The Informal Labor Market and The Costs of Sovereign Borrowing

Abstract

The informal labor market or informal sector is responsible for an economically significant fraction of GDP production in emerging economies. Taking the informal sector to be all economic activity intentionally concealed from tax authorities to avoid tax payments, an increase in the sector adversely impacts the government ability to collect tax revenues and may increase the probability of sovereign default. In turn, higher probability of sovereign default makes borrowing in international financial markets more costly. However, the current macro-finance models do not properly account for the role of the informal sector in explaining sovereign default risk. In this paper, I estimate a vector autoregressive model measuring the causal relationships between sovereign spreads, a measure of default risk, and the size of the informal sector. The results indicate that the size of the informal sector is as important as formal output variations in explaining sovereign spreads. Therefore, policies designed by emerging economies to reduce the size of the informal labor market are important to decrease the costs of borrowing in international financial markets and increase the financing options for productive investment.