Does economic freedom light the shadows? Economic freedom and the informal economy in developing countries

Drawing on a panel of developing countries from 1996 to 2018, this study provides a robust empirical assessment of economic freedom’s capacity to shrink the informal economy and identifies which specific subcomponents are most effective at driving formalization. We utilize the Method of Moments Quantile Regression (MMQR) and two-step System GMM, which addresses endogeneity and heterogeneity. We further test for robustness using two measures of informality: Dynamic General Equilibrium (DGE) and Multiple Indicators Multiple Causes (MIMIC). We find legal system integrity, trade freedom, and regulatory quality as the most significant drivers of formalization. However, our research uncovers a critical caveat: corruption significantly boosts informal activity even when economic freedom is high, while human capital serves as a vital catalyst for formal-sector participation. Our results suggest that the relationship between economic freedom and informality is not unconditional; rather, the capacity of market-based reforms to shed light on the shadows is significantly diminished by corruption, while it is bolstered by human capital investment.