Inequality, persistence of the informal economy, and club convergence

• Published in: World development 2021-03, Vol.139, p.105211, Article 105211
• Main Author: Gutiérrez-Romero, Roxana
• Format: Article
• Language: English
• Subjects: 18th century; Access to credit; Analysis; Business schools; Club convergence; Convergence; Convergence (Social sciences); Dualistic economy; Economics; Equality; Inequality; Informal economy; Institutions; Model testing; Redistribution; Tax law; Taxation
• ISSN: 0305-750X; 1873-5991
• DOI: 10.1016/j.worlddev.2020.105211

•Past inequality is one of the main drivers of the size of the informal economy.•Improvements in business environment have a small impact on the informal economy.•Past inequality explains why the informal economy is not converging.•There is club convergence. Higher past inequality leads to higher informality. Several new dualistic models have re-examined the causes of the informal economy and have made testable predictions about the long-lasting role of inequality. We test these predictions using historical indicators of inequality, dating back to the 1700s, and data on the informal economy across 138 countries over the 1991–2015 period. We find that past levels of inequality are the most salient factors explaining the size of the informal economy, while improving credit access, reducing tax burden and business costs play a minor role. These results are robust to using alternative inequality measures from various years during the 1700–1992 period, using instrumental variables, and four alternative measurements of the informal economy. Moreover, there is no evidence that the informal economy is converging to the same steady state. Instead, there is convincing evidence of club convergence. Countries with the highest levels of initial inequality are diverging from those that started with lower levels of inequality and those who have made significant redistribution. Results suggest the importance of early conditions in determining the persistence of the dual economy with important policy implications.