Government expenditure and informality in an emerging economy: the recent experience of India

This paper examines the absorption of government spending shocks in the presence of formal and informal production. Calibrating a two-sector open economy model that is consistent with data from India for the period 1990–2017, we show that increases in both government consumption and investment lead to a long-run decline in the shares of employment and output of the informal sector. However, the underlying mechanisms through which these long-run outcomes are achieved differ depending on the type of government spending shock, with the short-run immobility of capital and labor and the adjustment of the real exchange rate playing a key role in the process. While an increase in public consumption reduces the share of the informal sector through a real exchange rate depreciation and aggregate contraction in GDP, an increase in public investment works through a real exchange rate appreciation and an expansion of aggregate GDP. Overall, we find that while the reduction in informality driven by public investment is welfare enhancing, an increase in public consumption reduces welfare.