Pigouvian Exploitation, Informality and Economic Growth: Theory and Evidence

Given perfectly competitive labor markets combined with the profit-maximizing behavior of firms, real wages should equal the marginal product of labor (MPL). However, there is ample evidence that this equality is distorted in various economies in terms of both levels and growth rates. Basing our analysis on a demand-driven distribution and growth model, we investigate the relationship between the wage-productivity gap (also called the Pigouvian exploitation rate in the early literature) and economic growth, and assess how the presence of an informal sector interacts with this relationship. Using annual cross-country unbalanced panel data from 160 countries in a time-series window from 1950 to 2017, we show that informality strongly interacts with this relationship. Specifically, we find that in countries with a larger informal sector (as percentage of GDP), productivity gains are not compensated for by wage increases. Therefore, a larger wage-productivity gap is associated with higher growth rate while the growth regime is more likely to be profit-led.