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The Informal Sector

  • Aureo de Paula
  • Jose A Sheinkman

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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Paper provided by UCLA Department of Economics in its series Levine's Bibliography with number 122247000000001663.

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Date of creation: 15 Nov 2007
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Handle: RePEc:cla:levrem:122247000000001663
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  1. 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.
  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. 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.
  4. James Heckman & Carmen Pages, 2003. "Law and Employment: Lessons from Latin America and the Caribbean," NBER Working Papers 10129, National Bureau of Economic Research, Inc.
  5. Stephane Straub, 2005. "Informal Sector: The Credit Market Channel," ESE Discussion Papers 101, Edinburgh School of Economics, University of Edinburgh.
  6. 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.
  7. Almeida, Rita & Carneiro, Pedro, 2005. "Enforcement of labor regulation, informal labor, and firm performance," Policy Research Working Paper Series 3756, The World Bank.
  8. 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.
  9. Edward P. Lazear, 2005. "Entrepreneurship," Journal of Labor Economics, University of Chicago Press, vol. 23(4), pages 649-680, October.
  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. 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.
  12. 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.
  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. Alan A. Tait, 1991. "Value-Added Tax: Administrative and Policy Issues," IMF Occasional Papers 88, International Monetary Fund.
  15. Rauch, James E., 1991. "Modelling the informal sector formally," Journal of Development Economics, Elsevier, vol. 35(1), pages 33-47, January.
  16. 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).
  17. 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.
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