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Article history: In this paper, we investigate the evolution of the informal sector through structural transformation. We
Received 27 October 2017 develop both a three-sector and a five-sector dynamic general equilibrium (DGE) model, which can
Received in revised form simultaneously account for structural transformation between agriculture, industry and services, and
15 November 2017
between the informal and formal sectors. First, we incorporate the informal sector into an otherwise
Accepted 15 November 2017
Available online 1 December 2017
two-sector (agriculture and non agriculture) DGE model. Then, we augment this model and build a five-
sector DGE model extending the non-agricultural sector into industry and services, to separately account
for the evolution of informality in these two sectors. The calibrated model performs remarkably well in
Keywords:
Informality
accounting for the evolution of the sectoral employment shares and the size of the informal sector.
Structural transformation Finally, we use panel data econometric tools to investigate the empirical relationship between structural
DGE models transformation and the informal sector and find a strong negative relationship between the size of non-
Panel data agricultural sector and informality.
© 2017 Central Bank of The Republic of Turkey. Production and hosting by Elsevier B.V. This is an open
access article under the CC BY-NC-ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/).
https://doi.org/10.1016/j.cbrev.2017.11.002
1303-0701/© 2017 Central Bank of The Republic of Turkey. Production and hosting by Elsevier B.V. This is an open access article under the CC BY-NC-ND license (http://
creativecommons.org/licenses/by-nc-nd/4.0/).
118 O.E. Atesagaoglu et al. / Central Bank Review 17 (2017) 117e126
reallocation across sectors rely mainly on two types of approaches. The paper is organized as follows. Section 2 summarizes the
The first-type of models view structural transformation as a supply theoretical framework. Section 3 and Section 4 includes detailed
side phenomenon. In these types of models, changes in the struc- descriptions of the three-sector and five-sector versions of the
ture of production and employment are driven by sectoral differ- model. Section 5 presents the quantitative implications of the
ences in productivity growth rates or capital intensities. The model. Next, Section 6 conducts an empirical analysis in line with
pioneering work emphasizing the importance of differential rates the model's predictions. Finally, Section 7 provides some
of productivity growth on structural transformation was done by concluding remarks and a discussion.
Baumol (1967) and Baumol et al. (1985). Ngai and Pissarides (2007)
provide a modern version of Baumol0 s hypothesis using exogenous 2. Theoretical framework
differential rates of productivity growth to explain allocation of
capital and labor across sectors. Acemoglu and Guerrieri (2008) This section includes three - and five - sector models of struc-
provide a framework which shows that different capital in- tural transformation. In the three sector model, we lay out a
tensities and capital deepening can together generate structural framework which accounts for the transition from the agricultural
transformation. Caselli and Coleman (2002) shows that the pro- to non-agricultural sector. The structure of the agricultural sector is
ductivity of skilled and unskilled labor changes over the course of built on the work of Gollin et al. (2002), where a one-sector neo-
structural transformation. classical growth model is extended to include a explicit agricultural
The second-type of models, which view structural trans- sector. In our model, the non-agricultural sector involves both the
formation as a demand side phenomenon, are based on Engel0 s law. formal and informal sectors. To account for resource allocation
These types of models make use of sectoral differences in income between the formal and informal sectors, we use the framework of
elasticities of demand by utilizing non-homothetic preferences. Ihrig and Moe (2004).
One of the first papers in this vein is Gollin et al. (2002) which Then, we extend our framework to a five-sector model, in order
explains industrialization by using the relationship between the to also investigate resource allocation between industry
dynamics of sectoral employment shares and consumer demand. (manufacturing henceforth, to avoid confusion) and services. Here,
Another paper which makes a strong case for the impact of Engel0 s informality is incorporated into both of the non-agricultural sec-
law on structural transformation is Kongsamut et al. (2001). In this tors. Allocation of resources between these two sectors is driven by
paper, they build a three-sector model where consumers have differential rates of productivity growth as emphasized by Ngai and
Stone-Geary preferences over agricultural good, manufactured Pissarides (2007). Therefore, structural transformation in the
good and services. The other papers combine two different ap- economy is explained by both the non-homothetic preferences and
proaches to build a hybrid model (see, for example, Duarte and sectoral differences in productivity growth (for a similar environ-
Restuccia (2010) and Rogerson (2008)). Our framework is also ment, see also Bah (2009)).
based on a hybrid model, in which structural transformation is
driven by both non-homothetic preferences and differential rates of 3. The three-sector model
productivity growth.
The informal sector is considered to be an important charac- 3.1. Environment
teristic of both less-developed and advanced economies, and one
which has serious economic and social consequences. Schneider There is a representative household, which has K0 units of initial
and Williams (2013) provides a comprehensive overview of the endowment, owns the total land for the economy and has a time
shadow economy from a global perspective and Buehn and endowment T > 0. It allocates its time endowment across three
Schneider (2016) focuses on the definition and causal factors of sectors every period inelastically and consumes two types of goods:
the informal economy, providing a comparison of the size of agricultural and non-agricultural. The lifetime utility of the
shadow economies using different estimation methods. Schramm household is given by a Stone-Geary variety:
(2014) estimates the equilibrium effects of taxation on sectoral
choice and informal sector. Elgin and Uras (2013) investigates the X
T
relationship between financial development and the size of the bt log CMt þ V CAt (1)
informal economy. Many studies so far have utilized theoretical t¼0
and labor (NAt ) as factor inputs. The effect of capital can be viewed
1j j
as captured in the agricultural TFP (qAt ). A proportional tax t is ð1 tÞqAt Lt NAt ¼ C A (2)
levied on agricultural income. The output of the agricultural sector
is used only for consumption. Therefore, the resource constraint " #1=j
becomes: CA
NAt ¼ (3)
ð1 tÞqAt
j j
CAt ¼ ð1 tÞqAt L1
t NAt
After finding the agricultural employment, our problem is
t reduced to a two-sector dynamic general equilibrium model similar
where TFP evolves as qAt ¼ qA ð1 þ xAt Þ .
to the one in Ihrig and Moe (2004). Denoting the time endowment
Non-agricultural good is produced in both the formal and
left as T NAt ¼ Nt , the maximization problem becomes:
informal sectors. Production technology in the formal non-
agricultural sector has a Cobb-Douglas form using capital (KMt )
X
T
and labor (NMFt ) inputs. The informal non-agricultural sector has a max
T
bt log CMt
production technology which utilizes labor (NMIt ) and exhibits fCMt ;Nt ;Lt ;Ktþ1 gt¼0 t¼0
diminishing returns to scale. A proportional tax t is levied on both
the formal and informal sector income. However, when operating g 1g
in the informal sector, the household tends to hide income gener-
subject to CMt þ It ¼ ð1 tÞqMFt KMt NMFt þ ð1 rtÞqMIt NMI
f
t
ated from this sector. So, it only pays taxes at the rate rt, where r Ktþ1 ¼ ð1 dÞKt þ It
can be interpreted as the level of enforcement government imposes NMFt þ NMIt ¼ Nt
on the tax collection from the informal sector (see Ihrig and Moe
(2004)). The non-agricultural sector's output is used for both con- Combining the first order conditions of this problem yields the
sumption and investment, therefore the resource constraint Euler equation and the marginal product equality of the formal and
becomes: informal sectors, given respectively as:
" #1
g 1g
CMt þ It ¼ ð1 tÞqMFt KMt NMFt þ ð1 rtÞqMIt NMI
f CMtþ1 1 KMtþ1 g1
t ¼ 1 d þ ð1 tÞgqMFtþ1 (4)
CMt b NMFtþ1
where TFPs evolve as qMFt ¼ qMF ð1 þ xMFt Þt and
t
qMIt ¼ qMI ð1 þ xMIt Þ . The law of motion for aggregate capital stock KMt g
ð1 gÞð1 tÞqMFt ¼ ð1 rtÞfqMIt NMI
f1
(5)
is given by Ktþ1 ¼ ð1 dÞKt þ It . NMFt t
First, for simplicity, we normalize the size of total land in the where CAt , CMt and CSt stands for the consumption of agricultural
economy to 1. Then equalizing the agricultural consumption to good, manufactured good and services respectively. The parameter
subsistence level, we can easily find the employment in agricultural ε governs the elasticity of substitution between non-agricultural
sector as: goods and a gives the weights of two goods in allocation of non-
120 O.E. Atesagaoglu et al. / Central Bank Review 17 (2017) 117e126
service sector0 s output is only used for consumption. Therefore the Ktþ1 ¼ ð1 dÞKt þ It
g 1g h
resource constraints become: CSt ¼ ð1 tÞqSFt KSt NSFt þ ð1 rtÞqSIt NSIt
KMt þ KSt ¼ Kt
g 1g
CMt þ It ¼ ð1 tÞqMFt KMt NMFt þ ð1 rtÞqMIt NMI
f NMFt þ NSFt þ NMIt þ NSIt ¼ Nt
t
manufacturing and service sectors. Then rearranging equation (15), " ε1
ε 1 #" g
one can obtain the relative utilization of capital and labor in formal qSFt 1a
ε1 Kt
sectors as: Ct ¼ 1 þ ð1 tÞqMFt NSFt
qMFt a NFt
#
2 3g1
1 ð1 rtÞfqMIt NMI
f1
NSIt
gCε1 gc þ t
(26)
Kt 6 b þ d
M
1 7 h
¼4 5 (19)
NFt gð1 tÞqMFt
Rearranging the last equation, we find the evolution of labor in
the formal service sector:
c c ε þ ð1 aÞC ε .
where gc ¼ tþ1c t is the growth rate of ct ¼ ½aCM
ε1
t t St
q
ε
1aε1
1 ð1rtÞfqMIt NMI
f1
NSIt
Combining this ratio with equation (15) and substituting into Euler Ct 1 þ q SFt t
MFt a h
equation yields: NSFt ¼ g (27)
qMFt ð1 tÞ NKFt
t
2 2 3g1
g 3 1
f1
gCε1 gc
þ d 1 Given these, one can easily derive the evolution of labor in
6ð1 gÞð1 tÞqMFt
M
6 b 7 7
NMIt ¼ 4 4 5 5 (20) formal manufacturing, capital in formal manufacturing and formal
ð1 rtÞfqMIt gð1 tÞqMFt services, and all sectoral outputs.
which gives the evolution of informal labor used in manufacturing 5. Quantitative analysis
sector. Now we can easily find the evolution of informal labor in
services by using equation (11): Having characterized the equilibrium, we will now evaluate the
performance of the three-sector and five-sector models under the
assumption that the economy is at the steady state. We will
2 2 3g1
g 3 1
h1
gCε1 gc compare the implications of our framework with the US and world
6ð1 gÞð1 tÞqSFt 6 b þ d 17
M
7 average time series. The data of sectoral hours worked for the US
NSIt ¼ 4 4 5 5 (21)
ð1 rtÞhqSIt gð1 tÞqMFt and sectoral employment shares for other countries are obtained
from the Groningen 10-Sector Database. For the informal sector
The aggregate expenditure for non-agricultural goods are given size, we use the estimates of Elgin and Oztunali (2012). 1
by Ct ¼ pMt CMt þ pSt CSt , where pMt and pSt are the prices of manu-
facture goods and services, respectively. Also, given the wage rate 5.1. The three-sector model
equality between the sectors, we find the relative equilibrium
p q
prices as pMSt ¼ qMFt . Normalizing the price of manufactured good to 1, Before running the numerical simulations, we have to deter-
t SFt
mine the parameter values. We normalize the initial TFP levels in
the aggregate expenditure for manufactured goods and services agricultural (qA ) and non-agriculture sectors (qMF ) to 1. Given these,
can be denoted as: we set the value of the initial TFP parameter in informal non-
agriculture (qMI ) to 20 in order to match the initial size of the
qMFt informal sector in the US.2 We set the subsistence level consump-
C t ¼ C Mt þ C (22)
qSFt St tion (C A ) to 2 percent in order to match the initial size of the
agricultural sector in the US. To match the world average informal
Substituting for CMt and CSt from the resource constraints, we sector size and subsistence level consumption, we set qMI and C A to
obtain the following equation for non-agricultural consumption 30 and 6.5 percent, respectively. We take the values of TFP growth
rates in agriculture (xA ) and non-agriculture (xMF ) as 0.0326 and
Kt g NSIt f 0.013 from Gollin et al. (2002) and Rogerson (2008), where the
Ct ¼ qMFt ð1 tÞ NFt þ ð1 rtÞqMIt NMI
f
þ 1 environments are similar to ours. We set the TFP growth rate in
NFt MIt h
t N
also set the parameter value of tax rate (t) to 0.093 following Ihrig
and Moe (2004). Finally, we choose the value of (r) as 0.8, however
the results are not sensitive to small changes in the enforcement
rate. The parameter values are summarized in Table 1.
The results are shown in Figs. 1e4. As seen in Figs. 1 and 2, the
model can track the reallocation of hours worked between agri-
culture and non-agriculture and the share of the informal sector
remarkably well for the US. The share of employment decreases
from 9 percent to 2 percent in the US between 1950 and 2005. The
model predicts this decrease to be from 9 percent to 1 percent. The
size of the informal sector decreases from 13 percent to 8 percent
between 1960 and 2009, both in the model prediction and its data
counterpart. Therefore, the model has a good predictive power for
the US economy. Fig. 3 shows that, for the world average, the model
predicts a faster decrease in agriculture, and therefore a faster in-
cense in non-agriculture than its data counterpart. For the period Fig. 3. Employment shares in world average.
1951e2005, the model predicts a 9 percent larger decrease for the
share of agricultural employment. Similarly, for the size of the
informal sector, the model is able to pick up the downward trend,
but predicts a faster decrease. The informal sector size falls from 39
percent to 25 percent during the period of 1961e2008, while the
Table 1
Parameter values for the three-sector model.
g 0.33 b 0.96
h 0.495 d 0.08
j 0.7 xA 0.0326
t 0.093 xMF 0.013
r 0.8 xMI 0.016
Table 2
Parameter values for the five-sector model.
Table 3
Complete dataset summary statistics: 5-Year averages from 1960 to 2009.
Table 4
Informality vs. Structural Transformation: FE Estimations (5-year averages).
Informality 1 2 3 4 5 6 7 8
All panel regressions include a country fixed effect and year dummies. Absolute values of robust t-statistics are reported in parentheses. *, **, *** denote 1, 5 and 10% confidence
levels, respectively. F-test refers to the p-value of the joint significance of all the coefficients, whereas Time F-test refers to the joint significance of the year dummies.
informal sectors. We find that labor moves to the sectors with lower Fiji, Finland, France, Gabon, Gambia, Georgia, Germany, Ghana,
rates of productivity growth, as emphasized by Ngai and Pissarides Greece, Guatemala, Guinea, Guinea-Bissau, Guyana, Haiti,
(2007). We also find that the size of the informal sector decreases Honduras, Hong Kong, Hungary, Iceland, India, Indonesia, Iran,
through structural transformation, with informality decreasing in Ireland, Israel, Italy, Jamaica, Japan, Jordan, Kazakhstan, Kenya,
both industry and services. Korea Republic, Kuwait, Kyrgyzstan, Latvia, Lebanon, Liberia, Libya,
The quantitative implications of our models are consistent with Lithuania, Luxembourg, Madagascar, Malawi, Malaysia, Mali, Malta,
the data where employment share in agriculture decreases, in- Mexico, Moldova, Mongolia, Morocco, Mozambique, Namibia,
dustry follows an inverse-U-shaped pattern and services increases Nepal, Netherlands, New Zealand, Nicaragua, Niger, Nigeria, Nor-
through the period 1950e2005. Predictions of the model also way, Oman, Pakistan, Panama, Papua New Guinea, Paraguay, Peru,
match well with the informal sector dynamics observed in the data Philippines, Poland, Portugal, Qatar, Romania, Russia, Saudi Arabia,
set. Finally, using panel data estimations, we find strong empirical Senegal, Sierra Leone, Singapore, Slovakia, Slovenia, South Africa,
support for our observation in the model on the relationship be- Spain, Sri Lanka, Sudan, Suriname, Sweden, Switzerland, Syria,
tween the size of non-agricultural sector and informality. We show Taiwan, Tanzania, Thailand, Togo, Trinidad and Tobago, Tunisia,
that a larger non-agricultural sector is associated with a smaller Turkey, Uganda, Ukraine, United Arab Emirates, United Kingdom,
informal sector size. United States, Uruguay, Venezuela, Vietnam, Yemen, Zambia,
Zimbabwe.
APPENDIX
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