Trade and Domestic Distortions: The Case of Informality

Rafael Dix-Carneiro, Pinelopi Koujianou Goldberg, Costas Meghir and Gabriel Ulyssea

No 20250, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: We examine the effects of international trade in the presence of a set of domestic distortions giving rise to informality, a prevalent phenomenon in developing countries. In our quantitative model, the informal sector arises from burdensome taxes and regulations that are imperfectly enforced by the government. In equilibrium, smaller, less productive firms face fewer distortions than larger, more productive ones, potentially leading to substantial misallocation. We show that in settings with a large informal sector, the gains from trade are significantly amplified, as reductions in trade barriers imply a reallocation of resources from initially less distorted to more distorted firms. We confirm findings from earlier reduced-form studies that the informal sector mitigates the impact of negative labor demand shocks on unemployment. Nonetheless, the informal sector can exacerbate the adverse real income effects of economic downturns, amplifying misallocation. Last, our research sheds light on the relationship between trade openness and cross-firm wage inequality.

Keywords: Trade; Informality (search for similar items in EconPapers)
JEL-codes: F14 F16 J46 O17 (search for similar items in EconPapers)
Date: 2025-05
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