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The Informal Sector

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  • Áureo de Paula
  • José A. Scheinkman

Abstract

This paper investigates the determinants of informal economic activity. We present two equilibrium models of informality and test their implications using a survey of 48,000+ small firms in Brazil. We define informality as tax avoidance; firms in the informal sector avoid tax payments but suffer other limitations. In the first model there is a single industry and informal firms face a higher cost of capital and a limitation on size. As a result informal firms are smaller and have a lower capital labor ratio. When education is an imperfect proxy for ability, we show that the interaction of the manager's education and formality has a positive correlation with firm size. These implications are supported by our empirical analysis. The second model highlights the role of value added taxes in transmitting informality. It predicts that the informality of a firm is correlated to the informality of firms from which it buys or sells. The model implies that higher tolerance for informal firms in one production stage increases tax avoidance in downstream and upstream sectors. Empirical analysis shows that, in fact, various measures of formality of suppliers and purchasers (and its enforcement) are correlated with the formality of a firm. Even more interestingly, when we look at sectors where Brazilian firms are not subject to the credit system of value added tax, this chain effect vanishes.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13486.

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Date of creation: Oct 2007
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Handle: RePEc:nbr:nberwo:13486

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  1. Straub, Stéphane, 2005. "Informal sector: The credit market channel," Journal of Development Economics, Elsevier, vol. 78(2), pages 299-321, December.
  2. Maloney, William F. & Nunez, Jairo & Cunningham, Wendy & Fiess, Norbert & Montenegro, Claudio & Murrugarra, Edmundo & Santamaria,Mauricio & Sepulveda, Claudia, 2001. "Measuring the impact of minimum wages : evidence from Latin America," Policy Research Working Paper Series 2597, The World Bank.
  3. Fajnzylber, Pablo & Maloney, William F. & Montes-Rojas, Gabriel V., 2009. "Does Formality Improve Micro-Firm Performance? Quasi-Experimental Evidence from the Brazilian SIMPLES Program," IZA Discussion Papers 4531, Institute for the Study of Labor (IZA).
  4. Rauch, James E., 1991. "Modelling the informal sector formally," Journal of Development Economics, Elsevier, vol. 35(1), pages 33-47, January.
  5. Fortin, Bernard & Marceau, Nicolas & Savard, Luc, 1997. "Taxation, wage controls and the informal sector," Journal of Public Economics, Elsevier, vol. 66(2), pages 293-312, November.
  6. Rita Almeida & Pedro Carneiro, 2006. "Enforcement of regulation, informal labor and firm performance," CeMMAP working papers CWP02/06, Centre for Microdata Methods and Practice, Institute for Fiscal Studies.
  7. Emran, M. Shahe & Stiglitz, Joseph E., 2005. "On selective indirect tax reform in developing countries," Journal of Public Economics, Elsevier, vol. 89(4), pages 599-623, April.
  8. R. Hirschowitz, 1989. "The Other Path: The Invisible Revolution in the Third World," South African Journal of Economics, Economic Society of South Africa, vol. 57(4), pages 266-272, December.
  9. Alan A. Tait, 1991. "Value-Added Tax," IMF Occasional Papers 88, International Monetary Fund.
  10. Loayza, Norman A., 1997. "The economics of the informal sector : a simple model and some empirical evidence from Latin America," Policy Research Working Paper Series 1727, The World Bank.
  11. Edward P. Lazear, 2005. "Entrepreneurship," Journal of Labor Economics, University of Chicago Press, vol. 23(4), pages 649-680, October.
  12. James J. Heckman & Carmen Pagés, 2004. "Law and Employment: Lessons from Latin America and the Caribbean," NBER Books, National Bureau of Economic Research, Inc, number heck04-1, May.
  13. Koujianou Goldberg, Pinelopi & Pavcnik, Nina, 2003. "The response of the informal sector to trade liberalization," Journal of Development Economics, Elsevier, vol. 72(2), pages 463-496, December.
  14. Dominik H. Enste & Friedrich Schneider, 2000. "Shadow Economies: Size, Causes, and Consequences," Journal of Economic Literature, American Economic Association, vol. 38(1), pages 77-114, March.
  15. Jung, Young H. & Snow, Arthur & Trandel, Gregory A., 1994. "Tax evasion and the size of the underground economy," Journal of Public Economics, Elsevier, vol. 54(3), pages 391-402, July.
  16. Friedman, Eric & Johnson, Simon & Kaufmann, Daniel & Zoido-Lobaton, Pablo, 2000. "Dodging the grabbing hand: the determinants of unofficial activity in 69 countries," Journal of Public Economics, Elsevier, vol. 76(3), pages 459-493, June.
  17. Almeida, Rita & Carneiro, Pedro, 2005. "Enforcement of labor regulation, informal labor, and firm performance," Policy Research Working Paper Series 3756, The World Bank.
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