The Economics of the Informal Sector: A Simple Model and Some Empirical Evidence from Latin America

An increase in the size of the informal sector hurts growth by reducing the availability for public services for everyone in the economy and increasing the number of activities that use some existing public services less efficiently or not at all. Loayza presents the view that informal economies arise when governments impose excessive taxes and regulations that they are unable to enforce. Loayza studies the determinants and effects of the informal sector using an endogenous growth model whose production technology depends essentially on congestable public services. In this model, changes (in both policy parameters and the quality of government institutions) that promote an increase in the relative size of the informal economy will also generate a reduction in the rate of economic growth. Using data from Latin American countries in the early 1990s, Loayza tests some of the model's implications and estimates the size of the informal sector in these countries - identifying the size of the informal sector to latent variable for which multiple causes and indicators exist. The results suggest that: ° The size of the informal sector depends positively on proxies for tax burden and restrictions on the labor market. ° It depends negatively on a proxy for the quality of government institutions. ° An increase in the size of the informal sector hurts growth by reducing the availability of public services for everyone in the economy and by increasing the number of activities that use some existing public services less 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.