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The Informal Sector: An Equilibrium Model and Some Empirical Evidence from Brazil, Second Version

  • Aureo de Paula

    ()

    (Department of Economics,University of Pennsylvania)

  • Jose A. Scheinkman

    ()

    (Department of Economics, Princeton University)

We test implications of a simple equilibrium model of informality using a survey of 48,000+ small firms in Brazil. In the model, agent's ability to manage production differ and informal firms face a higher cost of capital and limitation on size, although these informal firms avoid tax payments. As a result, informal firms are managed by less able entrepreneurs, are smaller, and employ a lower capital-labor ratio. The model predicts that the interaction of an index of observable inputs to entrepreneurial ability and formality is positively correlated with firm size, which we verify in the data. Using the model, we estimate that informal firms in our dataset faced at least 1.3 times the cost of capital of formal firms.

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File URL: http://economics.sas.upenn.edu/system/files/10-024.pdf
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Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 10-024.

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Length: 30 pages
Date of creation: 30 Nov 2009
Date of revision: 26 Jul 2010
Handle: RePEc:pen:papers:10-024
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  1. Dabla-Norris, Era & Gradstein, Mark & Inchauste, Gabriela, 2008. "What causes firms to hide output? The determinants of informality," Journal of Development Economics, Elsevier, vol. 85(1-2), pages 1-27, February.
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