THE INFLUENCE OF GOVERNMENT POLICIES ON INFORMAL LABOR: IMPLICATIONS FOR LONG-RUN GROWTH BY JANE IHRIG AND KARINE S. MOE* Summary Using cross-sectional data from industrialized and developing economies, we examine long-run growth regressions linking government policies, informal employment and real GDP per worker. We find that changes in government policies of taxation and enforcement significantly affect growth in the infor- mal sector. Further, we show that increases decreases in informal employment significantly and nega- tively positively affect a country’s growth rate of real GDP per worker. The empirical link between government policies, informal employment and real GDP per worker holds irrespective of a country’s development. On average, changes in government policies, through their effect on the size of the informal sector, account for 6 percent of the growth rate of real GDP per worker between 1960 and 1990. Key words: growth, informal labor, taxation, enforcement 1 INTRODUCTION The Economist highlights the problem an informal economy creates for a govern- ment: ‘They the goverment may know less than ever about what is really going on in their economies jobless rates, for instance, will overstate the true level of unemployment – and will have an increasingly difficult time taxing it’ May 3, 1997, p. 63. We believe that the problem extends beyond these two important facets. Since formal firms tend to be more capital-intense, and hence more pro- ductive, than informal firms, shifting workers from the informal to the formal sector causes economies to grow. Growth in a country’s real GDP per worker is linked to lower child mortality rates, higher life expectancy, and other vital sta- tistics. Thus, it is important for governments to understand how their policies en- courage workers to shift between the informal and formal sectors. 1 * Karine Moe: Macalester College, Department of Economics, 1600 Grand Avenue, Saint Paul, MN 55105, USA; ph: 651 696-6746, moe@macalester.edu. Jane Ihrig: University of Virginia, Depart- ment of Economics, 114 Rouss Hall, Charlottesville, VA 22903, USA; ph: 804 924-6751, fax: 804 982-2904, ihrig@virginia.edu. We thank the editor and two anonymous referees for useful comments. 1 Up until the last few decades, many governments strove to eliminate their informal sectors in the name of modernization. Now that view has changed and many countries believe this sector should be a functioning part of the economy. DE ECONOMIST 148, NO. 3, 2000 De Economist 148, 331–343, 2000. © 2000 Kluwer Academic Publishers. Printed in the Netherlands.