David Smith and Brandon Parsons Co-Author New Study Analyzing the Power of Economic Freedom to Reduce the Informal Economy
In a new study published in Economic Change and Restructuring, Pepperdine Graziadio faculty member and interim dean David Smith, alongside Pepperdine Graziadio faculty member Brandon Parsons, provide a comprehensive empirical assessment of how market-oriented reforms influence the size of the informal economy in developing countries. Titled "Does economic freedom light the shadows? Economic freedom and the informal economy in developing countries," the open-access research utilizes advanced econometric modeling to evaluate data from 1996 to 2018. The study explores the specific drivers that encourage businesses to transition out of unregulated, underground sectors and into the formal market.
The article found that greater overall economic freedom consistently shrinks the informal economy, with the most pronounced formalizing effects occurring in countries where the informal sector is deeply entrenched. By breaking down the Economic Freedom of the World Index into its core subcomponents, the researchers identified legal system integrity, regulatory quality, and international trade freedom as the most powerful catalysts for driving formalization. "We find legal system integrity, trade freedom, and regulatory quality as the most significant drivers of formalization," the authors noted in the study, underscoring that institutional foundations shape the cost-benefit calculus for businesses choosing to operate legally.
However, the research uncovers a critical caveat to market-based transitions: the relationship between economic freedom and informality is highly dependent on institutional integrity and social infrastructure. The study demonstrates that systemic corruption significantly boosts informal activity and diminishes the positive impacts of market reforms, while targeted investments in human capital heavily bolster formal-sector participation. Ultimately, Smith and Parsons emphasize that economic freedom reforms reducing entry barriers are most effective when directly paired with aggressive anti-corruption efforts and robust educational investments.
Read the full article here.