Environmental Regulation, Pollution and the Informal Economy

The regulation of environmental pollution is challenging. Particularly, the presence of institutional weaknesses like informal economy may not allow effective regulation. In this context, this paper addresses three related questions: (a) How stringent environmental regulation affects pollution? (b) What is the link between stringency of environmental regulation and the size of the informal economy? (c) How informal economy affects formal sector pollution? We use a data set of more than 100 countries from 2007 to 2010, a multivariate framework that controls for the influence of important factors and an index of perceived stringency of environmental regulation. The main findings of the paper, in line with theoretical reasoning, are that (i) stringent environmental regulation reduces pollution and (ii) stringent environmental regulation increases the size of the informal economy. This evidence suggests that informal economy helps avoid environmental regulation by being outside the regulatory sphere. An additional support to this finding is provided by the robust negative correlation between the size of the informal economy and the formal sector pollution. Our findings are based on interactive and non-linear effects that are tested and verified. In this regard, the paper raises new issues about possible mechanisms to reduce pollution in the presence of the informal economy.(This abstract was borrowed from another version of this item.)