Growth and the Informal Economy: A study on the effect of growth on the relative size of the informal economy in the developing world

Abstract: Throughout the developing world the informal (“black”) economy is a current issue. It constitutes a source of vulnerability to the people affiliated to it, and further hampers the nation´s economic performance. In addition it is at large unresponsive to policy change, and is further on difficult to monitor by government officials. The informal economy is a global problem. Previous studies on the informal economy suggest, in agreement with the classical theory, that the informal economy will wither away with growth. However, this study, using proxy-data from 102 developing countries suggests that the decreasing effect of growth on the informal economy cannot be taken for granted. This paper argues that, to ensure that the size of the informal economy is decreasing with growth, policy makers need to take steps to increase the cost associated with informal employment arrangements. An altering of the institutional settings regarding employment arrangements is crucial to ensure that the informal economy is indeed decreasing with growth.