Understanding the informal sector: implications for Pakistan

Abstract

This paper has been motivated by the growing concern about growth of informal sector in the developing world, especially Pakistan. A general equilibrium model has been developed to determine its causes. It has been proposed in the model that firms decide between formality and informality based on the cost-benefit analysis carried out pertinent to participation in each sector. Furthermore, limited absorptive capacity in the formal sector also leads to expansion of the informal sector. It has been established in this paper that burden of government regulation, such as startup costs, taxation, labor laws, bribery, etc., adds to the cost of formalization, despite the fact that the formal sector gives firms the benefit of access to credit markets, protection of property rights and so on. It has been finally exhibited in the model that government effectiveness and its institutional quality, which is enhanced under federal and democratic form of governance, augment the benefits of formalization while simultaneously mitigating its costs. Therefore, democratic federal countries with effective governments and strong public institutions are likely to have to smaller size of informal economy even in face of stringent regulatory burden due to comparatively higher profits realized in the formal sector. To ascertain these propositions, a global approach has been adopted in this paper using Driscoll and Kraay (1998) Errors with Fixed Effects Panel Regression conducted for 131 countries and Quasi Maximum Likelihood Regression for 125 countries for the years between 2006 and 2015. The empirical findings of present study largely corroborate the theoretical percepts.