A competitive model of the informal sector

Amaral, Pedro S.; Quintin, Erwan

doi:10.1016/j.jmoneco.2005.07.016

Cited by 285 publications

(192 citation statements)

References 18 publications

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“…7 Amaral and Quintin (2006) outline a theoretical framework where the only difference between informal and formal sector firms is that informal sector firms are seen as more likely to default on loans, have difficulty accessing credit and, because of this, rely on self financing. Because of the complementarity between skill and capital, high skill capital intensive firms enter the formal sector and hire high skill workers.…”

Section: Section I: Introductionmentioning

confidence: 99%

The formal sector wage premium and firm size

Badaoui¹,

Strobl²,

Walsh³

2010

Journal of Development Economics

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We show theoretically that when larger firms pay higher wages and are more likely to be caught defaulting on labor taxes, then large-high wage firms will be in the formal and small-low wage firms will be in the informal sector. The formal sector wage premium is thus just a firm size wage differential. Using data from Ecuador we illustrate that firm size is indeed the key variable determining whether a formal sector premium exists. Forthcoming in the Journal of Development Economics Section I: IntroductionOne of the main differences between labor markets in developing compared to developed economies is the existence of large informal sectors. For example, in Latin America the informal sector is estimated to absorb over half of the urban labor force. 1 Importantly in this regard, it is generally assumed and empirically substantiated by much of the literature that workers in the informal sector are paid less than their formal sector counterparts. 2 However, theoretically it is not clear why this should be the case. While a tax wedge would explain differences in gross wages, if workers can move between sectors then net wages should surely be equalized. Earlier papers in the literature, such as Lewis (1954) or Harris and Todaro (1970), attempted to explain this phenomena by assuming a dual labor market structure where workers earned rents in the primary sector and secondary sector workers queued for good jobs. There are of course many other models that could also be used to justify why workers in particular sectors would earn wage premiums -as, for example, variants of the efficiency wage model or union models -but applying these to explain a wage premium for formal sector employees would still mean arbitrarily assuming that formal sector workers earn rents because of some exogenously imposed feature that for some reason is more relevant to the formal rather than the informal sector.In this paper we start off by demonstrating that in essentially any labor market model where in equilibrium larger firms pay higher wages, if larger firms are more likely to be caught defaulting on labor taxes, then large-high wage firms will be in the formal and small-low wage firms will be in the informal sector. The formal sector premium is thus just a firm size premium. In order to solve for the wage distribution explicitly in the case where the firm size wage premium emerges endogenously, we 1 See ILO (2002). 2 See, for example, Mazumdar (1981), Heckman and Hotz (1986), Pradhan and van Soest (1995), Tansel (1999), and Gong and van Soest (2002).2 then incorporate taxes on labor income and an enforcement technology into the equilibrium search model of Burdett and Mortensen (1998). More specifically, firms post wages and workers may work in the formal sector or may opt for a tax free outside option, which could be viewed as informal sector employment, as discussed by Albrecht et al. (2005). We find that in this set-up formal sector employees do indeed earn rents relative to their informal counterparts in the model. However,...

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Section: Section I: Introductionmentioning

confidence: 99%

The formal sector wage premium and firm size

Badaoui¹,

Strobl²,

Walsh³

2010

Journal of Development Economics

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“…Furthermore, the returns to surplus education increase considerably for formal workers along the wage distribution suggesting that this type of jobs represents better employment opportunities for overeducated workers. This probably reflects the fact that formal workers may take advantage of the higher productivity 11 11 The productivity of formal firms could be higher than that of informal firms because a higher capital-labour ratio caused by the fact that informal firms may have less access to credit (Amaral and Quintin, 2006). Another reason is that informal firms continue to operate at a small size that allows them to scape from government control and, therefore, cannot exploit possible economies of scale.…”

Section: Research Institute Of Applied Economicsmentioning

confidence: 99%

Double Penalty in Returns to Education: Informality and Educational Mismatch in the Colombian Labour Market

Herrera-Idárraga

López‐Bazo

Motellón

2015

The Journal of Development Studies

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“…Among recent models of the informal economy the ones that are closely related to this paper are Amaral and Quintin [2006], Antunes and Cavalcanti [2007], Prado [2007] and Aruoba [2010].…”

Section: Working Papers Seriesmentioning

confidence: 99%

“…9 Amaral and Quintin [2006] try to account for characteristics of the labor market in developing countries, where despite free entry to the formal sector informal workers tend to be less educated and are paid less than formal workers. In their model, the informal economy arises from imperfections in the capital market due to a lack of commitment to financial contracts.…”

Section: Working Papers Seriesmentioning

confidence: 99%

Tax Rates, Governance, and the Informal Economy in High‐income Countries

Kuehn

2013

Economic Inquiry

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Approximately 16.7% of output in high-income OECD countries is produced informally. Across these countries, the size of the informal economy is positively related to tax rates and negatively related to governance quality. While existing models of the informal economy mostly focus on developing countries, this paper studies the mechanisms behind the informal economy in high-income countries. I build a model economy where agents can become workers or entrepreneurs. Entrepreneurs decide how much of their production to declare as formal and to report for tax purposes and how much to keep informal and hidden. Informal economic activity carries a risk of getting caught, taxed, and fined. Simulations show that differences in tax rates alone can only account for approximately 23% of informality across high-income countries while differences in governance quality, the extent to which tax rates are enforced seem to play a more important role. Taking into account both, governance quality and tax rates, the model can account for 72% of informality in high-income countries. I run a policy experiment that raises governance quality in Greece, Italy, Spain, and Portugal to Finish standards. Informality across these countries is reduced by an average 13 percentage points and in case tax collection costs increase less than five fold, the policy also implies higher tax revenues.JEL classification: E26, H20, H26, J24

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A competitive model of the informal sector

Cited by 285 publications

References 18 publications

The formal sector wage premium and firm size

The formal sector wage premium and firm size

Double Penalty in Returns to Education: Informality and Educational Mismatch in the Colombian Labour Market

Tax Rates, Governance, and the Informal Economy in High‐income Countries

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