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Government policy in the formal and informal sectors

Listed author(s):
  • Prado, Mauricio

The paper quantitatively investigates, in general equilibrium, the interaction between the firms' choice to operate in the formal or the informal sector and government policy on taxation and enforcement, given a level of regulation. A static version of Ghironi and Melitz's (2005) industry model is used to show that firms with lower productivity endogenously choose to operate in the informal sector. I use cross-country data on taxes, measures of informality, and measures of regulation (entry and compliance costs, red tape, etc.) to back out how high the enforcement levels must be country by country to make the theory match the data. The welfare gains from policy reforms are on average 1.2% (measured in terms of consumption) for OECD countries. I also find that the welfare gains from reducing regulation are on average 2.1%. Finally, performing a similar decomposition to that of Hall and Jones (1999), I find that distortions associated with informality account for a factor of 1.5 of the output per capita difference between the richest and the poorest countries.

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File URL: http://www.sciencedirect.com/science/article/pii/S001429211100050X
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Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 55 (2011)
Issue (Month): 8 ()
Pages: 1120-1136

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Handle: RePEc:eee:eecrev:v:55:y:2011:i:8:p:1120-1136
DOI: 10.1016/j.euroecorev.2011.04.010
Contact details of provider: Web page: http://www.elsevier.com/locate/eer

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  1. James R. Tybout, 2000. "Manufacturing Firms in Developing Countries: How Well Do They Do, and Why?," Journal of Economic Literature, American Economic Association, vol. 38(1), pages 11-44, March.
  2. Djankov, Simeon & La Porta, Rafael & López-de-Silanes, Florencio & Shleifer, Andrei, 2001. "The Regulation of Entry," CEPR Discussion Papers 2953, C.E.P.R. Discussion Papers.
  3. 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.
  4. Pierre-Daniel G. Sarte, 1999. "Informality and rent-seeking bureaucracies in a model of long-run growth," Working Paper 99-07, Federal Reserve Bank of Richmond.
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