Can innovation reduce the size of the informal economy? Econometric evidence from 138 countries

KOUAKOU, Dorgyles C.M. and YEO, Kolotioloma I.H. (2023): Can innovation reduce the size of the informal economy? Econometric evidence from 138 countries.

Abstract

A substantial body of literature has examined the determinants of the informal economy. However, this literature has predominantly focused on proximate causes, such as unemployment and taxation, while largely overlooking the role of innovation. This paper contributes to filling this gap by studying the impact of innovation production on the size of the informal economy using a sample of 138 countries, spanning the period from 2007 to 2018. Estimations, based on the entropy balancing method for continuous treatments, demonstrate that innovation reduces the size of the informal economy, emphasizing the importance of innovation policies in addressing informality. This result remains robust across a wide array of controls, alternative estimation techniques, restricted samples, and different measures of both the informal economy and innovation. The study identifies economic development, domestic credit mobilization, and e-government as channels through which innovation influences the informal economy. Potential government policies are explored.

• Item Type: MPRA Paper
• Language: English
• Keywords: Informal economy; Innovation; Economic development; Domestic credit mobilization; E-government; Entropy balancing
• Subjects: O - Economic Development, Innovation, Technological Change, and Growth > O1 - Economic Development > O11 - Macroeconomic Analyses of Economic Development; O - Economic Development, Innovation, Technological Change, and Growth > O1 - Economic Development > O17 - Formal and Informal Sectors ; Shadow Economy ; Institutional Arrangements; O - Economic Development, Innovation, Technological Change, and Growth > O3 - Innovation ; Research and Development ; Technological Change ; Intellectual Property Rights > O31 - Innovation and Invention: Processes and Incentives; O - Economic Development, Innovation, Technological Change, and Growth > O3 - Innovation ; Research and Development ; Technological Change ; Intellectual Property Rights > O38 - Government Policy

References

Aghion, P. & Howitt, P. (1996), ‘Research and development in the growth process’, Journal of Economic Growth 1(1), 49-73.

Akcigit, U., Grigsby, J., Nicholas, T. & Stantcheva, S. (2022), ‘Taxation and innovation in the twentieth century’, The Quarterly Journal of Economics 137(1), 329-385.

Akcigit, U. & Kerr, W. (2018), ‘Growth through heterogeneous innovations’, Journal of Political Economy 126(4), 1374-1443.

Alberola, E. & Urrutia, C. (2020), ‘Does informality facilitate inflation stability?’, Journal of Development Economics 146, 102505.

Allard, G., Martinez, C. A. & Williams, C. (2012), ‘Political instability, pro-business market reforms and their impacts on national systems of innovation’, Research Policy 41(3), 638-651.

Alm, J. & Embaye, A. (2013), ‘Using dynamic panel methods to estimate shadow economies around the world, 1984–2006’, Public Finance Review 41(5), 510-543.

Amable, B., Ledezma, I. & Robin, S. (2016), ‘Product market regulation, innovation, and productivity’, Research Policy 45(10), 2087-2104.

Angrist, J. D. & Krueger, A. B. (2001), ‘Instrumental variables and the search for identification: From supply and demand to natural experiments’, Journal of Economic Perspectives 15(4), 69-85.

Apeti, A. E. (2023), ‘Household welfare in the digital age: Assessing the effect of mobile money on household consumption volatility in developing countries’, World Development 161, 106110.

Apeti, A. E. & Edoh, E. D. (2023), ‘Tax revenue and mobile money in developing countries’, Journal of Development Economics 161, 103014.

Arellano, M. & Bond, S. (1991), ‘Some tests of specification for panel data: Monte carlo evidence and an application to employment equations’, The Review of Economic Studies 58(2), 277-297.

Arellano, M. & Bover, O. (1995), ‘Another look at the instrumental variable estimation of error-components models’, Journal of Econometrics 68(1), 29-51.

Balima, H. & Sy, A. (2021), ‘IMF-supported programs and sovereign debt crises’, IMF Economic Review 69(2), 427-465.

Balima, H. W. (2020), ‘Coups d’´etat and the cost of debt’, Journal of Comparative Economics 48(3), 509-528.

Balima, H. W., Combes, J.-L. & Minea, A. (2021), ‘The “dark side” of credit default swaps initiation: A close look at sovereign debt crises’, Macroeconomic Dynamics 25(1), 124-153.

Balima, W. H. (2017), ‘Do domestic bond markets participation help reduce financial dollarization in developing countries?’, Economic Modelling 66, 146-155.

Baltagi, B. H., Demetriades, P. O. & Law, S. H. (2009), ‘Financial development and openness: Evidence from panel data’, Journal of Development Economics 89(2), 285-296.

Banerji, A. & Jain, S. (2007), ‘Quality dualism’, Journal of Development Economics 84(1), 234-250.

Becker, S. O. (2016), ‘Using instrumental variables to establish causality’, IZA World of Labor, 250.

Bellucci, A., Favaretto, I. & Giombini, G. (2014), Does innovation affect credit access? New empirical evidence from Italian small business lending, IAW Discussion Papers 104, Tübingen.

Berdiev, A. N. & Saunoris, J. W. (2016), ‘Financial development and the shadow economy: A panel VAR analysis’, Economic Modelling 57, 197-207.

Berdiev, A. N. & Saunoris, J. W. (2018), ‘Does globalisation affect the shadow economy?’, The World Economy 41(1), 222-241.

Besley, T. & Persson, T. (2014), ‘Why do developing countries tax so little?’, Journal of Economic Perspectives 28(4), 99-120.

Blanton, R. G., Early, B. & Peksen, D. (2018), ‘Out of the shadows or into the dark? Economic openness, IMF programs, and the growth of shadow economies’, The Review of International Organizations 13, 309-333.

Blundell, R. & Bond, S. (1998), ‘Initial conditions and moment restrictions in dynamic panel data models’, Journal of Econometrics 87(1), 115-143.

Brewer III, E., Minton, B. A. & Moser, J. T. (2000), ‘Interest-rate derivatives and bank lending’, Journal of Banking & Finance 24(3), 353-379.

Buehn, A. & Schneider, F. (2012), ‘Shadow economies around the world: novel insights, accepted knowledge, and new estimates’, International Tax and Public Finance 19, 139-171.

Cantner, U., Dettmann, E., Giebler, A., Guenther, J. & Kristalova, M. (2019), ‘The impact of innovation and innovation subsidies on economic development in German regions’, Regional Studies 53(9), 1284-1295.

Capasso, S. & Jappelli, T. (2013), ‘Financial development and the underground economy’, Journal of Development Economics 101, 167-178.

Chatterjee, S. & Turnovsky, S. J. (2018), ‘Remittances and the informal economy’, Journal of Development Economics 133, 66-83.

Chava, S., Nanda, V. & Xiao, S. C. (2017), ‘Lending to innovative firms’, The Review of Corporate Finance Studies 6(2), 234-289.

Chen, J., Wang, L. & Li, Y. (2020), ‘Natural resources, urbanization and regional innovation capabilities’, Resources Policy 66, 101643.

Chinn, M. D. & Ito, H. (2006), ‘What matters for financial development? Capital controls, institutions, and interactions’, Journal of Development Economics 81(1), 163-192.

Choi, J. P. & Thum, M. (2005), ‘Corruption and the shadow economy’, International Economic Review 46(3), 817-836.

Chu, A. C., Cozzi, G., Furukawa, Y. & Liao, C.-H. (2019), ‘Inflation and innovation in a schumpeterian economy with north–south technology transfer’, Journal of Money, Credit and Banking 51(2-3), 683-719.

Cooray, A., Dzhumashev, R. & Schneider, F. (2017), ‘How does corruption affect public debt? An empirical analysis’, World Development 90, 115-127.

Costamagna, R. (2015), ‘Inflation and R&D investment’, Journal of Innovation Economics & Management 17(2), 143-163.

Dabla-Norris, E., Gradstein, M. & Inchauste, G. (2008), ‘What causes firms to hide output? The determinants of informality’, Journal of Development Economics 85(1), 1-27.

Dell’Anno, R. (2016), ‘Analyzing the determinants of the shadow economy with a “separate approach”. An application of the relationship between inequality and the shadow economy’, World Development 84, 342-356.

Dell’Anno, R. & Solomon, O. H. (2008), ‘Shadow economy and unemployment rate in USA: is there a structural relationship? An empirical analysis’, Applied Economics 40(19), 2537-2555.

Djankov, S., Ganser, T., McLiesh, C., Ramalho, R. & Shleifer, A. (2010), ‘The effect of corporate taxes on investment and entrepreneurship’, American Economic Journal: Macroeconomics 2(3), 31-64.

Djankov, S., La Porta, R., Lopez-de Silanes, F. & Shleifer, A. (2002), ‘The regulation of entry’, The Quarterly Journal of Economics 117(1), 1-37.

Dong, Y., Skowronski, K., Song, S., Venkataraman, S. & Zou, F. (2020), ‘Supply base innovation and firm financial performance’, Journal of Operations Management 66(7-8), 768-796.

Dreher, A. (2006), ‘Does globalization affect growth? Evidence from a new index of globalization’, Applied Economics 38(10), 1091-1110.

Dreher, A., Kotsogiannis, C. & McCorriston, S. (2009), ‘How do institutions affect corruption and the shadow economy?’, International Tax and Public Finance 16, 773-796.

Dreher, A. & Schneider, F. (2010), ‘Corruption and the shadow economy: an empirical analysis’, Public Choice 144, 215-238.

Edler, J. & Fagerberg, J. (2017), ‘Innovation policy: what, why, and how’, Oxford Review of Economic Policy 33(1), 2-23.

Efron, B. & Tibshirani, R. (1986), ‘Bootstrap methods for standard errors, confidence intervals, and other measures of statistical accuracy’, Statistical Science 1(1), 54-75.

Eilat, Y. & Zinnes, C. (2002), ‘The shadow economy in transition countries: Friend or foe? A policy perspective’, World Development 30(7), 1233-1254.

Elbahnasawy, N. G. (2014), ‘E-government, internet adoption, and corruption: An empirical investigation’, World Development 57, 114-126.

Elbahnasawy, N. G. (2021), ‘Can e-government limit the scope of the informal economy?’, World Development 139, 105341.

Elbahnasawy, N. G., Ellis, M. A. & Adom, A. D. (2016), ‘Political instability and the informal economy’, World Development 85, 31-42.

Elgin, C., Kose, M. A., Ohnsorge, F. & Yu, S. (2022), Understanding the informal economy: Concepts and trends, in ‘The Long Shadow of Informality: Challenges and Policies’, World Bank Publications, chapter 2, pp. 33-92.

Elgin, C. & Oyvat, C. (2013), ‘Lurking in the cities: Urbanization and the informal economy’, Structural Change and Economic Dynamics 27, 36-47.

Fields, G. S. (1975), ‘Rural-urban migration, urban unemployment and underemployment, and job-search activity in LDCs’, Journal of Development Economics 2(2), 165-187.

Fong, C., Hazlett, C. & Imai, K. (2018), ‘Covariate balancing propensity score for a continuous treatment: Application to the efficacy of political advertisements’, The Annals of Applied Statistics 12(1), 156-177.

Freel, M. S. (2007), ‘Are small innovators credit rationed?’, Small Business Economics 28(1), 23-35.

Frey, C. B., Neuh¨ausler, P. & Blind, K. (2019), ‘Patents and corporate credit risk’, Industrial and Corporate Change 29(2), 289-308.

Friedman, E., Johnson, S., Kaufmann, D. & Zoido-Lobaton, P. (2000), ‘Dodging the grabbing hand: the determinants of unofficial activity in 69 countries’, Journal of Public Economics 76(3), 459-493.

Fu, X., Mohnen, P. & Zanello, G. (2018), ‘Innovation and productivity in formal and informal firms in Ghana’, Technological Forecasting and Social Change 131, 315-325.

Goel, R. K. & Nelson, M. A. (2016), ‘Shining a light on the shadows: Identifying robust determinants of the shadow economy’, Economic Modelling 58, 351-364.

Gong, Y. & Hanley, A. (2021), ‘Exports and new products in China – a generalised propensity score approach with firm-to-firm spillovers’, The Journal of Development Studies 57(12), 2136-2155.

Gygli, S., Haelg, F., Potrafke, N. & Sturm, J.-E. (2019), ‘The KOF globalisation index–revisited’, The Review of International Organizations 14, 543-574.

Hainmueller, J. (2012), ‘Entropy balancing for causal effects: A multivariate reweighting method to produce balanced samples in observational studies’, Political Analysis 20(1), 25-46.

Harris, J. R. & Todaro, M. P. (1970), ‘Migration, unemployment and development: A two-sector analysis’, The American Economic Review 60(1), 126-142.

Hirtle, B. (2009), ‘Credit derivatives and bank credit supply’, Journal of Financial Intermediation 18(2), 125-150.

Hottenrott, H., Hall, B. H. & Czarnitzki, D. (2016), ‘Patents as quality signals? The implications for financing constraints on R&D’, Economics of Innovation and New Technology 25(3), 197-217.

Hsu, P.-H., Tian, X. & Xu, Y. (2014), ‘Financial development and innovation: Cross-country evidence’, Journal of Financial Economics 112(1), 116-135.

International Labour Organization (2017), World social protection report 2017–19: Universal social protection to achieve the sustainable development goals, Technical report, International Labour Organization.

International Labour Organization (2018), Women and men in the informal economy: A statistical picture (Third edition), Technical report, International Labour Organization.

International Labour Organization (2019), Advancing social justice: Shaping the future of work in Africa, Technical report, International Labour Organization.

International Labour Organization (2020), ILO Monitor: COVID-19 and the world of work. Third edition, Technical report, International Labour Organization.

Jacolin, L., Keneck Massil, J. & Noah, A. (2021), ‘Informal sector and mobile financial services in emerging and developing countries: Does financial innovation matter?’, The World Economy 44(9), 2703-2737.

Kouakou, D. C. M. (2022), ‘Separating innovation short-run and long-run technical efficiencies: Evidence from the Economic Community of West African States (ECOWAS)’, European Journal of Comparative Economics 19(1), 103-141.

Kouakou, D. C. M. (2023a), ‘Competing against ‘invisibles’: the effect of competition from informal firms on formal firms’ R&D’, Eurasian Business Review 13(1), 87-117.

Kouakou, D. C. M. (2023b), ‘Explaining process innovation in developing countries: The role of a firm’s status, formal or informal’, Managerial and Decision Economics 44(6), 3077-3085.

Krammer, S. M. S. & Kafouros, M. I. (2022), ‘Facing the heat: Political instability and firm new product innovation in sub-Saharan Africa’, Journal of Product Innovation Management 39(5), 604-642.

Kullback, S. (1959), Information Theory and Statistics, Wiley, New York.

La Porta, R. & Shleifer, A. (2008), ‘The unofficial economy and economic development’, Brookings Papers on Economic Activity pp. 275-352.

La Porta, R. & Shleifer, A. (2014), ‘Informality and development’, Journal of Economic Perspectives 28(3), 109-126.

Lai, H.-p. & Kumbhakar, S. C. (2018), ‘Endogeneity in panel data stochastic frontier model with determinants of persistent and transient inefficiency’, Economics Letters 162, 5-9.

Leiponen, A. (2005), ‘Skills and innovation’, International Journal of Industrial Organization 23(5), 303-323.

Liu-Evans, G. & Mitra, S. (2019), ‘Informality and bank stability’, Economics Letters 182, 122-125.

Loayza, N. V. (2016), ‘Informality in the process of development and growth’, The World Economy 39(12), 1856-1916.

Loayza, N. V. & Rigolini, J. (2011), ‘Informal employment: Safety net or growth engine?’, World Development 39(9), 1503-1515.

Lu, Q. & Chesbrough, H. (2022), ‘Measuring open innovation practices through topic modelling: Revisiting their impact on firm financial performance’, Technovation 114, 102434.

MacKinnon, J. G. (2006), ‘Bootstrap methods in econometrics’, Economic Record 82(s1), S2-S18.

Mann, W. (2018), ‘Creditor rights and innovation: Evidence from patent collateral’, Journal of Financial Economics 130(1), 25-47.

Mazzucato, M. & Semieniuk, G. (2017), ‘Public financing of innovation: new questions’, Oxford Review of Economic Policy 33(1), 24-48.

Medina, L. & Schneider, F. (2018), ‘Shadow economies around the world: What did we learn over the last 20 years?’, Working Paper No. 2018/017, International Monetary Fund, Washington, D.C.

Medina, L. & Schneider, F. (2019), ‘Shedding light on the shadow economy: A global database and the interaction with the official one’, CESifo Working Paper No. 7981.

Mitra, S. (2017), ‘To tax or not to tax? When does it matter for informality?’, Economic Modelling 64, 117-127.

Nadauld, T. D. & Weisbach, M. S. (2012), ‘Did securitization affect the cost of corporate debt?’, Journal of Financial Economics 105(2), 332-352.

Ndoya, H. & Djeufack, A. (2021), ‘Urbanization, governance and informal economy: an African tale’, Economics Bulletin 41(3), 1525-1540.

Ndoya, H., Okere, D., Laure Belomo, M. & Atangana, M. (2023), ‘Does ICTs decrease the spread of informal economy in Africa?’, Telecommunications Policy 47(2), 102485.

Neuenkirch, M. & Neumeier, F. (2016), ‘The impact of US sanctions on poverty’, Journal of Development Economics 121, 110-119.

Nguimkeu, P. (2022), ‘A structural model of informality with constrained entrepreneurship’, Economic Development and Cultural Change 70(3), 941-980.

Nickell, S. (1981), ‘Biases in dynamic models with fixed effects’, Econometrica 49(6), 1417-1426.

OECD & Eurostat (2005), Oslo Manual: Guidelines for Collecting and Interpreting Innovation Data, 3rd edn, OECD Publishing, Paris.

Ohnsorge, F., Okawa, Y. & Yu, S. (2022), Lagging behind: Informality and development, in ‘The Long Shadow of Informality: Challenges and Policies’, World Bank Publications, chapter 4, pp. 123-204.

Pham, T. H. H. (2017), ‘Impacts of globalization on the informal sector: Empirical evidence from developing countries’, Economic Modelling 62, 207-218.

Robins, J. M., Hern´an, M. A. & Brumback, B. (2000), ‘Marginal structural models and causal inference in epidemiology.’, Epidemiology 11(5), 550-560.

Roodman, D. (2009a), ‘How to do xtabond2: An introduction to difference and system GMM in Stata’, The Stata Journal 9(1), 86-136.

Roodman, D. (2009b), ‘A note on the theme of too many instruments’, Oxford Bulletin of Economics and Statistics 71(1), 135-158.

Schipper, T. C. (2020), ‘Informality, innovation, and aggregate productivity growth’, Review of Development Economics 24(1), 125-143.

Schneider, F. (2010), ‘The influence of public institutions on the shadow economy: An empirical investigation for OECD countries’, Review of Law & Economics 6(3), 441-468.

Schneider, F., Buehn, A. & Montenegro, C. E. (2010), ‘Shadow economies all over the world: New estimates for 162 countries from 1999 to 2007’, Policy Research Working Paper No. WPS 5356, World Bank Group, Washington, D.C.

Schumpeter, J. A. (1912), The Theory of Economic Development, Harvard University Press, Cambridge.

Seo, M. H. & Shin, Y. (2016), ‘Dynamic panels with threshold effect and endogeneity’, Journal of Econometrics 195(2), 169-186.

Svirydzenka, K. (2016), ‘Introducing a new broad-based index of financial development’, Working Paper No. 2016/005, International Monetary Fund, Washington, D.C.

Teobaldelli, D. & Schneider, F. (2013), ‘The influence of direct democracy on the shadow economy’, Public Choice 157, 543-567.

Teteryatnikova, M. (2018), ‘R&D in trade networks: The role of asymmetry’, International Journal of Industrial Organization 61, 307-350.

Todaro, M. P. (1969), ‘A model of labor migration and urban unemployment in less developed countries’, The American Economic Review 59(1), 138-148.

Tübbicke, S. (2022), ‘Entropy balancing for continuous treatments’, Journal of Econometric Methods 11(1), 71-89.

Ulyssea, G. (2018), ‘Firms, informality, and development: Theory and evidence from Brazil’, American Economic Review 108(8), 2015-2047.

Vegetabile, B. G., Griffin, B. A., Coffman, D. L., Cefalu, M., Robbins, M. W. & McCaffrey, D. F. (2021), ‘Nonparametric estimation of population average dose-response curves using entropy balancing weights for continuous exposures’, Health Services and Outcomes Research Methodology 21(1), 69-110.

White, R. & Buehler, D. (2018), ‘A closer look at the determinants of international migration: decomposing cultural distance’, Applied Economics 50(33), 3575-3595.

Williams, C. C. (2023), Theorising an e-government approach towards formalising the informal economy, in ‘Formalization of the Informal Economy: An E-government Approach’, Springer, pp. 21-56.

Windmeijer, F. (2005), ‘A finite sample correction for the variance of linear efficient two-step GMM estimators’, Journal of Econometrics 126(1), 25-51.

Yang, K. & Rho, S.-Y. (2007), ‘E-government for better performance: Promises, realities, and challenges’, International Journal of Public Administration 30(11), 1197-1217.

Yiu, S. & Su, L. (2018), ‘Covariate association eliminating weights: a unified weighting framework for causal effect estimation’, Biometrika 105(3), 709-722.

Zanello, G., Fu, X., Mohnen, P. & Ventresca, M. (2016), ‘The creation and diffusion of innovation in developing countries: A systematic literature review’, Journal of Economic Surveys 30(5), 884-912.

Zhu, Y., Coffman, D. L. & Ghosh, D. (2015), ‘A boosting algorithm for estimating generalized propensity scores with continuous treatments.’, Journal of Causal Inference 3(1), 25-40.