Academic journal article The Journal of Developing Areas

Modeling the Informal Economy in Mexico. a Structural Equation Approach

Academic journal article The Journal of Developing Areas

Modeling the Informal Economy in Mexico. a Structural Equation Approach

Article excerpt

ABSTRACT

This paper uses annual data for the period 1970-2006 in order to estimate and investigate the evolution of the Mexican informal economy. In order to do so, we model the informal economy as a latent variable and try to explain it through relationships between possible cause and indicator variables using structural equation modeling (SEM). The model uses tax burden, salary levels, inflation, unemployment and excessive regulation as potential incentives or deterrents for the informal economy. Our results indicate that the Mexican informal sector at the beginning of the 1970's accounted for 40 percent of GDP, and then it slightly decreased to stabilize around 30 percent of GDP from the late 1980's onwards. The results also confirm the importance of salaries and excessive regulation as causes of the informal economy in Mexico and the existence of a positive relationship between informality and GDP.

JEL Classifications: C39, E26, O17.

Keywords: Informal Economy, Economic Growth, Structural Equations.

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

Informality has re-gained economists' attention in the past years due to a generalized perception that the informal sector around the globe is expanding1. Understanding the causes of informality and the impact it might have on the economy, especially on growth, is fundamental to develop effective policy measures and to avoid its potential negative externalities.

The term "Informal Economy" was coined by Hart (1973;1990), who used this term to explain certain self-employment characteristics in Africa. Nowadays, the concept of informality has evolved and encompasses a broad set of economic activities, which can go from street vendors to hidden production, illegal labour, corruption, smuggling, prostitution and tax avoidance. This phenomenon affects both developing and rich countries alike.

In the literature, the informal sector is referred as black market, shadow economy, illegal economy, corruption, not registered economy, underground economy, informal economy, and so on. Sometimes these definitions are used as synonyms; however, in some occasions they differ in meaning depending on which particular dimension of informality they focus (i.e. tax avoidance, corruption, illegal labour, etc.). Nevertheless, all these definitions refer to unregistered or unreported activities within the economy.

Given the unregistered (hidden) nature of informal activities, measuring or estimating the actual size of informality is very difficult. Through the years a wide range of methods2 and techniques have been used, although none of them is fully recognized or totally reliable.

In Mexico, as well as in the rest of the Latin America, the phenomenon of informality is clearly visible on the streets of the major cities3. The so called "street vendors" (vendedores ambulantes) plague huge areas of the Latin American capitals, obstructing entire streets and generating unfair competition to the official establishment. These informal agents manage to operate outside the formal framework and are a constant source of externalities to the economy. Although most economists would agree with this, the magnitude and sign of these externalities are still unclear and open to debate. This is in part due to the lack of consensus among researchers regarding a common definition and a robust estimation technique able to capture all the dimensions of the informal sector.

From a policy perspective, in particular for a developing country like Mexico, measuring and understanding the evolution of the informal sector becomes imperative, especially when its magnitude is believed to be relatively high. In fact, the International Labor Organization (1999), Schneider (2002), and Vuletin (2008) estimate that the size of the Mexican informal sector in the past decade ranged from 30 to 40 percent of GDP employing more or less the same percentage of the available labor force4. …

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