DE GRUYTER Global Economy Journal.

2017; 20170002

Osama Sweidan1

Economic Freedom and the Informal Economy

1
Department of Economics and Finance, United Arab Emirates University, Al-Ain, United Arab Emirates, E-mail:
osweidan@uaeu.ac.ae

Abstract:
This paper empirically investigates the effect of economic freedom on the informal economies in a sample of
112 countries over the period 2000–2007. We employ two methodologies: fixed effect and the GMM models.
We find a statistically significant negative relationship between economic freedom and the informal economy.
This conclusion indicates that the nature of the economic system plays an important role in seizing the infor-
mal economy. Further, our results demonstrate that the formal and informal economies are substitutes. The
policy implication is that economies with high share of informal economy should work with fewer economic
restrictions.
Keywords: informal economy, economic freedom, panel analysis, fixed effect model, GMM model
JEL classification: C23, E26
DOI: 10.1515/gej-2017-0002

1 Introduction
The informal economy has attracted the attention of economists and policymakers over the past five decades.
The informal economy is still a highly debated topic because there are disagreements about many aspects such
as the definition of the economic activities involved, the estimation procedures, and the use of the estimates
in economic analysis and policy aspects Schneider, Buehn, and Montenegro 2010.1 There is little doubt that
this fuzzily seen economy plays a major role in employment creation, income generation and production in
the world economy International Labor Organization (International Labor Organization 2013). Moreover, its
role was fundamental to the sustenance of many economies. For example, Onis and Rubin (2003) pointed out
that the strong informal economy of Turkey prevented it from collapsing during the crisis of 2000–2001. This
economy provided a natural escape route for those who lost their jobs in the formal economy. In the same vein,
Alexeev (1995) stated that the Russia’s (former Soviet Union) formal economy could not have survived with-
out the support of its informal economy. Besides, it made the Russian economy more efficient and improved
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consumer welfare.2 By contrast, some economists focused on the negative effects of the informal economy. For
example, Elbahnasawy, Ellis, and Adom (2016) stated that the informal economy stimulates inefficient use of
resources, encourages adoption of low-return technologies and small-scale production, distorts investment,
worsens income inequality, and formal macroeconomic data does not reflect the correct magnitudes of con-
sumption and income. Losby, Kingslow, and Else (2003) examined the attitudes and behaviors of 55 Americans
who had worked in legal but informal work inside the US. They summarized the advantage and disadvan-
tage of informal jobs as follows. Advantages: being paid in cash without taxes, exercising creativity and self-
expansion, a way to build occupational skills, and best solution to a temporary situation. Disadvantages: not
having employment benefits, lack of economic security, reduced opportunity to establish credit, dealing with
unscrupulous workers, and high risk or penalties for not reporting earned income to the government.
For many years many governments and policymakers had expected that the informal economy will disap-
pear following solid economic development. However, the informal economy remains a main source of pro-
duction, income and employment (International Labor Organization 2012). Schneider, Buehn, and Montenegro
(2010) showed that the weighted average size of the informal economy (as a percentage of formal GDP) in Sub-
Saharan Africa was 37.6 %, in Europe and Central Asia it was 36.4 %, and in high income OECD countries it
was 13.4 %. It is obvious that countries demonstrating higher economic progress have lower shares of infor-
mal economy. Moreover, the ILO stated that the employment share of this economy is around 75 percent and
more of non-agricultural employment in some developing countries.3 Measuring the magnitude and nature
of the informal economy are vital for a number of reasons: to be able to design and evaluate effective policies
to support the transition to formality, to identify the population groups involved in such activities to support
them, to understand global and national employment trends, and for analyzing the linkages between growth
and employment (International Labor Organization 2013).
Osama Sweidan is the corresponding author.
© 2017 Walter de Gruyter GmbH, Berlin/Boston.

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Literature shows that the informal economy is growing over time despite disagreements about its defini-
tion. Schneider, Buehn, and Montenegro (2010) defined4 the shadow economy as: “It includes all market-based
legal production of goods and services that are deliberately concealed from public authorities to avoid payment of income,
value added or other taxes; to avoid payment of social security contributions; having to meet certain legal labour market
standards, such as minimum wages, maximum working hours, safety standards, etc; and complying with certain admin-
istrative procedures, such as completing statistical questionnaires or administrative forms”. We adopt this definition5
because it contains the most known factors that underpin informal economies. These factors are related to more
restrictions or extensive government interventions in allocating the resources of private agents in the economy.
For example, rising the tax burden and social security contributions and increased regulation in the formal
economy, particularly of labor markets (Blackburn, Bose, and Capasso 2012; Dreher, Kotsogiannis, and McCor-
riston 2009; Elbahnasawy, Ellis, and Adom 2016; Friedman et al. 2000; Tanzi 1999; Giles 1999a; Schneider and
Enste 2000; Tanzi 1998). On the other hand, economic freedom means the degree to which the policies and
institutions of the world countries are supportive of individual economic choices. The cornerstones of the con-
cept of economic freedom are personal choice, voluntary exchange, freedom to enter markets and compete, and
security of the person and privately owned property (Gwartney, Lawson, and Hall 2015). Similarly, Berggren
(2003) defined economic freedom as “a composite that attempts to characterize the degree to which an economy is a
market economy – that is, the degree to which it entails the possibility of entering into voluntary contracts within the
framework of a stable and predictable rule of law that upholds contracts and protects private property, with a limited degree
of interventionism in the form of government ownership, regulations, and taxes.” Exploring the relationship between
the informal economy and economic freedom will take us back to one of the fundamental and persistent de-
bates among the school of thoughts in the economic theory; more individual choices versus more government
interventions in the economy? The goal of this paper is not to re-open this debate directly. Rather we are seeking
to investigate the effect of one side of the debate on the informal economy. Thus, the present paper investigates
the effect of economic freedom on the relative importance of the informal economy. It contributes to the liter-
ature along two dimensions. First, the empirical work of this topic in the literature is very limited. Based on
our knowledge, we found only one study Schneider, Buehn, and Montenegro 2010, which empirically explored
this relationship on the basis of data from a sample of 21 transition countries over the period 1994–2006. Thus,
we are re-evaluating this hypothesis by using a larger sample and different methodologies. Second, we believe
that this topic is fundamental to policymakers and economists because it tells whether the economic system
matters in creating or contributing to the informal economy.

Table 1: Summary statistics.

Variables Obs. Mean Std. Dev. Min Max
u�u�u� u�u�u�u�u�u�,u� 896 31.0 12.5 8.1 67.7
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u�u�u� u�u�u�u�u�2u�,u� 896 −0.23 0.52 −4.6 5.9

u�u�u�u�.u�u�u�u�u�u�u�u�,u� 896 6.8 0.95 4.0 8.8
u�u�u�u�.u�u�u�u�u�ℎu�,u� 896 4.4 3.6 −12.7 33.7
u�u�u�u�u�.u�u�u�u�u�,u� 896 8.0 4.8 0.6 29.8
u�u�.u�u�u�u�u�u�u�u�,u� 896 0.29 0.90 −2.1 2.1
u�u�u�u�.u�u�u�u�u�u�,u� 896 61.0 17.1 24.2 92.4
u�u�u�u�u�.u�u�u�,u� 896 59.9 23.0 10.8 98.3

The rest of the paper is organized as follows. Section 2 presents the theoretical link between economic free-
dom and the informal economy. Section 3 introduces the data and methodology adopted in our work. Section
4 discusses the results. Section 5 provides a sensitivity analysis of our main results. Section 6 presents the con-
clusions and policy implications.

2 Literature Review
Literature does not contain solid theoretical work directly connecting economic freedom to the informal econ-
omy.6 The linkage might be indirect and could be understood between the lines. At the level of theory, classical
economists such as Adam Smith and David Ricardo, concluded that preserving free market economy and indi-
vidual choices, the protection of private property rights, low tariffs, and a minimal government intervention in
the economy, which implies that low taxes and government expenditures, lead to economic prosperity. Techni-
cally, this conclusion or description is consistent with the abovementioned definition of economic freedom. In
other words, economic freedom leads to economic growth. At the same time, one prevalent view states that the

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informal economy is a substitute for the formal one. This indicates that the informal economy expands during
economic recessions and shrinks during economic expansions (Heintz and Pollin 2003; Elgin and Oztunali 2014;
Elbahnasawy, Ellis, and Adom 2016). Conversely, some studies suggest a more complex and dynamic relation-
ship between formal and informal economies (Galli and Kucera 2003). They suggest a compositional shift in the
nature of informal employment over business cycles. During economic expansions, increasing share of infor-
mal employment (expansion of the informal economy) might be “subordinate” to formal firms – in this phase
of business cycle, firms draw on reserve labor in the informal sector such as through subcontracting. However,
as those in informal employment lose their relationships to formal firms during economic recessions, an in-
creasing share of informal employment may be of “survival” nature. Technically, this implies that the informal
economy and formal economy can grow together. Elbahnasawy, Ellis, and Adom (2016) reported mixed signs
(positive and negative) to the relationship between economic growth and the informal economy.
Holmes and Spadling (2011) tried to answer the following question: Why does economic freedom matter?
They described economic freedom as “a crucial component of liberty. It provides individuals with the ability to profit
from their own ideas and labor, to work, produce, consume, own, trade, and invest according to their personal choices”.
Moreover, Berggren (2003) considered economic freedom as a significant kind of incentive generated by eco-
nomic institutions that is able to provide economic growth for the following reasons; it promotes a high returns
on productive efforts through low taxation, the protection of private property, it enables talent to be allocated
to where it generates the highest value, and it promotes the flow of trade and capital investment to where pref-
erence satisfaction and returns are the highest. Based on the abovementioned descriptions, economic freedom
tends to enhance economic growth in the formal economy and, as long as the two economies are substitutes,
the informal economy should shrink. Moreover, La Porta and Shleifer (2008, 2014) found that informal firms
are small and extremely unproductive compared with even the small formal firms. Besides, formal firms are
managed by much better educated administrators than informal ones and use more capital, have different cus-
tomers, market their products, and use more external finance. This implies that high productivity comes from
formal firms which is central to economic development. Much of the empirical work on the relationship be-
tween economic freedom and economics growth shows a positive relation (Hussain and Haque 2016; Adkins,
Moomaw, and Savvides 2002; De Haan and Sturm 2000; 2001; Doucouliagos and Ulubasoglu 2006; Gwartney,
Lawson, and Holcombe 1999; Panahi, Assadzadeh, and Refaei 2014; Piateka, Szarzeca, and Pilca 2013; Pitlik
2002; Weede and Kämpf 2002).
In a similar and directly related literature to our topic, Asoni (2008) presented a survey of the literature
on property rights and economic growth. Recall that property rights are one of the important components of
economic freedom. The survey aimed at highlighting the link between property rights and economic growth.
She found that property rights protection limits the uncertainties concerning political power and reward the
efforts of the individuals, which are considered to be the root cause of long-run economic growth. It creates
sufficient incentive for individuals to invest in capital and in new and more efficient styles of organizations.
On the contrary, lack of protection of property rights can hinder economic growth through different channels:
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expropriation of private wealth, corruption of civil servants, excessive taxation and barriers to adoption of new
technologies.
On the empirical side, Schneider, Buehn, and Montenegro (2010) found a negative relationship between
economic freedom and the ratios of informal to formal economies in 21 transition countries over the period
1994–2006. They used the Heritage Foundation economic freedom index, which ranges from 0 to 100, where 0
is least economic freedom and 100 maximum economic freedom. Galli and Kucera (2003) explored the relation-
ship between civic rights7 and formal sector wages, on the one hand, and formal and informal employment on
the other hand. They concluded that countries with stronger civic rights have higher shares of formal employ-
ment and lower shares of informal employment.

3 Data and Methodology

3.1 Data
We used a perfectly balanced sample of data for 112 countries. The data used in our panel analyses cover the
period 2000–2007. Overall, we had 896 observations drawn from several sources, as we will explain shortly. One
main challenge in the current study is the availability of continuous data for the main variables of our work.
Thus, we decided to reduce the yearly sample data in order to include the largest number of countries.
Our study has eight variables, two dependent and six independent. The two dependent variables are pro-
jections concerning the informal economy. We extracted our data from the two dependent variables discussed
in Schneider, Buehn, and Montenegro (2010) and Elgin and Oztunali (2012). The former used the Multiple Indi-
cators Multiple Causes (MIMIC) estimation model and constructed the set of estimates for 162 countries for the

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period 1999–2007. The latter used the two-sector dynamic general equilibrium model and succeeded in building
a large set of estimates for 161 countries over the period 1950–2009. We used Elgin and Oztunali (2012) index as
an alternative variable of informal economy in the sensitivity analysis to confirm the robustness of our results.
The independent variables consist of the following variables. Economic freedom index, real GDP growth rate,
unemployment rate, regulation quality, globalization index, and trade restrictions. Economic freedom index is
extracted from the data disseminated by Fraser Institute.8 It measures the degree to which the policies and in-
stitutions of the world countries are supportive of economic freedom. The economic freedom summary index
is constructed as the average of the following five broad areas: size of government: expenditures, taxes, and
enterprises; legal structure and security of property rights; access to sound money; freedom to trade interna-
tionally; and regulation of credit, labor, and business (Gwartney, Lawson, and Hall 2015). The expected sign
of the effect of economic freedom is negative. Real GDP growth rate and the unemployment rate are extracted
from the World Bank World Development Indicators (WBWDI) via Data Stream and their expected signs are
negative and positive, respectively. Regulation quality is extracted from Worldwide Governance Indicators of
WGI were those issued by the World Banks (WB).9 They reveal perceptions of the ability of the government to
formulate and implement sound policies and regulations that permit and promote private sector development.
The range of this indicator is −2.5 (weak performance) to 2.5 (strong performance). Moreover, it is gathered
from a large number of enterprises, citizens and expert survey respondents in developed and developing coun-
tries. The expected sign for this variable is negative. The source of globalization index and trade restrictions is
KOF Swiss economic institute. Globalization can be defined “as the process of greater interdependence among coun-
tries and their citizens” (Carbaugh 2010, 2). The globalization index covers three main dimensions: economic
integration, social integration, and political integration. The index is a weighted average of the three dimen-
sions. The expected sign of the globalization index is negative. The trade restrictions index is a sub-index of
the economic integration dimension of the globalization index. It is a weighted average of the following four
restrictions: hidden imports barriers, mean tariff rate, taxes on international trade, and capital account restric-
tions. The expected sign of the trade restrictions is positive. Summary statistics of the abovementioned variables
are reported in Table 1.

3.2 Methodology
We adopt two estimation methodologies to assure solidity of evidence. The first methodology is the panel
regression analysis (fixed effect (FE)). The second one is the dynamic panel Generalized Method of Moments
(GMM) model. Throughout the empirical estimation of the models, we take into consideration a number of
issues: nonstationarity, endogeneity, heteroskedasticity, autocorrelation, and cross-panel correlation.
All the econometric models used to explore the informal economy are ad-hoc models (not derived ones).
For example, Schneider, Buehn, and Montenegro (2010) used 17 variables to explain the informal economy in
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different samples of countries. They picked different groups of these variables for each group of countries.
In a recent study, Elbahnasawy, Ellis, and Adom (2016) examined the effect of the political environment on
the informal economy. They also used an ad-hoc model consisting of different variables to measure political
instability and four economic variables as controllers to explain the informal economy. We follow up on such
previous works and pick several variables to explain the informal economy. We mainly assume that the informal
economy can be explained by economic freedom. We also control for the variables mentioned in Section Section
3.1 We begin our empirical work by estimating the following ad-hoc panel model:
𝐼𝑛𝑓 𝑜𝑚𝑟𝑎𝑙u�,u� = 𝛽0 + 𝛽1 𝐸𝑐𝑜𝑛.𝐹𝑟𝑒𝑒𝑑𝑜𝑚u�,u� + 𝜃𝑋u�,u� + 𝜇u� + 𝑒u�,u� [1]
where 𝐼𝑛𝑓 𝑜𝑚𝑟𝑎𝑙u�,u� is the ratio of the informal economy to the formal economy, 𝑋u�,u� is the vector of the explana-
tory variables, 𝜇u� denotes the unobserved country specific effects (time invariant characteristics), 𝑒u�,u� stands for
the error term and we assume it is 𝑖.𝑖.𝑑 ∼ (0, 𝜎u� ). The subscripts 𝑖 and 𝑡 denote countries and time periods,
respectively. We assume that 𝜇u�,u� and 𝑒u�,u� are independent. Besides, the 𝑋u�,u� is independent of 𝜇u�,u� and 𝑒u�,u� for all
𝑡. We estimate eq. 1 by employing the fixed effect model. During the panel data analysis, endogeneity, variable
omission and measurement errors may result from the presence of unobserved time-invariant characteristics.
To mitigate the problems of endogeneity and measurement errors, we proceed by estimating the following
dynamic panel model:
𝐼𝑛𝑓 𝑜𝑚𝑟𝑎𝑙u�,u� = 𝛼𝐼𝑛𝑓 𝑜𝑚𝑟𝑎𝑙u�.u�−1 + 𝛽1 𝐸𝑐𝑜𝑛.𝐹𝑟𝑒𝑒𝑑𝑜𝑚u�,u� + 𝜃𝑋u�,u� + 𝜇u� + 𝑒u�,u� [2]
where 𝐼𝑛𝑓 𝑜𝑚𝑟𝑎𝑙u�,u�−1 is the lag of the ratio of the informal economy to the formal economy. To eliminate
unobserved time-invariant effects, we adopt the GMM estimator which expresses the first difference of eq. 2 as
follows:
Δ𝐼𝑛𝑓 𝑜𝑚𝑟𝑎𝑙u�,u� = 𝛼Δ𝐼𝑛𝑓 𝑜𝑚𝑟𝑎𝑙u�.u�−1 + 𝛽1 Δ𝐸𝑐𝑜𝑛.𝐹𝑟𝑒𝑒𝑑𝑜𝑚u�,u� + 𝜃Δ𝑋u�,u� + Δ𝑒u�,u� [3]

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Equation 3 shows clearly that the unobservable time-invariant effect has been removed by differencing both
sides of eq. 2), but an endogenous bias may still exist in the correlation between the lagged difference of the
dependent variable (Δ𝐼𝑛𝑓 𝑜𝑚𝑟𝑎𝑙u�,u�−1 ) and the error term (Δ𝑒u�,u� ). To solve this issue, Arellano and Bond (1991)
suggested using lagged values of the endogenous explanatory variables as instruments within the GMM proce-
dure. Arellano and Bover (1995) and Blundell and Bond (1998) developed their GMM framework by considering
efficient instrumental variable estimators. In our analysis, we employ the Arellano-Bond test of autocorrelation
and the Sargan test of over-identifying restrictions to test for instrument validity.

3.2.1 Non-stationarity of the Variables

If the variables under investigation in our model are nonstationary, we could end up with a spurious regression.
Therefore, to properly perceive non-stationarity, we conducted three panel unit root tests: Levin, Lin, and Chu
(LLC) unit root test, the Fisher-type (F) test, and the Im, Pesaran, and Shin (IPS) test. The null hypothesis for
the LLC test states that: the panels contain unit roots, against the alternative hypothesis, i. e., the panels are
stationary. Meanwhile, the null hypothesis for F and IPS tests states that all panels contain unit roots. The
corresponding alternative hypothesis states that at least one panel is stationary for the F test, and some panels
are stationary for the IPS test. We report on the panel unit root tests in Table 2. It reveals the results of the unit
root tests for the data at the level. The three tests have confirmed that all the variables are stationary at the level
except the ratio of the informal economy to formal economy of Elgin and Oztunali (2012). Thus, this variable
only enters the regression model in the first difference.10 The significance scales of the p-value are reported
under Table 2.

Table 2: Panel unit root tests.

Variables LLC IPS F
u�u�u� u�u�u�u�u�u�,u� −69.9* −14.8* 44.6*
u�u�u� u�u�u�u�u�2u�,u� −4.3* 8.9 −1.3
u�u�u�u�.u�u�u�u�u�u�u�u�,u� −28.9* −1.9** 13.78*
u�u�u�u�.u�u�u�u�u�ℎu�,u� −28.6* −3.5* 22.7*
u�u�u�u�u�.u�u�u�u�u�,u� −31.66* −2.40* 26.36*
u�u�.u�u�u�u�u�u�u�u�,u� −32.7* −4.9* 27.6*
u�u�u�u�.u�u�u�u�u�u�,u� −35.42* −4.53* 22.34*
u�u�u�u�u�.u�u�u�,u� −28.93* −3.31* 12.80*
∗
p < 0.01
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∗∗
p< 0.05. and
∗∗∗
p < 0.10
Notes: Tests are conducted with the following conditions: include panel means, time trend, remove cross sectional means, and one lag ADF regression.

3.3 Preliminary Estimation

In the interest of enhancing the robustness of our results and make sure that we are heading in the right direc-
tion, we implement the Hausman test to examine whether we should use the random effect model or the FE
model. The null hypothesis of the Hausman test states that the preferred model is of the random effect type.
The result shows that the value of the Chi2 is statistically significant (Chi2 (6) = 239.73, Prob>Chi2 = 0.00). Thus,
we can reject the null hypothesis and use the FE model. Prior to estimating the FE model, a number of estimates
should be considered. First, we conduct the modified Wald test for group-wise heteroscedasticity. The null hy-
pothesis of the test is homoscedasticity.11 The results were highly significant (Chi2 (112) = 39331.97, Prob>Chi2
= 0.00). In view of this, we can reject the null hypothesis of homoscedasticity at the 1 % level, which implies that
our model does have the problem of heteroscedasticity. Second, we perform the Wooldridge test of serial cor-
relation in panel data. From the result obtained, we can reject the null hypothesis of no serial correlation at 1 %
level, F(1, 111) = 148.066, Prob>F = 0.00. Third, we execute the Pesaran’s test of cross sectional independence to
check whether the residuals are correlated across countries. The results of the test are highly significant (20.460,
Prob = 0.00). Consequently, we can reject the null hypothesis, which states that residuals are not correlated, and
so we cannot use simple OLS. To solve the abovementioned problems regarding our model, we estimate and
report only robust standard errors in our results.

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4 The Results
Column 1 in Table 3 reports the robust estimates from the FE model. They show a statistically negative relation-
ship between the economic freedom index and the ratio of the informal economy to the formal economy at the
1 % significance level. This implies that an increase in economic freedom of 1 % will reduce the proportion of
the informal economy by 105 %. Likewise, economic growth and the globalization index exhibit statistically sig-
nificant negative relationships with the informal economy at the 1 % significance level. On the contrary, unem-
ployment rate, regulatory quality, and trade restrictions have exhibited significant positive relationships with
the informal economy. All variables excepting regulatory quality have the expected signs. Thus, the perception
about regulatory quality is in favor of supporting the establishment of the informal economy. Further estima-
tion has shown that this sign is related to sampling; for example, the effect of regulatory quality in the OECD
countries utilizing the GMM model is statistically significant and negative. In summary, the results from the FE
model suggest that an increase in economic freedom reduces the relative importance of the informal economy.

Table 3: Fixed effects estimates.

Coefficients Coefficients Coefficients (OECD) Coefficients
(remaining)
(1) (2) (3) (4)
u�u�u�u�.u�u�u�u�u�u�u�u�,u� −1.05* −0.97* −0.98* −1.05*
(0.24) (0.27) (0.34) (0.27)
u�u�u�u�.u�u�u�u�u�ℎu�,u� −0.072* −0.067* −0.044** −0.075*
(0.011) (0.011) (0.019) (0.013)
u�u�u�u�u�.u�u�u�u�u�,u� 0.20* 0.19* 0.09** 0.23*
(0.034) (0 .028) (0.044) (0.043)
u�u�.u�u�u�u�u�u�u�u�,u� 0.85*** 0.67 −0.10 0.97***
(0.46) (0.51) (0.27) (0.55)
u�u�u�u�.u�u�u�u�u�u�,u� −0.18* −0.17* −0.14* −0.17*
(0.024) (0.025) (0.037) (0.028)
u�u�u�u�u�.u�u�u�,u� 0.025* 0.025* 0.044* 0.019
(0.009) (0.009) (0.009) (0.013)
Constant 45.34* 44.69* 33.86* 49.51*
(1.83) (1.87) (3.62) (2.00)
R2 (within) 0.51 0.51 0.64 0.51
F-test 42.96* 38.42* 13.53* 39.63*
Panel observation 896 800 272 624
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No. of Countries 112 100 34 78

∗
Notes: p < 0.01
∗∗
p < 0.05, and
∗∗∗
p < 0.10
Robust standard errors are in parenthesis.

In Table 4, Column 1, reports the estimates of the two-step GMM estimator. We estimate our model by
the xtdpd command. We treat the lagged informal economy as the endogenous variable in the GMM-style
instruments, with lags of 2 and longer for the differenced equation. The two-step GMM results are consistent
with the results from the FE model. Economic freedom does have a statistically significant negative relationship
with the informal economy at the 10 % level. The only difference between the results of the two methods is
that in the GMM model, the globalization index, and trade restrictions become statistically insignificant. In
the sensitivity analysis presented in Section 5, we had noted that the effect of globalization index and trade
restrictions become statistically significant with the right sign by employing the GMM model for the OECD
countries only. We can now confirm that the impact of those two variables is sensitive to sampling. Overall, the
results of the FE and the two-step GMM models support the negative influence of economic freedom on the
informal economy.

Table 4: Two step GMM estimates.

Coefficients Coefficients Coefficients Coefficients Coefficients
(OECD) (remaining)
(1) (2) (3) (4) (5)
u�u�u� u�u�u�u�u�u�,u�−1 0.84* 0.84* 0.81* 0.88* 0.63*

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(0.07) (0.095) (0.078) (0.074) (0.049)

u�u�u�u�.u�u�u�u�u�u�u�u�,u� −0.42*** −0.36*** −0.30** −0.50** −0.47**
(0.25) (0.22) (0.14) (0.27) (0.21)
u�u�u�u�.u�u�u�u�u�ℎu�,u� −0.10* −0.10* −0.07* −0.10* 0.03*
(0.031) (0.032) (0.017) (0.031) (0.01)
u�u�u�u�u�.u�u�u�u�u�,u� 0.052** 0.033 −0.013 0.059** 0.060**
(0.025) (0.029) (0.041) (0.031) (0.032)
u�u�.u�u�u�u�u�u�u�u�,u� 2.81* 2.12* −0.22*** 2.69* 0.39*
(0.96) (0.83) (0.12) (0.88) (0.15)
u�u�u�u�.u�u�u�u�u�u�,u� −0.044 −0.057 −0.046*** −0.058 0.015
(0.038) (0.0372) (0.026) (0.046) (0.013)
u�u�u�u�u�.u�u�u�,u� 0.026 0.028 0.022** 0.039 −0.004
(0.026) (0.023) (0.009) (0.033) (0.004)
Constant 7.34* 7.67*** 8.00** 8.70** 1.76***
(3.75) (4.39) (3.22) (4.10) (0.92)
Wald Chi2 546.73* 412.02* 1045.44* 462.61* 273.65*
Arellano–Bond test AR(2), 0.40 0.33 0.94 0.26 0.42
p-value
Sargan test of override, 0.51 0.27 0.16 0.46 0.22
p-value
Number of countries 112 100 34 78 112
Number of obs. 784 700 238 546 784
Obs. Per country 7 7 7 7 7
Number of instruments 26 26 25 26 58
∗
Notes: p < 0.01
∗∗
p < 0.05, and
∗∗∗
p < 0.10
Robust standard errors are in parenthesis.

5 Sensitivity Analysis
In this part, we check the sensitivity of the results reported in Table 3 and Table 4, columns 2, 3, 4, and 5. This
inspection relies on two methodologies. First, we use the sub-samples of the original estimation. Second, we
use an alternative measure of the informal economy.
As for the first methodology, we estimated three sub-samples which are extracted from the original esti-
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mated sample in Section 4. These sub-samples consist of the following groups: 100 countries, the OECD coun-
tries only (34 countries), and the remaining countries (78 countries). The results are reported in Table 3 and
Table 4, Columns 2, 3, and 4. The outcomes from estimating all these sub-samples by using both methodologies
show that economic freedom significantly reduces the ratio of the informal economy to the formal economy.
Likewise, economic growth has a statistically significant negative relationship with the relative importance of
the informal economy in both methodologies and all the estimated sub-samples.
The majority of the unemployment rate estimated coefficients have statistically significant positive relation-
ship with the informal economy. By focusing on the GMM model estimates presented in Columns 3 and 4, we
find that the unemployment rate is an insignificant determinant of the informal economy in the OECD coun-
tries; however, it is significant among the remaining countries. We suggest that the informal economy may be a
closer substitute to the formal economy in the remaining countries. However, the OECD countries may have had
more welfare programs to support their unemployed labor forces. Contrary to our finding, Schneider, Buehn,
and Montenegro (2010) found that the unemployment rate is a significant determinant in the OECD countries,
but it is insignificant in 98 developing countries. They justified their results by stating that the more regulated
and hence less flexible labor markets in the OECD countries significantly contribute to their respective informal
economies.
Most of the estimated coefficients related to the regulatory quality are statistically significant and positively
impact the informal economy. In the OECD countries, this effect is negative. This indicates that the perception
about the government performance in the OECD is against the informal economy. However, the perception in
the remaining countries is in the opposite direction. Approximately, half of the estimated coefficients of the
globalization index and trade restrictions are statistically significant with the signs as expected.
As for the second methodology, we extracted our data on the alternative dependent variable (the ratio of the
informal economy to the formal economy) from Elgin and Oztunali (2012). We investigated whether the new
dependent variable was indeed stationary. Two of the three tests showed that the new dependent variables

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are non-stationary and all confirm their stationarities at the first difference. The results from the level unit
root tests are reported in Table 3 under the name 𝐼𝑛𝑓 𝑜𝑚𝑟𝑎𝑙2u�,u� . From these, we estimated the GMM model by
employing the first difference of 𝐼𝑛𝑓 𝑜𝑚𝑟𝑎𝑙2u�,u� . Contrary to previous estimates from the GMM model, we find that
the explanatory variables of our model are not strictly exogenous.12 Hence, we treated the lagged of economic
freedom, unemployment rate and the informal economy as endogenous variables.13 The results are reported in
Column 5, of Table 4. Consistent with the abovementioned findings of our work, the results of the GMM model
show a statistically significant negative relationship between economic freedom and the informal economy.
Unemployment rate and regulatory quality have a positive relationship with the informal economy. Further,
the results display that the effect of the globalization index and trade restrictions are statistically insignificant.
These conclusions are also consistent with the findings of the current study. Contrary to the previous findings of
this paper, the effect of the economic growth is positive.14 Overall, the results of the sensitivity analysis are not
desperately affected by the different estimation scenarios examined by us. All the results in the present paper
support a statistically significant negative relationship between economic freedom and the ratio of the informal
economy to formal economy. Moreover, all the other independent variables have clear and stable effects on the
relative importance of the informal economy.

6 Conclusions and Policy Implications

Informal economy has attracted the attention of economists and policymakers alike. This subject is one of con-
troversial topics in economics and social research. Technically, there are disagreements about many issues
related to this topic. Governments and policymakers expected that the informal economy is likely to vanish
with the process of concrete economic development. However, the informal economy remains a main source
of production, income and employment in the world economy. Literature does not have a compact theoretical
framework connecting economic freedom to informal economy. Economists consider economic freedom as a
significant incentive to economic growth. These incentives include low taxation levels, protection of property
rights, and efficient allocation of resources. As a result, researchers spent more effort towards understanding
the determinants of the informal economy. Consequently, the goal of the present paper has been to explore
the effect of economic freedom on the relative importance of the informal economy. Technically, we are testing
whether more individual choices and less restrictions on economies are able to seize and reduce the ratio of
the informal economy to the formal economy. Our literature survey has shown that the empirical work on this
topic is very limited.
We have employed a perfectly balanced sample of data drawn from 112 countries. Our panel data have cov-
ered the period 2000–2007. We have adopted two estimation methodologies to guarantee solid evidence: FE and
GMM models. Our paper has presented strong evidence that economic freedom has a statistically significant
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negative influence on the informal economy. This implies that the characteristics of the economic system play a
vital role in seizing the advantages derivable from the informal economy. Moreover, our outcomes confirm that
the formal and informal economies are substitutes. The direct policy implication of our results is that economies
with a high share of informal economy should work with fewer restrictions and more economic freedom.

Notes
1
For more different opinions see Pedersen (2003) and Giles (1999a, 1999b) , Thomas (1999) and Tanzi (1999) .
2
Shmelev (1990) also pointed out the importance of the former Soviet Union’s informal economy. Besides, see Johnson, Kaufmann, and
Shleifer (1997) on how the interaction of politics, economic and institutional incentives affects the growth of the informal economy, and in
turn how the informal economy influences economic performance.
3
For more data on the employment share of the informal economy for some single countries, see International Labor Organization
(2012), page 3.
4
Schneider and Enste (2000) reported in Table 1, page 79 definition to the informal or underground economy in which he included legal
and illegal activities and monetary and nonmonetary transactions.
5
For more definitions see Smith (1994) .
6
Scholars have used different names to refer to the informal economy. They used back economy, irregular economy, subterranean econ-
omy, underground economy, shadow economy, non-official economy, hidden economy, and submerged economy.

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7
Such as freedom of association and collective bargaining rights.
8
The link to the data is http://www.freetheworld.com/release.html.
9
http://info.worldbank.org/governance/wgi/index.aspx#home.
10
This variable is stationary at the first difference.
11
H0: sigma(i)ˆ2 = sigmaˆ2 for all i.
12
When we included all the explanatory variables of the model, the null hypothesis of Sargan test “instruments are valid instruments or
the instruments as a group are exogenous” is rejected. But, when we treated economic freedom and unemployment rate as an endogenous
variable in our model, the null hypothesis could not be rejected.
13
We pointed out in Section 3.2 that we rely on Arellano-Bond test of autocorrelation and Sargan test of over-identifying restrictions to
test for instrument validity.
14
Recall that this result is justified by literature and some researchers reported a similar finding.

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