Engine for growth or drag on productivity? : the informal sector and domestic investment in developing countries
Thesis (M.P.P.)--Georgetown University, 2011.; Includes bibliographical references.; Text (Electronic thesis) in PDF format. The informal sector accounts for an immense share of income, output and employment in low- and middle-income countries, providing jobs to over two billion people worldwide. Nevertheless, the current policy debate is largely biased against informality, with major actors assertively pushing for formalization. Yet as the informal sector continues to expand, some have asked whether this phenomenon could in fact be a lifeboat for poor economies, enabling citizens to engage in more flexible modes of production in the face of institutional and regulatory constraints. This study addresses a critical knowledge gap by empirically investigating the impact of informal sector size on the economic dynamism of low- and middle-income economies. It hypothesizes that at low income levels, informal sector size has a positive effect on economic dynamism (as measured by domestic investment), but that as economies become richer they reach a tipping point at which this effect becomes increasingly negative. A fixed-effects panel analysis of 22 developing countries between 1995 and 2006 finds strong evidence of a non-monotonic relationship between the economic impact of informal sector size and GDP per capita. The effect of informality on domestic investment changes direction with country income level and appears to describe an inverted U-shape, suggesting the existence of an 'informal sector Kuznets curve'. Moreover, informality has positive effects in low-income countries with diminishing returns to scale, and optimal informal sector size is inversely related to country income level. These findings recommend adopting a two-track approach: low-income countries would gain from implementing policies that fuel the informal sector as an engine of growth in the short run, while simultaneously laying the groundwork for a long-run increase in formality. This calls for a more nuanced understanding of the informal sector's economic repercussions, particularly in countries at lower levels of development.
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