Inequality, Informality, and Optimal Progressivity

How should governments design progressive labor-income taxes when workers can shift labor supply into untaxed informal work? Using household surveys for Brazil, Colombia, Mexico, and Peru, we document steep gradients in informality, employment, and unemployment across the income distribution. We analyze non-linear tax schedules in a heterogeneous-agent model with search frictions, savings, and an endogenous formal — informal labor-supply margin. Progressivity operates through an inclusion margin at the bottom-negative income taxes increase formal attachment — and an evasion margin at the top, where higher marginal tax rates shift labor supply into the untaxed sector. These opposing forces imply that both welfare and formality are hump-shaped in progressivity; in a calibration to Mexico, the welfare-maximizing degree of progressivity is about five times the current level.