The composition of the informal economy i. For transition and emerging countries, where the informal sector is expected to be predominant compared to underground production, uncompromising policy measures intended to reduce informality by increasing enforcement may have largely detrimental effects e. The definition of informal economy Several classifications and labels have been used to define informal economy.
These numerous and often inconsistent definitions are not just a result of the unobserved nature of the issue, but are also attributable to the different aims and policy perspectives that motivate investigations into the subject. As a result, it is common in the literature that adjectives such as informal, shadow, hidden, second, unrecorded, unofficial, unobserved are used alongside terms such as economy, sector, market, and GDP.
However, these labels often refer to distinct phenomena and should be used appropriately to avoid misunderstandings. One recent study tries to reconcile the most used definitions of shadow or informal economy in economic research with the concept of the non-observed economy NOE , which is used in Statistical National Accounting . Three types of the NOE adjustments of GDP estimates are particularly relevant here: underground production, informal sector production, and illegal production. There are several potential channels and economic rationales that may explain how inequality directly and indirectly affects informality, and vice versa.
Figure 1 displays some of these causal mechanisms that drive the complex relationship between inequality and informality. The effect of inequality on the accumulation of human capital is the main channel of interaction between inequality and informality, primarily due to its impact on the labor market. In particular, increasing income inequality decreases human capital accumulation due to imperfect capital markets and higher fertility rates.
Why income inequality is bad for the climate | World Economic Forum
The effect on the formal economy is supported by clear empirical evidence showing that richer people have fewer children than poorer people. Moreover, income inequality is associated with gender inequality and lower female incomes, and the latter is negatively correlated with the fertility rate. As a result, a more unequal distribution of assets leads to a higher fertility rate, and, under the assumption of an imperfect capital market, it reduces productive investments in human capital per capita because families do not have sufficient access to credit .
The income distribution may also affect the future growth rate of the informal economy: a larger share of poor and unskilled workers is usually more inclined to accept lower salaries and health and safety standards in the workplace than richer and more skilled workers because they have fewer and qualitatively worse job opportunities, implying that informal economic activity will rise as inequality increases. Moreover, prolonged informal work experience may be associated with social stigma and loss of the human and social capital required for re-employment in the formal economy, leading to situations in which workers become effectively trapped in informal employment.
An increase in income inequality decreases physical capital accumulation due to lower domestic aggregate demand and, in turn, economies of scale. The economic intuition for these assertions is that, on the formal side of the economy, greater inequality reduces the aggregate demand for goods and services. Domestic product markets are thus too small to fully develop local industries or to attract foreign direct investment .
As a consequence, a more unequal income distribution reduces physical capital accumulation and, in turn, reduces formal GDP. On the informal side of the economy, small-scale enterprises find it easier to hide from public authorities i. Through these dimensions of socio-political unrest, high economic disparities, which reduce social capital and institutional quality, diminish overall productivity and economic growth in the official economy. On the hidden side of the economy, considering that taxpayers systematically adjust their evasion levels according to their satisfaction levels with public policy and the quality of their relationship with authorities, it is expected that by decreasing tax morale i.
A second group of models suggests that more inequality increases social demand for redistribution throughout the political process. Typically, transfer payments e. Hence, inequality increases the size of underground production . Analysis of the relationship between the formal and informal economy is one of the most relevant and challenging issues in this literature.
However, the effect of informality on economic growth remains considerably ambiguous, theoretically and empirically. This misallocation subsequently slows down economic growth. Empirical evidence on transition economies supports this view and shows that informality has a negative impact on the official economy . In particular, the negative impact occurs because informality biases firm size, sectoral output composition, ownership, pricing, market regulation, and the ability to innovate and to attract foreign participation.
For example, the need to hide informal activities from public authorities leads to: limited protection of property rights that increases both entrepreneurial and credit risk; informal firms being forced to operate at suboptimal scale; ownership being constrained to family components or single individuals; and to a greater probability of becoming the victim of extortion and corruption. According to this approach, informal activities provide cheap goods and services, which increase the level of competition faced by regular enterprises.
By the same token, more formal production increases the demand for goods and services produced by unobserved activities. Indeed, various studies showed that a reverse causality can occur, that is, the informal economy has a beneficial effect on economic development. Focusing on transition economies, the most obvious benefit of the informal economy is that it helps maintain economic activity when rent-seeking the extraction of uncompensated value from others without making any contribution to productivity and corruption raise the cost of formal production .
What is economic inequality?
Informal activities can increase competition in the formal economy and impose upper bounds on governmental activities and regulatory burdens. They may contribute to an increase in financial resources and provide entrepreneurial experiences that are important, especially in transition and emerging countries. Thus, a positive relationship between informality and the formal economy is also theoretically and empirically possible. Empirical research that may rationalize these contradictory findings shows that while informal activities boost economic growth in developed economies, they reduce the growth rate of the official GDP in developing countries .
As a result, adequate knowledge of both sectoral composition and degree of economic development are critical in determining the correlation whether positive or negative between the informal and formal economy and, as a consequence, the indirect effects of inequality on informality, and vice versa. Several channels can explain how the informal economy has reverse effects on income inequality.
On the one hand, a sizable level of informality reduces government revenue and intensifies pressure on public finances, which, in turn, reduces the quality and quantity of publicly provided goods and redistributive policies . In particular, a growing informal economy presents problems because informal workers and producers do not pay taxes, but rather free ride on public services; this is a source of inefficiency in the public provision and allocation of private and public resources. With particular reference to transition and emerging countries, lower tax revenues impede adequate public investment in physical e.
With respect to social issues, the informal economy exacerbates a lack of trust in official institutions, feeds resentment among citizens, and favors corruption and illegal activities. These consequences all contribute to a reduction in institutional quality. Evidence suggests that large levels of informality coincide with less redistribution and more income inequality . Research on transition economies suggests that the very presence of an informal economy typically leads to a smaller number of competing foreign enterprises.
This lesser threat of competition from foreign firms reduces allocative efficiency and innovation, facilitates rent-seeking activity, and allows for further consolidation of monopoly power, leading to higher profits for firms at the expense of consumers, thereby increasing inequality . On the other hand, the informal economy often absorbs the unemployed from the formal economy, serving as a source of income and human capital accumulation for excluded and unskilled workers.
In this sense, informal activities provide employment to those with lower incomes and fewer job opportunities; therefore, informality may have a beneficial effect on income distribution. These contrasting effects may provide the rationale for empirical evidence that describes a statistically insignificant relationship between the size of the informal economy and the Gini coefficient, which is a well-respected measure of inequality .
In particular, informality and inequality develop in the same direction i. The prevalent view in the empirical literature is that higher inequality increases the size of the informal economy, though some studies find a statistically insignificant correlation see  for an overview. However, this variance in outcomes is normally attributed to data limitations and bias from measurement errors. Moreover, these studies only provide correlational evidence. Thus, estimates should be considered tentative.
The very presence of an informal economy biases this type of data, which is typically used to calculate aggregate inequality indexes, because unrecorded income may not be uniform across the income distribution spectrum .
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This means that as the share of unrecorded income earned by the poor increases, the estimate of income inequality will be more biased underestimated , and vice versa. When focusing on transition countries, the first attempt to document a relationship between income inequality and the relative size of the informal economy was based on estimates of informality calculated by the electricity method for the years to in 17 transition economies .
This research found a positive correlation between income inequality and the informal economy. However, this result has not been corroborated by more recent empirical analyses. For example, a statistically insignificant relationship between the size of the informal economy and the Gini coefficient was found using a larger data set of transition countries . Inconclusive findings were also obtained using microdata from the Serbian labor market, extracted by the Living Standard Measurement Surveys.
In this case, it was found that informality played an increasingly important role in explaining earnings inequality in , but not in . Indefinite results on the relationship between informality and inequality were also found in separate panel regressions for 16 transition countries . This research concluded that statistical significance and the correlation between informality and inequality depend on the estimation method and the time period considered when determining informality. Specifically, informal economy and inequality show a statistically insignificant relationship if the size of the informal economy is estimated by the currency approach, modified electric consumption , or is derived from statistics compiled by national agencies.
Conversely, if estimates of informality are calculated using the MIMIC approach , then a positive correlation with income inequality occurs. The Renaissance later faced to Venice, planning of a human bunch and in security-sector of the energy conflicts with the many since the trafficking of the studies and the sanctions of Marco Polo, where the is of fast illegal selection was Given yet and required overPage actions with self-made links.
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