Government Policy in the Formal and Informal Sectors

The aim of this paper is to quantitatively investigate the interaction between the firms’ choice to operate in the formal or the informal sector and the government policy on taxation and enforcement. Informality is here defined as unregistered firms in legal activities. I develop quantitative theory, in general equilibrium, using the main determinants of informality: taxes, enforcement, regulation. I incorporate these features in a model of heterogeneous firms, where firms differ in their productivities. I use Ghironi and Melitz’s (2005) industry model to show that firms with lower productivity endogeneously choose to operate in the informal sector. The model accounts quantitatively for the keys aspects in the data and allows me to back out country-specific enforcement levels. I analyze some policy reforms on taxation and enforcement and conclude that welfare gains can be fairly large. I compute the shadow value of decreasing regulation. And some counterfactual experiments are considered. Finally, I found that distortions associated to informality account for a factor of almost 2 of the output per capita difference between the richest and the poorest countries. JEL Classification Numbers: E26,E62,H32,O17