Political Economics of Informal Economy: Does Formalization Cause Electoral Losses?

1. Political Economics of Informal Economy: Does Formalization Cause Electoral Losses? by Mustafa İsmihan (mismihan@atilim.edu.tr) BülentTemel (btemel@post.harvard.edu) (Atılım University, Department of Economics)

2. Research question Is downsizing informal sector politically counterproductive in developing countries?

3. “Informal economy” Economic activities outside the knowledge or regulatory scrutiny of the state

4. “Informal economy” ⊃ (Traditional informal economy + Semi-formal economy)

5. “Semi-formal economy” Formally existing, but informally operating businesses Ex: Dolmuş (shared cabs)

6. Informal econ / formal econ 13%-76% in developing countries 20%-43% in frm Soviet countries 8%-30% in OECD countries Ihrig, J. and K. Moe, 2004, Lurking in the shadows: the informal sectors and government policy. Journal of Development Economics 73, 332.

7. Informal econ/formal econ in Turkey Up to 184% Davutyan, N., 2008, Estimating the size of Turkey's informal sector: an expenditure-based approach. Journal of Economic Policy Reform 11, 264.

8. Measurement methods & findings Money demand (0-46%) Electricity use (5%-64%) Tax collection (26%-184%) Multiple indicators (31%-35%) Davutyan, N., 2008, Estimating the size of Turkey's informal sector: an expenditure-based approach. Journal of Economic Policy Reform 11, 264.

9. IE in Developed Econs Smaller but increasing problem 1960-1995: Six percentage-points jump in the US, 11 in Germany, 14 in Sweden Schneider, F. and D. Enste, 2000, Shadow economies: size, causes and consequences. Journal ofEconomic Literature 38, 81.

10. Costs of IE ↘ tax revenues Budget deficit, debt stock Unfair competition, discouraged inv, slow growth ↘ FDI Distrust among people Misdiagnosis of the country’s needs Corruption Inflation

11. Factors of IE Low average income High minimum wage (90% of avg inc in TR, 50% even in frm Soviet countries) Labor-intensiveness Loose tax enforcement High social security contributions Costly job termination (26 wks OECD, 95 TR) High corporate income taxes Bureacracy in starting business (32 procedures in TR, 18 for mid-income countries)

12. Outcome Informality becoming a norm → Disinformalization becoming unpopular = Electorally counter-productive ?

13. Framework For disinformalization to be implemented, its electoral gains must be > its losses in the short run

14. Costs of disinformalization Compensatory public spending Tax cuts ↓ Fiscal imbalance Inflation and slower growth ↓ Lost votes

15. Gains from disinformalization ↗ Tax revenues and redistributive services ↗ Growth ↓ Electoral support

16. where R: Net electoral returns (% pt change in incumbent’s vote share, G: Targeted growth (% pt increase in real GDP)α: % pt increase in incumbent’s vote share for every G pt (α > 0), D: Budget deficit (as share of output), β: % pt decrease in incumbent’s vote share for every D pt (β < 0). R = αG + βD (1)

17. where c: Deficit-to-growth ratio(Budget deficit tolerated per unit of targeted growth) = D/Gc shows leadership’s competence Alternatively... R = (α+βc)G (2)

18. (α+βc): The rate of electoral return for each % pt increase in GDP growth(α > 0) Λ (β < 0)If (α>ǀβcǀ) → There is a positive net electoral return

19. Alternatively...c*: Threshold c where R is 0. (c* = -α / β where c* >0). Then...c = c* → R = 0.c > c* → R < 0.c < c* → R > 0.

20. Since α and β represent voters’ preferences, c is the only variable policymakers can influence for electoral gains

21. In Turkey α = 0.696 Akarca, A., 2011, A prediction for the AKP’s nationwide vote share in the 12 June parliamentary elections. İşletme İktisat ve Finans 26, 53-74.

22. β = Electoral losses due to deficiti = -0.28 i İsmihan, M., 2009b, Kronik istikrarsızlık ve potansiyel büyüme hızı: Türkiye deneyimi, 1960-2006. DEÜ İİBF Dergisi 24, 73-91.

23. R = αG + βD(1) = 0.696G – 0.28D

24. Net electoralreturnsin alternative scenarios

25. Finding Electoral consequences of disinformalization programs are influenced by political competence in administering distributive pressures

26. Policy issues in the Turkish context 1) Fighting informal economy can be an electoral advantage (not disadvantage) if administered competently

27. Policy issues in the Turkish context 2) Success is a function of expectations management

28. Policy issues in the Turkish context 3) EU goal could be instrumental in detaching from the costs

29. Policy issues in the Turkish context 4) Improved job creation prospects should incentivize pol leaderships to pursue disinformalization (Disinf → ↗ taxes & layoff costs → Part-timers and temps

30. For ex: If TR’s avg work wk (52 hr) is reduced to S. Korea’s (48), 325,000 new jobs’d be created (The World Bank, 2006, p. ix). 1M new jobs if EU-15 avg (38.5) is attained. The World Bank, 2006, Turkey Labor MarketStudy. Report no. 33254-TR, Washington, DC: World Bank, pg IX.

31. Policy issues in the Turkish context 5) Mass media is crucial for good PR to the program, and it benefits from it

32. Policy issues in the Turkish context 6) Academia should be utilized for feasible execution (competence)

33. Policy issues in the Turkish Context 7) Improved tax enforcement would be well worth its costs (Inspector #/1M taxpayers: 6 in TR, 13 in FR, 15 in UK) The World Bank, 2006, Turkey Labor MarketStudy. Report no. 33254-TR, Washington, DC: World Bank, pg IX.

34. Thank you Mustafa İsmihanmismihan@atilim.edu.tr BülentTemelbtemel@post.harvard.edu