Abstract
This paper examines the absorption of government spending shocks in the presence of formal and informal production. Calibrating a two-sector open economy model that is consistent with data from India for the period 1990–2017, we show that increases in both government consumption and investment lead to a long-run decline in the shares of employment and output of the informal sector. However, the underlying mechanisms through which these long-run outcomes are achieved differ depending on the type of government spending shock, with the short-run immobility of capital and labor and the adjustment of the real exchange rate playing a key role in the process. While an increase in public consumption reduces the share of the informal sector through a real exchange rate depreciation and aggregate contraction in GDP, an increase in public investment works through a real exchange rate appreciation and an expansion of aggregate GDP. Overall, we find that while the reduction in informality driven by public investment is welfare enhancing, an increase in public consumption reduces welfare.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Data availability
There were no raw data used in this study.
Notes
The dependent economy model, as it originated with Salter (1959) and Swan (1960), was purely static. Dynamic extensions have been developed by many authors including Bruno and Sachs (1982), Brock and Turnovsky (1994), Turnovsky and Sen (1995), and Brock (1996). The role of traded versus nontraded investment in the dependent economy model is addressed in detail by Brock and Turnovsky (1994). While most of this literature treats private investment as non-traded, Chatterjee and Mursagulov (2016) depart from this framework by introducing investment goods that are produced in the traded sector. Their paper, however, is focused more on the dynamic implications of the composition of government spending in the dependent economy framework.
The function \(U(.)\) has the standard curvature properties, i.e., both consumption goods yield positive but diminishing marginal utility. The separability of the labor-leisure choice in utility is mainly for simplicity of exposition and does not affect our results substantially.
See e.g., Schneider and Enste (2000), Fleming et al. (2000), Ihrig and Moe (2004), and Johnson et al. (1998), among others. Turnovsky and Basher (2009) examine how a mix of taxation of labor and capital in the formal sector and auditing and penalties in the informal sector can help raise tax revenues and expand long-run economic activity, while keeping the sectoral shares of output unchanged.
Betts and Kehoe (2008) provide evidence of a strong positive correlation between the relative price of non-traded goods and the real exchange rate.
Intersectoral mobility costs for capital have been studied extensively in international trade; see Mayer (1974) and Jones (1975) for early contributions. These costs have also recently been incorporated within the framework of small open economy models, as in Morshed and Turnovsky (2004), van der Ploeg (2011), Chatterjee and Mursagulov (2016), Chatterjee and Turnovsky (2018) and Chatterjee et al. (2022).
As discussed in Chatterjee and Turnovsky (2018), this is a slightly loose definition of the labor force participation rate, since the model does not generate any involuntary unemployment. For example, if there were job seeking and separation every period, then these allocations of time would also be included in the labor force participation rate. In our specification, the agent either works or consumes leisure, which implies that the fraction of time allocated to working in the two sectors is identical to the labor force participation rate.
The instantaneous movement between sectoral labor and leisure is obtained by setting \(\chi = z = 0,{\text{ and }}\sigma \to \infty\). Our approach to modeling the labor market is somewhat more reduced-form, but the main results remain unaffected by alternative modeling choices such as the introduction of unemployment and search and matching frictions. Our principal focus is not the structure of the labor market per se, but rather the dynamic absorption of government spending shocks in the presence of an informal sector. As Turnovsky and Basher (2009) point out, the sluggishness of intersectoral mobility is both realistic and supported by empirical evidence, and leads to a depiction of sectoral movements as a function of forward-looking wage differentials across sectors, similar to the Harris and Todaro (1970) framework.
An important issue in modeling small open economies such as this is the closure of the financial market; see Turnovsky (1997) and Schmitt-Grohé and Uribe (2003) where several alternatives are detailed. These include introducing an endogenous borrowing premium, as in (15), which is most appropriate in the case of the developing economy being analyzed here. This approach originated with Bardhan (1967), and many variants can be found in the literature. These pertain primarily to the normalization of debt as a reflection of the country’s debt-serving ability.
That is, if we let \(\mu_{kf}\) denote the shadow (utility) value of capital, then \(q_{kf} \equiv {{\mu_{kf} } \mathord{\left/ {\vphantom {{\mu_{kf} } {q_{1} }}} \right. \kern-0pt} {q_{1} }}\), and similarly for the other shadow prices. Written in this way, the normalized prices become “asset prices” independent of utility units, with the optimality conditions (16i) and (16j) treating labor as an asset, analogous to capital.
Intersectoral labor movement is proportional to the differential asset price, which upon integrating the arbitrage relationships (16i) and (16j) forward, is the discounted sum of expected future sectoral after-tax wage differentials.
Writing the household budget constraint (2) as \(\dot{N}(t) = r(t)N(t) + X(t) + T_{f} (t)\), the first transversality condition in (16 k) can be written as \(N_{0} + e^{{\int_{0}^{t} {r(\tau )d\tau } }} \int_{0}^{t} {[X(\tau ) + T_{f} } (\tau )]e^{{ - \int_{0}^{\tau } {r(s)ds} }} d\tau = 0\), which constrains the path for lump sum taxes.
Public capital, \(K_{G}\) is also a state variable but evolves exogenously in accordance with (19c) and hence is determined residually.
These earlier studies subjected the relative magnitude of these parameters to robustness checks.
The productivity parameters \(A_{f} {\text{ and }}A_{s}\) are indices and therefore not directly comparable. While we set \(A_{f} > A_{s} ,\) the magnitude of the differential \(A_{f} - A_{s}\) does not affect the qualitative implications of the model.
As noted above, we use the share of self-employment in the non-agricultural labor force as a proxy for informal employment. This measure most likely overstates the actual share of self-employment. As such our model’s equilibrium share of informal employment is below this proxy measure. Similarly, there are scarce reliable estimates of the share of informal output in India’s GDP. This prompts us to use a range from two recent papers, namely Elgin et al. (2021) and Chatterjee et al. (2021). The model’s equilibrium share of informal output falls nicely within this range.
References
Amaral, P., & Quintin, E. (2006). A competitive model of the informal sector. Journal of Monetary Economics, 53, 1541–1553.
Bardhan, P. K. (1967). Optimal foreign borrowing. In K. Shell (Ed.), Essays on the theory of optimal economic growth. Cambridge: MIT Press.
Betts, C. and T. Kehoe (2008), Real Exchange Rate Movements and the Relative Price of Non-traded Goods, NBER Working Paper #14437.
Bom, P. R., & Ligthart, J. E. (2014). What have we learned from three decades of research on the productivity of public capital? Journal of Economic Surveys, 28, 889–916.
Brock, P. L. (1996). International transfers, the relative price of nontraded goods and the current account. Canadian Journal of Economics, 29, 163–180.
Brock, P. L., & Turnovsky, S. J. (1994). The dependent economy model with traded and nontraded capital goods. Review of International Economics, 2, 306–325.
Bruno, M., & Sachs, J. (1982). Energy and resource allocation in a small open economy. Review of Economic Studies, 49, 845–859.
Chatterjee, S., Kelly, M. C., & Turnovsky, S. J. (2022). Foreign aid, public investment, and the informal economy. Economic Inquiry, 60, 174–201.
Chatterjee, S., Lebesmuehlbacher, T., & Narayanan, A. (2021). How productive is public investment? Evidence from formal and informal production in India? Journal of Development Economics, 151, 10265.
Chatterjee, S., & Mursagulov, A. (2016). Fiscal policy and the real exchange rate. Macroeconomic Dynamics, 20, 1742–1770.
Chatterjee, S., & Turnovsky, S. J. (2018). Remittances and the informal economy. Journal of Development Economics, 133, 66–83.
De Paula, A. and J. Scheinkman (2007), The informal sector, third version. PIER Working Paper Archive.
Di Giannatale, S., Ramirez, G., & Smith, R. (2011). Estimating the effects of formality on mexican informal microfirms. A joint multivariate approach. México: CIDE.
Elgin, C, Kose, M., Ohnsorge, F. & Yu, S. (2021) Understanding informality. CAMA Working Paper no 76/2021.
Fernandez, A., & Meza, F. (2015). Informal employment and business cycles in emerging economies: The case of Mexico. Review of Economic Dynamics, 18, 381–405.
Finkelstein Shapiro, A. (2014). Self-employment and business cycle persistence: Does the composition of employment matter for economic recoveries? Journal of Economic Dynamics and Control, 46, 200–218.
Finkelstein Shapiro, A., & Mandelman, F. S. (2016). Remittances, entrepreneurship, and employment dynamics over the business cycle. Journal of International Economics, 103, 184–199.
Fleming, M., Roman, J., & Farrell, G. (2000). The shadow economy. Journal of International Affairs, 53, 387–409.
Gomis-Porqueras, P., Peralta-Alva, A., & Waller, C. (2014). The shadow economy as an equilibrium outcome. Journal of Economic Dynamics and Control, 41, 1–19.
Gupta, S., Kangur, A., Papageorgiou, C., & Wane, A. (2014). Efficiency-adjusted public capital and growth. World Development, 57, 164–178.
Harris, J., & Todaro, M. (1970). Migration, unemployment, and development: A two-sector analysis. American Economic Review, 60, 126–143.
Havranek, T., Horvath, R., Irsova, Z., & Rusnak, M. (2015). Cross-country heterogeneity in intertemporal substitution. Journal of International Economics, 96, 100–118.
Hayashi, F. (1982). Tobin’s marginal q and average q: A neoclassical interpretation. Econometrica, 50, 213–224.
Ihrig, J., & Moe, K. S. (2004). Lurking in the shadows: The informal sector and government policy. Journal of Development Economics, 73, 541–557.
Johnson, S., Kaufmann, D., & Zoido-Lobaton, P. (1998). Regulatory discretion and the unofficial economy. American Economic Review, 88, 387–392.
Jones, R. (1975). Income distribution and effective protection in a multicommodity trade model. Journal of Economic Theory, 11, 1–15.
La Porta, R., & Shleifer, A. (2008). The unofficial economy and economic development. Brookings Papers on Economic Activity, 2008, 275–363.
La Porta, R., & Shleifer, A. (2014). Informality and development. Journal of Economic Perspectives, 28, 109–126.
Mandelman, F. S., & Montes-Rojas, G. (2006). Microentrepreneurship and the business cycle: Is self-employment a desirable outcome? World Development, 79, 1914–1925.
Mayer, W. (1974). Short-run and long-run equilibrium for a small open economy. Journal of Political Economy, 82, 955–967.
Morshed, M., & Turnovsky, S. J. (2004). Sectoral adjustment costs and real exchange rate dynamics in a two-sector dependent economy. Journal of International Economics, 63, 147–177.
Ordonez, J. (2014). Tax collection, the informal sector, and productivity. Review of Economic Dynamics, 17, 262–286.
Prado, M. (2011). Government policy in the formal and informal sectors. European Economic Review, 55, 1120–1136.
Rauch, J. (1991). Modeling the informal sector formally. Journal of Development Economics, 35, 33–47.
Salter, W. E. G. (1959). Internal and external balance: The role of price and expenditure effects. Economic Record, 35, 226–238.
Schmitt-Grohé, S., & Uribe, M. (2003). Closing small open economy models. Journal of International Economics, 61, 163–185.
Schneider, F., & Enste, D. (2000). Shadow economies, size, causes, and consequences. Journal of Economic Literature, 38, 77–114.
Schündeln, M. (2013). Appreciating depreciation: Physical capital depreciation in a developing economy. Empirical Economics, 44, 1277–1290.
Swan, T. W. (1960). Economic control in a dependent economy. Economic Record, 36, 51–66.
Thomas, J. J. (1992). Informal economic activity. University of Michigan Press.
Turnovsky, S. J. (1997). International macroeconomic dynamics. Cambridge: MIT Press.
Turnovsky, S. J., & Basher, Md. A. (2009). Fiscal policy and the structure of production in a two-sector developing economy. Journal of Development Economics, 88, 205–216.
Turnovsky, S. J., & Sen, P. (1995). Investment in a two-sector dependent economy. Journal of the Japanese and International Economies, 9, 29–55.
van der Ploeg, F. (2011). Natural resources: Curse or blessing? Journal of Economic Literature, 49, 366–420.
Acknowledgements
Chatterjee acknowledges support from the Dr. Harold A. Black Distinguished Professorship at the University of Georgia and Turnovsky’s research was supported in part by the Ford and Louisa Van Voorhis Professorship at the University of Washington. We are grateful for comments from an anonymous referee that helped clarify the scope of this paper.
Funding
The authors have not disclosed any funding.
Author information
Authors and Affiliations
Corresponding author
Ethics declarations
Conflict of interest
The authors have not disclosed any competing interests.
Additional information
Publisher's Note
Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.
Rights and permissions
Springer Nature or its licensor (e.g. a society or other partner) holds exclusive rights to this article under a publishing agreement with the author(s) or other rightsholder(s); author self-archiving of the accepted manuscript version of this article is solely governed by the terms of such publishing agreement and applicable law.
About this article
Cite this article
Chatterjee, S., Turnovsky, S.J. Government expenditure and informality in an emerging economy: the recent experience of India. Ind. Econ. Rev. 58 (Suppl 2), 293–318 (2023). https://doi.org/10.1007/s41775-023-00183-y
Accepted:
Published:
Issue Date:
DOI: https://doi.org/10.1007/s41775-023-00183-y