Francisco. Barro, R. (1990) Government Spending in a Simple Model of Endogenous Growth. Journal of Political Economy, October, supplement. Barro, R., and X. Sala-i-Martin (1992) Public Finance in Models of Economic Growth. The Review of Economic Studies, October. Barro, R., and X. Sala-i-Martin (1995) Economic Growth. McGraw-Hill, Inc. Bentler, P.M., and D.G. Bonett (1980) Significance Tests and Goodness of Fit in the Analysis of Covariance Structures. Psychological Bulletin, 88: 588-606. Bollen, K.A. -36- (1986) Sample Size and Bentler and Bonett's Nonnormed Fit Index. Psychometrika, 51: 375-377. Braun, J., and N. Loayza (1994) Taxation, Public Services, and the Informal Sector in a Model of Endogenous Growth. Policy Research Working Paper No. 1334, The World Bank, July. Burgess, R., and N. Stern (1993) Taxation and Development. Journal of Economic Literature, Vol. 31, June. Chaudhury, T. (1989) A Theoretical Analysis of the Informal Sector. World Development, March. Chickering, A., and M. Salahdine (1991) Introduction and The Informal Sector Search for Self-Governance. The Silent Revolution. Eds. A. Chickering and M. Salahdine. International Center for Economic Growth, San Francisco. De Grazia, R. -37- (1982) Clandestine Employment: A Problem of Our Times. The Underground Economy in the United States and Abroad. Eds. V. Tanzi, D.C. Heath and Company. Lexington, Massachusetts. De Soto, H. (1989) The Other Path. Harper & Row, New York. Frey, B., and H. Weck-Hanneman (1984) The Hidden Economy as 'Unobserved Variable'. European Economic Review, 26: 33-53. Gupta, M. (1993) Rural-Urban Migration, Informal Sector, and Development Policies: A Theoretical Analysis. The Journal of Development Economics, June. Gupta, P., and S. Gupta (1984) Black Economy: A Review of Methodologies. The Unsanctioned Economy. Huq, M., and M. Sultan (1991) 'Informality' in Development: The Poor as Entrepreneurs in Bangladesh. -38- The Silent Revolution. Eds. A. Chickering and M. Salahdine. International Center for Economic Growth, San Francisco. Joreskog, K., and A. Goldberger (1975) Estimation of a Model with Multiple Indicators and Multiple Causes of a Single Latent Variable. Journal of the American Statistical Association, September. Joreskog, K., and D. Sorbom (1985) LISREL VI: Analysis of Linear Structural Relationships by Maximum Likelihood, Instrumental Variables, and Least Squares. Uppsala: University of Uppsala. Knack, S., and P. Keefer (1994) Institutions and Economic Performance: Cross-Country Tests Using Alternative Institutional Measure. IRIS Working Paper #109 (Economics and Politics, forthcoming). Loayza, N. (1994) Labor Regulations and the Informal Sector. Policy Research Working Paper No. 1335, The World Bank, July. Lucas, R. -39- (1988) On the Mechanics of Economic Development. Journal of Monetary Economics, July. Lubell, H. (1991) The Infonnal Sector in the 1980s and 1990s. Development Centre Studies, OECD, Paris. Mazumdar, D. (1976) The Urban Informal Sector. World Development, Vol. 4, No. 8. Nipon, P. (1991) The Informal Sector in Thailand. The Silent Revolution. Eds. A. Chickering and M. Salahdine. International Center for Economic Growth, San Francisco. North, D. (1981) Structure and Change in Economic History. Norton, New York. Olson, M. (1982) The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities. Yale University Press, New Haven. -40- Portes, A., M. Castells, and L. Benton (1989) World Underneath: The Origins, Dynamics, and Effects of the Informal Economy. The Informal Economy: Studies in Advanced and Less Developed Countries. Eds. A. Portes, M. Castells, and L. Benton. Johns Hopkins, Baltimore. Rama, M. (1995) Do Labor Market Policies and Institutions Matter? The Adjustment Experience in Latin America and the Caribbean. Mimeo, The World Bank, May (forthcoming in Labour, Basil Blackwell). Rauch, J. (1991) Modeling the Informal Sector Formally. The Journal of Development Economics, January. Rebelo, S. (1991) Long-Run Policy Analysis and Long-Run Growth. Journal of Political Econony, June. Romer, P. (1986) Increasing Returns and Long-Run Growth. Journal of Political Economy, October. -41- Silvani, C., and J. Brondolo (1993) An Analysis of VAT Compliance. Mimeo, Fiscal Affairs Department, International Monetary Fund, 1993. Shome, P. (1992) Trends and Future Directions in Tax Policy Reform: A Latin American Perspective. Bulletin of the International Bureau of Fiscal Documentation, September. Tokman, V. (1992) The Informal Sector in Latin America: From Underground to Legal. Beyond Regulation: The Informal Economy in Latin America. Ed. V. Tokman. PREALC, Lynne Rienner, Boulder, Colorado. The World Bank (1994) World Development Report. Washington, D.C. The World Bank (1995) World Development Report. Washington, D.C. The World Bank (1995) Averting the Old Age Crisis. Washington, D.C. -42- Appendix I Data Sources Causal Variables: 1. Corporate income tax rate. Data on corporate income tax rates in 1991 are taken from Shome (1992). When the country has more than one rate, the highest rate is used. Bolivia is a special case. In 1991, there was no tax on corporate income per se. A tax of 3 % of net worth was levied instead. In order to estimate the implied corporate income tax rate, the net-worth tax rate is divided by the real interest rate. For the calculation of the real interest rate, the neoclassical-growth-model relation between growth, real interest and depreciation rates is used. Using the parameter values presented in Barro and Sala-i- Martin (1995), the real interest rate in Bolivia is estimated at 8.1 %. 2. Labor market restrictions. The proxy for labor market restrictions is the ratio of the index of labor market regulations presented in Rama (1995) to real per capita GDP. The Rama index is divided by real per capita GDP in order to account for differences in labor productivity across countries. Rama considers eight types of labor-market regulations for 31 countries in Latin America and the Caribbean during the period 1980-92, when these regulations remained basically unchanged. The eight variables considered by Rama are number of ILO conventions ratified, number of days of annual leave with pay, number of days of maternity leave, social security contribution as a percentage of wages, government employment as a percentage of labor force, minimum wage as a percentage of average wage, severance pay and percentage of labor force in unions. After normalizing each variable, the Rama index is obtained by averaging over the eight variables. The real per capita GDP data correspond to the year 1990 and are taken from Summers-Heston Penn -43- World Table 5.6. 3. The strength of the enforcement system. The strength of the enforcement system is proxied by an average of three subjective indicators reported in International Country Risk Guide (ICRG) for the period 1990-92. The three indicators considered are quality of the bureaucracy, corruption in government, and rule of law. For the indicator quality of the bureaucracy, high scores indicate "autonomy from political pressure" and "strength and expertise to govern without drastic changes in policy or interruptions in government services", also existence of an "established mechanism for recruiting and training." For corruption in government, lower scores indicate "high government officials are likely to demand special payments" and "illegal payments are generally expected throughout lower levels of government" in the form of "bribes connected with import and export licenses, exchange controls, tax assessment, police protection, or loans". Rule of law "reflects the degree to which the citizens of a country are willing to accept the established institutions to make and implement laws and adjudicate disputes." Higher scores indicate "sound political institutions, a strong court system, and provisions for an orderly succession of power." Lower scores indicate "a tradition of depending on physical force or illegal means to settle claims." ICRG is a publication of Political Risk Services of Syracuse, NY and is cited in Knack and Keefer (1994). Indicatorg: 1. Value-added tax evasion rate. Data for this variable correspond to one of the years in the period 1990-93 for each country in the sample. The VAT evasion rate is calculated as one minus the tax compliance rate, where the tax compliance rate is calculated as -44- follows, VAT revenue compliance rate Potential base of VAT Average VAT rate The VAT evasion rate data are obtained from Silvani and Brondolo (1993) for Chile, Honduras, Guatemala, Panama, Uruguay, Argentina, Ecuador, Mexico, Bolivia, Colombia and Peru. For Brazil, Costa Rica and Venezuela, the compliance rates are not available. However, the revenue productivity (the percentage of GDP collected per point of the VAT rate) can be obtained from the IMF. Data on countries with both compliance rate and revenue productivity are used to fit a line relating these two measures. The relationship is then used to estimate the compliance rates for those three countries. 2. Fraction of labor force not contributing to social security. This variable is obtained from Averting The Old Age Crisis, the World Bank, 1995. The variable measures the number of workers not contributing to social security as a percentage of the labor force. Data are available for all Latin American countries in our sample. The years for which data are available, however, are not the same. For most countries the figures correspond to years around 1991, but for some the latest available year is in the mid 80's (e.g. Bolivia 1985, and Guatemala 1986). Infrastructure: 1. Electricity Consumption (KWH per person) in 1992. This is calculated as electricity production x (1 - system losses). Electricity production (KWH per person) and system -45- losses (% of total output) are obtained from the World Development Report 1995, the World Bank. 2. Telephone Mainlines (per 1,000 persons) in 1992. This variable is obtained from the World Development Report 1995, the World Bank. 3. Roads in good condition (km per million persons) in 1988. This is calculated as Road density (km per million persons) x Roads in good condition (% of paved roads). Data are from the World Development Report 1994, the World Bank. 4. Population with access to safe water (% of total) in 1990. Data are from the World Development Report 1994, the World Bank. 5. Public infrastructure index. It is the simple average of the standardized values of the above fou; indicators. All indicators are standardized by computing z-values, that is, dividing the deviations from the mean by the standard deviation. Growth Rate: The growth rates of real per capita GDP from 1980 to 1992 are calculated using the least- square method. Real per capita GDP data are from the World Bank National Accounts. -46- Table 1. The Size of the Informal Sector: Standardized and Absolute Values Standardized Value Absolute Value Country (% of GDP) Chile -1.342 18.2 Argentina -1.107 21.8 Costa Rica -1.012 23.3 Mexico -0.762 27.1 Venezuela -0.523 30.8 Ecuador -0.494 31.2 Colombia -0.240 35.1 Uruguay -0.236 35.2 Brazil -0.062 37.8 Honduras 0.516 46.7 Guatemala 0.754 50.4 Peru 1.243 57.9 Panama 1.518 62.1 Bolivia 1.746 65.6 Mean 0.000 38.8 Standard deviation 1.000 15.3 -47- Table 2. The Growth Effects of Public Infrastucture and the Informal Sector (t-statistics in parenthesis) Dependent Variable Growth Rate of Real Per Capita GDP Public (1980-92) Infrastructure Index (1) (2) (3) (4) (5) Size of the Informal Sector -0.8852 -0.8435 -0.5814 (-2.61) (-2.16) (-2.98) Public Infrastructure Index 0.5622 0.0718 (1.69) (0.24) Corporate Income Tax Rate -0.4436 (-1.09) Labor-Market Restrictions -0.4333 (-0.84) Strength and efficiency of 0.3598 government institutions (1.16) P-value (F-Statistic) 0.0233 0.0798 Adjusted R2 0.3584 0.1201 0.3068 0.2537 0.3381 Number of Observations 14 14 14 14 14 Note: The above t-statistics are computed using heteroskedasticity-corrected standard errors. Regression coefficients are standardized so that they reflect the change in the growth rate produced by a one-standard deviation of the explanatory variable. -48- Table 3. The Informal Sector and Other Determinants of Economic Growth (t-statistics in parenthesis) Dependent Variable Growth Rate of Real Per Capita GDP (1980-92) (1) (2) (3) (4) (5) Size of the Informal Sector -1.2482 -1.3165 -1.3303 -1.4555 -1.2245 (-3.33) (4.30) (-3.79) (-3.45) (-3.44) Real Per Capita GDP, 1980 -0.6418 -0.7956 -0.8906 -0.1523 -1.9685 (-2.04) (-2.92) (-2.80) (-3.84) (-4.36) Secondary School 0.4302 0.7341 0.8426 0.7118 Attainment, 1980 (1.86) (2.32) (2.66) (2.34) Average Tariff for -0.5226 -0.6138 -0.3439 Intermediate and Capital (-1.26) (-1.46) (-0.86) Goods, 1985 Average Inflation Rate, -0.2497 -0.6027 1980-92 (-0.46) (-1.60) Public Infrastructure Index, 1.1966 1990 (2.04) P-value (F-Statistic) 0.0046 0.0077 0.0305 0.0724 0.0365 Adjusted R2 0.4595 0.5119 0.5222 0.4735 0.6490 Number of Observations 14 14 12 12 12 Note: The above t-statistics are computed using heteroskedasticity-corrected standard errors. Regression coefficients are standardized so that they reflect the change in the growth rate produced by a one-standard deviation of the explanatory variable. -49- Figure 1. The Growth Rate in the Presence of the Informal Sector -50- , I , I , I i-al a s 1 -50- Figure 2. Results of the MIMIC Model Share of Variance Causes Indicators Explained by the Tax Burden 0.33 Informal Sector L j U ~~~.84) VAT Evasion Labor-Marke- 0.49 Size of Rate 0.751 Labor-Market 1 0.49 the 0 ___ ~ ~ 2-4) Inform al Restrictions (2-0i)1' Inoma | Sec tor 0.5o Percentage of (2..30) Non- Strength and agricultural 0.341 efficiency of W orkers Not government 0.42 Covered by institutions (-1.75) Social Security Period of Estimation: 1990-1993 Number of Observations: 14 Overall Model Fit: -- I: Constraints on residual covariance matrix implied by the model are valid X2(2) = 0.5095, p-value = 0.7751 -- Joreskog and Sorbom 1986: Goodness of Fit (GFI) = 0.9849 GFI Adjusted for Degree of Freedom = 0.8864 -- Bentler and Bonett 1980: Normed Index = 0.9810 -- Bollen 1986: Normed Index (Accounting for Degrees of Freedom) = 0.9051 -51- Figure 3. The Relation of Public Infrastructure and Growth with the Informal Sector (a) n~~~~~~~~~~~~~~~~~~~~~~~~~~' y =-0.8852x (-2.61) 3 2 .5 -1 1.5 -2 Size of the Informal Sector (b) ...................................................................... ...............................,.,... ...................................................... y = -0.5814x (-2.98) .......................................... - . ......................................................................................................1__ Size of the Informal Sector -52- Policy Research Working Paper Series Contact Title Author Date for paper WPS1705 The Polish Expenence with Bank Fernando Montes-Negret January 1997 T Ishibe and Enterprise Restructuring Luca Papi 38968 WPS1706 Monetary Policy during Transition: Martha de Melo January 1997 C. 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