Testing three views about the determinants of informal economy: New evidence at global level and by country groups using the CS-ARDL approach

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This paper investigates the heterogeneous, long, and short-run and causal relationship between the size of the informal economy and three usual variables related to each of the most important theoretical approaches on informality, namely, the dualist, legalist, and structuralist view. Specifically, we consider GDP per capita, institutional quality and trade openness. We explore this relationship, using novel econometric techniques such as CS-ARDL panel data approach to analyses a sample of 133 countries over the period 1995 to 2017. The results show a long-run relationship between the variables at the global level and by country group. GDP per capita, institutional quality and trade openness are negatively associated with the size of the informal economy. The signs confirm the dual and legal hypothesis; however, the sign is opposite to that suggested by the structuralist hypothesis. Additionally, we obtain a U-shaped relationship between the size of the informal economy and the level of economic development. This means that the informal economy does not tend to disappear in the long run. In terms of policy implications, we provide support about the effectiveness of GDP per capita, institutional quality and trade openness in diminishing the size of the informal economy. Nevertheless, based on our results of a U-shaped relationship between informality and GDP per capita, public policy should be designed conditional on the level of development of a certain country.