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Government expenditure and informality in an emerging economy: the recent experience of India

Author

Listed:
  • Santanu Chatterjee

    (University of Georgia)

  • Stephen J. Turnovsky

    (University of Washington)

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.

Suggested Citation

  • Santanu Chatterjee & Stephen J. Turnovsky, 2023. "Government expenditure and informality in an emerging economy: the recent experience of India," Indian Economic Review, Springer, vol. 58(2), pages 293-318, September.
    • Handle: RePEc:spr:inecre:v:58:y:2023:i:2:d:10.1007_s41775-023-00183-y
    DOI: 10.1007/s41775-023-00183-y
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    More about this item

    Keywords

    Government consumption; Public capital; Informal sector; Real exchange rate; Capital mobility; Labor mobility;
    All these keywords.

    JEL classification:

    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • F2 - International Economics - - International Factor Movements and International Business
    • F3 - International Economics - - International Finance
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance

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