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Trade and Domestic Distortions: The Case of Informality

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Listed:
  • Rafael Dix-Carneiro
  • Pinelopi Koujianou Goldberg
  • Costas Meghir
  • Gabriel Ulyssea
  • Pinelopi Goldberg

Abstract

We examine the effects of international trade in the presence of a set of domestic distortions giving rise to informality, a prevalent phenomenon in developing countries. In our quantitative model, the informal sector arises from burdensome taxes and regulations that are imperfectly enforced by the government. In equilibrium, smaller, less productive firms face fewer distortions than larger, more productive ones, potentially leading to substantial misallocation. We show that in settings with a large informal sector, the gains from trade are significantly amplified, as reductions in trade barriers imply a reallocation of resources from initially less distorted to more distorted firms. We confirm findings from earlier reduced-form studies that the informal sector mitigates the impact of negative labor demand shocks on unemployment. Nonetheless, the informal sector can exacerbate the adverse real income effects of economic downturns, amplifying misallocation. Last, our research sheds light on the relationship between trade openness and cross-firm wage inequality.

Suggested Citation

  • Rafael Dix-Carneiro & Pinelopi Koujianou Goldberg & Costas Meghir & Gabriel Ulyssea & Pinelopi Goldberg, 2025. "Trade and Domestic Distortions: The Case of Informality," CESifo Working Paper Series 11873, CESifo.
  • Handle: RePEc:ces:ceswps:_11873
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    References listed on IDEAS

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    More about this item

    Keywords

    trade liberalization; misallocation; distortions; informality;
    All these keywords.

    JEL classification:

    • F14 - International Economics - - Trade - - - Empirical Studies of Trade
    • F16 - International Economics - - Trade - - - Trade and Labor Market Interactions
    • J46 - Labor and Demographic Economics - - Particular Labor Markets - - - Informal Labor Market
    • O17 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements

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