Inequality, Informality, and Credit Market Imperfections

Abstract

This paper develops a microfounded macroeconomic modeling framework to investigate the relationship between informality and the income distribution. We show that multiple equilibria may rise if credit markets are imperfect and that there is a nondivisible entry cost in the formal economy. The theoretical analysis demonstrates that in the steady state, low levels of inequality are negatively correlated with high informality; conversely, high inequality exacerbates informality. This finding supports the hypothesis of an optimal level of inequality that minimizes the informal economy relative to the impact of other levels of inequality. However, for ordinary income distributions, changes in the level of inequality have only a slight effect on the informality rate. We calibrate the model using data on the U.S. and Mexican economies to estimate the level of inequality that minimizes the informality rate. The self-employment rate emerges as the most relevant determinant of the informality rate.

Inequality and informality in transition and emerging countries

“…As a result, a more unequal distribution of assets leads to a higher fertility rate, and, under the assumption of an imperfect capital market, it reduces productive investments in human capital per capita because families do not have sufficient access to credit [2].…”

“…The prevalent view in the empirical literature is that higher inequality increases the size of the informal economy, though some studies find a statistically insignificant correlation (see [2] for an overview). However, variance in outcomes is normally attributed to data limitations, regional differences, and bias from measurement errors.…”

Inequality and informality in transition and emerging countries

“…A recent attempt to rationalize this unstable evidence hypothesizes a non-linear (concave upwards) relationship between inequality and informality [3]. This research may indirectly explain the statistically insignificant correlations for transition countries [5], [11], [12].…”

“…underground production). Accordingly, (very) low inequality resulting from an excessive tax burden on formal business activity increases the extent of the informal economy [3].…”

“…As a result, a more unequal distribution of assets leads to a higher fertility rate, and, under the assumption of an imperfect capital market, it reduces productive investments in human capital per capita because families do not have sufficient access to credit [3].…”