Informal sector, corruption and economic development in Africa: an empirical analysis based on panel data

Abstract

The informal sector has emerged as an important sector in Africa where many countries are striving to attain Sustainable Development Goal (SDG) number 8 on decent work and economic growth. The presence of a growing number of individuals and firms in the informal sector in Africa and the need to attain SDG 8 through formalisation have reignited the debate on informality and its possible causes and effects on the growth trajectory of African economies. Empirical questions on the determinants of informality are still not adequately answered. One question which continues to generate a lot of debate and contrasting results is the relationship between the informal sector and corruption. Both informality and corruption have emerged as ‘twin challenges’ in Africa, with a far reaching impact on economic development. The relationship between the informal sector and corruption has been an inconclusive and a polemical issue in both academic and developmental discourse. From a theoretical perspective, the two can be substitutes or complements, but the exact nature of the relationship is not clear. The main objective of this study is to empirically investigate the relationship between the informal sector, corruption and economic development in Africa, over the period 2005 to 2015. The objective of the study was answered through two ways: theoretical and empirical methodology. In the theoretical methodology, a classical approach was applied. The classical theory suggests that in the presence of a market for corruption, corruption control can reduce the size of the informal sector through reducing the supply of corruption, thereby raising the price of corruption. The negative relationship between corruption control and the size of the informal sector is supported by the described empirical data for Africa. The results from descriptive statistics, in particular the scatter plots, demonstrate that control of corruption, government effectiveness and economic development as measured by the Human Development Index (HDI) are negatively associated with the size of the informal sector. The negative association between the control of corruption and the size of the informal sector entails that corruption increases the size of the informal sector. With regards to the empirical solution, the total population of 54 African countries was considered for the study. However, a panel of 46 countries was analyzed as the other eight countries, although considered together with the rest, were scientifically isolated from the panel due to data challenges. Robustness checks were carried out to check if estimates are not sensitive to sample size or region. Further, for purposes of this study, the sample was also divided into Southern and Eastern Africa, and Northern and Western Africa. Panel data was applied in order to account for both time and country-specific heterogeneity. The use of panel data allows one to study variability through comparability of the level of informality in countries such as Zimbabwe where the economy has remained largely informalised. Four panel estimators, namely, the Pooled Effects, Fixed Effects or Within Effects, Random Effects or GLS, and Dynamic Panel Model (Arrelano-Bond), were applied. Model specification tests identified the Fixed Effect Model as the most appropriate model. Hence, the discussed results are largely from the Fixed Effects Model. On measurement of informality, the study relied on the shadow economy estimates constructed by Medina and Schneider (2018) for 158 countries from 1991 to 2015. On corruption, the study used the Control of Corruption Index (COCO) published by the World Bank, in the Governance Index Report. Unlike previous studies which used GDP per capita only as a proxy for economic development, this study went a step further and used Human Development Index (𝐻𝐷𝐼) as a proxy for economic development. Profit tax as a percentage of GDP was also tested as a potential determinant of informality. The endogeneity of the corruption variable was corrected using an instrumental variable. The findings show that an improvement in the control of corruption or government effectiveness reduces the level of informality in Africa while, an increasing informal sector is a breeding ground for corruption. The two variables are complements or jointly determined. Countries with large underground economies possess high levels of corruption, and countries with high levels of corruption are associated with large underground economies. The complementarity of corruption and the size of underground economy implies that policies that target one of the two will also help in tackling the other. In addition, the results show that economic development reduces the magnitude of informality, while a larger informal sector today implies a bigger informal sector in the future. One of the findings of this study is that previous studies which applied GDP per capita as a measure of economic development largely underestimated the impact of economic development on the size of the informal sector. The findings of the study show that the negative association between the control of corruption and the size of the informal sector holds for both the Northern and Southern regions of Africa. The impact is however bigger in the Northern Region, as a marginal improvement in corruption control has a bigger impact in reducing the size of the informal sector compared to the Southern Region. The results from the study also show that the level of informality in a country has a memory. A bigger informal sector today is likely to propel the level of the informal sector in the future. The findings show that a growth of the informal sector by one percentage point today will increase the informal sector by about 0.185 percentage points in the following year. The results from time dummies also indicate that the size of the informal sector in Africa started to grow significantly during the financial crisis period in 2009. The main implication of these findings is that African countries can target one of the two in order to reduce both the size of the underground economy and corruption. The other implication is that a policy that targets curing one of the problems will have positive external effects in curing the other unintended problem. Furthermore, the findings imply that African countries with large underground economies may continue to experience growing informal economies due to lack of regulatory capacity and weak enforcement. Solving the two problems is a double hurdle for African countries.