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Current Account, Informal Economy and Fiscal Policy

Final Report Summary - CAINF (Current Account, Informal Economy and Fiscal Policy)

For most of the economies in the world, current account deficits are an important source of instability, as they make countries vulnerable to external shocks. Another important problem is the size of the informal sector which has many economic and social implications. This project aimed to develop a coherent framework to link these two important issues in a coherent framework both from an empirical and theoretical perspective. This model would be used to analyze the effects of the presence of an informal sector on the external balances of European countries, specifically how it affects the current account/trade balance and the role of fiscal policy in an open, integrated economy.
In line with these objectives, our first task was to construct a dataset including the main macroeconomic variables along with the size of the informal sector for a large set of countries. The novelty of our dataset is that it included the size of the informal sector for 161 countries for the time period 1960-2013. Our estimates rely on the calibration of a two-sector dynamic stochastic general equilibrium model for the countries included in our analysis. We are constantly updating our dataset which will allow researcher to understand the evolution of informality and its effects on different economic variables.

Using our dataset, we have finished working on a project, although not directly related to the main objectives, which investigates the relation between current account imbalances and output volatility using a Panel-VAR framework. Our findings suggest that a larger current account deficit is associated with higher output volatility, which sets countries to a relatively less stable growth path and constitutes an obstacle for sustainable growth, particularly for emerging market economies. This study was published in Economic Modeling in July 2013.

We analyzed the relationship between current account imbalances and informal economy using techniques of dynamic panel data econometrics. In this part of the project, we have investigated the relationship between economic growth and current account imbalances and informality. Our findings suggest that there is a negative relationship between economic growth and current account deficits. Furthermore, economic growth is negatively associated with the size of the informal sector and a larger informal sector reinforces the negative effect of current account imbalances on economic growth. Especially, for emerging market economies with persistent current account imbalances, economic growth episodes are coupled with current account deficits and exhibit a switch from informality to formality.

We developed a theoretical model which is consistent with these empirical observations. We have worked on a small open economy model with heterogeneous firms, which incorporates imported input and informality/formality decisions of firms. Our model endogenizes informality by introducing a trade-off, which assumes that formal firms are more productive in the sense that they have access to the government infrastructure, however they have to incur additional operating costs consistent with the previous literature on informal economies. This endogeneity allows us to analyze the two-way causality between fiscal policy and informality in an open economy context, and evaluate the effects of such policies on the external balances of countries. We have shown that a reduction in the tariff rates or tax rates reduces the size of the informal sector together with an increase in the GDP and imports of the country but deteriorating the trade balance.

Finally, we aimed to further enhance the baseline model to include the effect of real exchange rates. To this end, we have estimated firm-level elasticities of exports and imports relative to real exchange rate using confidential firm-level data from Turkish manufacturing industry. We have shown that firms are affected differently by the real exchange rate movements, therefore a complete model should incorporate this differential impact on the firm behavior. We are currently embedding this element to our benchmark model. Furthermore, for the robustness of the empirical analysis, we have estimated our empirical model with bilateral trade data instead of the aggregate analysis conducted in the first period.

To sum up, the empirical analysis using the novel dataset provides a starting point for empirical research on current account imbalances, international trade and informality. The theoretical model developed in this project, to the best of our knowledge, is the first which incorporates use of imported inputs, exports and informality/formality decisions of firms. In this regard, forms a benchmark for academic research aiming to assess the role of informality on current account and trade balance from a firm-level analysis.