Do public-sector employment reductions promote the informal economy?

Abstract

Using information from all International Monetary Fund conditionality programmes from 1990 to 2018, we implement a dynamic Augmented Inverse Probability Weighting Regression Adjustment approach to enquire whether public-sector employment retrenchment may be incompatible with the goal of shrinking the informal economy. The estimated effect 5 years after the policy intervention indicates an increase in the share of the shadow economy to GDP by about 1.3 percentage points. More importantly, this change involves a sizable reallocation of private economic activity from its formal to its informal part; that is, the size of the formal private sector relative to the size of the informal sector decreases by seven percentage points. We interpret these findings through a two-sector model in which there is interdependence between worker incomes and the allocation of product demand across the formal and informal sectors.