Informal Economies, Information and the Environment.

• Author: KAHN, MATTHEW E.

"If household and firm activities are not observable by government, then they may not be observable by those affected by environmental degradation either.... [W]e have a regulatory challenge: when information is scarce, private bargaining is unlikely to suffice ... and government will lack a basis for regulatory action."

Many less developed countries (LDCs) contain sizeable shadow economies. For example, informal economic activity constitutes perhaps 70 percent of the GDP of Nigeria and Egypt, and perhaps as much as 30 percent of the GDP of Chile, Costa Rica, Venezuela, Brazil, Paraguay and Colombia.(1) The magnitude of the shadow economy in these and other countries may have serious environmental consequences. Environmental regulators seeking to provide incentives for environmental protection and conservation, for example, face enormous difficulties in monitoring and enforcing laws in the shadow sector. Groups and individuals operating in this sector recognize that they are not likely to be held accountable for actions that degrade environmental quality. The lack of accountability and incentives to comply with strong environmental standards raises the possibility that parties operating in the shadow sector will engage in activities that threaten the quality of the environment. This includes activities that cause an increase in the number of hazardous waste sites, the degradation of local air and water quality, species loss and total greenhouse gas emissions.

While informal sectors exist in all economies, the impact of unobserved economic activity on the environment might be more intense in developing countries for at least four reasons: first, as suggested above, the shadow sectors of LDCs are likely to represent a higher proportion of gross GDP than in developed countries; second, LDCs characteristically have more relatively rural and unpopulated areas, in which the inhabitants lack sufficient incentives (economic or otherwise) to motivate well-defined property rights;(2) next, developing countries are poorer, and thus their governments have fewer resources with which to monitor polluters; and finally, if environmental health is understood as a "luxury good"(3) then developing countries may lack the motivation to develop institutions that expose shadow sectors to regulation.

Given the challenge shadow economies pose to environmental regulators, are there strategies that a well-intentioned government can pursue to mitigate environmental damage? This paper will investigate three major related questions:

1. How does the existence of shadow sectors affect the design of environmental regulation?

2. How might regulators set environmental policies if they had more information concerning economic activity within shadow sectors?

3. Could economic development (including income growth) and increased international trade help "lift the shadow" and thus aid environmental regulators in pursuing accountability?

   In general, environmental economic policies should provide appropriate incentives for firms and households to reduce environmental degradation. Designed appropriately, such government intervention can guide markets toward outcomes that are socially preferable if, as expected, these actors ignore to some extent the environmental consequences of their actions. Appropriate intervention, however, may require expensive studies to gather useful information regarding actors in the shadow economy. Thus, regulators may choose not to gather this information.

   Consider the underlying policy problems: firms and households make millions of choices every day which go unobserved by regulators and may have an impact on the environment. These are choices such as: the quantity and type of fuel to use; or, whether to dump hazardous wastes or dispose of them properly If a regulator observed each activity and thereby knew how much damage was caused, they could provide appropriate incentives--facing polluters with the full costs of their activities. For example, this could be accomplished by instituting a tax equal to the environmental damage of each activity. Even in well-developed regulatory systems, however, it is costly (in time and money) to obtain information regarding all of the activities that occur, the damages they cause and the costs of reducing pollution. Thus, in shadow economies, where much of the economic activity is not officially observed, policy options may be quite limited.(4)

   In the view of many policymakers and citizens, limitations on policy choices also arise due to an important tradeoff: environmental protection may hinder production and consumption.(5) This is especially noteworthy considering the low levels of consumption in developing economies containing substantial shadow sectors. For example, in New England, restricting fishing to protect fish stock lowered incomes and increased unemployment among fishermen. A ban on logging to protect the spotted owl likewise encountered great resistance from logging communities in the northwest United States. Both of these cases highlight the difficulties in designing and implementing environmental policy, even in developed countries. Likewise, an LDC government seeking to restrict entry into a tropical forest in order to protect species may threaten the well-being of those generating income--or subsistence--from the forest. Without suggesting how a society or policymaker should value any of these, it is important to remember the tradeoffs inherent in making environmental policy

   This paper considers the set of strategies available to an environmental regulator with limited information. We study how the existence of large, informal sectors affects the choices that regulators make in limiting environmental damage, and then consider the effects of economic growth on environmental quality, including the possibility that growth may actually promote the formalization of what might otherwise be "shadow" sectors. After more fully describing some underlying policy problems, we consider policymaking conditions distinguished by the amount of information available: policies made without information; policies made with limited information; and policy situations in which more information is available.

   ENVIRONMENTAL DEGRADATION IN THE ABSENCE OF REGULATION

   To judge the benefits of environmental regulation, it is important to imagine the environmental consequences of an average person's daily behavior in an economy that features no regulation. In an LDC, bathing and cooking breakfast requires high-polluting fuels, such as coal, wood, or even dung, which are cheap to purchase but will increase local air pollution. Commuting to work contributes little to local air pollution if one walks; while a person who rides a bus or drives a car will contribute to local air pollution and global greenhouse gas production. A manufacturing job may contribute to water and air pollution. After work, a fish dinner may be provided by fishing that is unregulated at the local lake. This lake may be polluted by runoff from the household's daily water use, perhaps threatening the health of the future fish stock and its consumers. In cooking this dinner and in keeping his home comfortable in the evening, additional polluting fuels are consumed. Thus, in the absence of regulation, while some will act responsibly in their own visible environment, few will recognize, or care, about the environmental consequences their actions have on society at large.

   Most households recognize that they contribute to pollution, but they are likely to view themselves as too "small" to make a difference. Each driver in Los Angeles contributes to local smog levels, but if any one driver reduced miles driven, air quality would improve by almost zero. Such effects therefore seem easy to ignore, but as a whole, households impose significant negative externalities on the environment (that is, imposes costs on others). The social costs of driving choices therefore exceed the private costs, and private choices can lead to socially undesirable outcomes.

   These facts suggest that government action is needed to avoid the damage caused by such externalities. The Coase Theorem, however, suggests that socially efficient outcomes may be achievable even in the complete absence of government regulation. It posits that as long as parties on either side of the debate have strong property rights (that is, a right to pollute, or a right to not have one's environment polluted), and so long as those affected by externalities bargain with those whose actions cause the external effects, socially efficient outcomes will result.(6)

   When the conditions of the Coase Theorem do not hold though, externalities will yield social inefficiency. In many cases, it simply is not feasible, or too costly, to encourage bargaining between sides. For instance, it is difficult and costly for a fisherman in the Gulf of Mexico to determine precisely which parties are responsible for agricultural runoff that pollutes the Mississippi River (which in turn, pollutes the Gulf) much less to actually bargain with them.

   For shadow economies, high costs of bargaining between parties play a crucial role. If household and firm activities are not observable by government, then they may not be observable by those affected by environmental degradation either. Thus, while an affected household could in principle identify a polluting firm and offer to pay them not to pollute, the prospect of doing so is bleak. The costs of finding the firm, and the difficulty of enforcing such a deal, may be too great.(7) Thus we have a regulatory challenge: when information is scarce, private bargaining is unlikely to suffice between households and firms and government will lack a basis for regulatory action.

   Finally, we should place this likely environmental degradation into a few distinct settings. Rural settlers may degrade common property such as forests and lakes. Urban households may pollute...