Essays on Capital Controls and the Informal Economy

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This dissertation addresses the issues of capital controls and informal economy. Both subjects have evoked considerable interest in both academic environments and policy circles, especially given their importance for developing countries. The dissertation is structured as follows. Chapter 1 analyzes how exchange rate regimes influence fiscal discipline. This important question has typically been addressed using models assuming perfect capital mobility, even though capital controls are pervasive in developing countries. This chapter analyzes the effects of capital controls on fiscal performance by focusing on dual exchange rate regimes. In a model in which fiscal policy is endogenously determined by a non-benevolent fiscal authority, the paper shows that capital controls induce impatient politicians to have looser fiscal policies than under fixed and flexible regimes operating under perfect capital mobility. While capital controls enable politicians to enjoy the same temporarily low inflation as fixed regimes (since the commercial exchange rate is assumed to be fixed) lax fiscal policies also result in a temporary consumption boom which is regarded as desirable by impatient politicians. The consumption boom occurs because, as households attempt to get rid of unwanted real money balances, the real domestic interest rate falls. Empirical analysis confirms that capital controls lead to larger primary deficits than fixed and flexible regimes. The study considers a dynamic panel data specification and controls for endogeneity by using a standard instrumental variables approach and natural disaster events to evaluate the response of fiscal policies under diverse regimes. Chapter 2 estimates the size of the informal economy for the Eastern Caribbean Currency Union (ECCU) countries and 26 mainly Latin American countries in the early 2000s, being the first study to address this issue for the ECCU economies and many other Central American and Caribbean countries. Using a structural equation modeling approach we find that a stringent tax system and regulatory environment, higher inflation and dominance of the agriculture sector are key factors in determining the size of the informal economy. The results also confirm that a higher degree of informality reduces labor unionization, the number of contributors to social security schemes and enrollment rates in education.