Informality, Governance and Growth

This paper develops a growth framework of a typical developing and democratic setting with formal and informal sectors, which faces trade-off of redistribution through either direct subsidy or strategic regulatory concession to operate informal activities. Inverted U-shaped growth and welfare functions against governance are found, which suggests a deliberated weak governance can raise growth and welfare of the economy with large informal sector keeping taxation at lower level. The governance that maximises growth varies inversely with subsidy given to informal sector and formal labour bargaining power. Unlike the level maximising welfare, the governance that maximises growth becomes independent of the bargaining power in case of no subsidy. Using standard parameters, the calibrated growth and welfare functions support these relations. Econometric results derived from instrumental and system regression models using pooled data for 46 countries during 1995-2009 justify such conjectures. This explains why the growing countries show higher level of informality.