Informal sector, productivity, and tax collection

The informal sector is a prominent characteristic of many developing countries. Most of the literature has focused on understanding the determinants of informality. The connection between the informal sector and economic development is, nonetheless, relatively less understood. One of the most important determinants of informality is the tax enforcement quality of a country which, some authors argue, additionally distorts firms' decisions and creates inefficiency. In this paper, I assess the quantitative importance of the effects of incomplete tax enforcement on aggregate output and productivity. I use a dynamic general equilibrium framework to study effects that have received little attention in the literature. I calibrate the model using data for Mexico, an economy where 31% of the employees work in informal establishments. I then investigate the effects of improving enforcement. My main finding is that under complete enforcement, Mexico's labor productivity and output would be 17% higher.