Does an informal sector reduce the economic dividends of political stability? Empirical evidence

Political stability is generally hailed as an asset that yields positive economic dividends. In particular, the macroeconomic environment is likely to benefit from political stability. On the other hand, the existence of a sizeable shadow (or informal) economy represents institutional weaknesses and may undermine the macroeconomic environment. The latter effect is more likely if the shadow economy reduces the government’s tax revenues and disturbs the balance of demand and supply for formal businesses. This paper tests these contradictory tendencies. Circumventing the issues related to reverse causality and endogeneity of the informal sector, we define a qualitative variable for the size of the informal sector. The qualitative variable assumes a value of 1 for all the countries having an informal sector exceeding 25 percent of GDP on average over our sample period. Using a large data set of 162 countries over the 1999 to 2007 period we find that an informal sector can undermine the positive effect of political stability. The results are robust against alternative specifications and satisfy the usual assumptions of valid empirical analysis.