Government Policy in the Formal and Informal Sectors

Jose Mauricio Prado ()

No 751, Seminar Papers from Stockholm University, Institute for International Economic Studies

Abstract: The paper quantitatively investigates, in general equilibrium, the interaction between the firms' choice to operate in the formal or the informal sector and government policy on taxation and enforcement, given a level of regulation. A static version of Ghironi and Melitz’s (2005) industry model is used to show that firms with lower productivity endogenously choose to operate in the informal sector. I use cross-country data on taxes, measures of informality, and measures of regulation (entry and compliance costs, red tape, etc) to back out how high the enforcement levels must be country by country to make the theory match the data. Welfare gains from policy reforms can be fairly large. I find also that welfare gains from reducing regulation are almost twice those computed for the policy reform. Finally, distortions associated with informality account for a factor of 1.5 of the output per capita difference between the richest and the poorest countries.

Keywords: Informal economy; General equilibrium; Regulation (search for similar items in EconPapers)
JEL-codes: E61 H30 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dev, nep-mac, nep-pbe and nep-reg
Date: Written 2007-08-06
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