Taxation, credit constraints and the informal economy

This paper extends Evans and Jovanovic (1989)’s entrepreneurship model to incorporate the informal sector. Specifically, entrepreneurs can operate either in the formal sector – in which they have limited access to credit markets, but have to pay taxes – or in the informal sector – in which they can avoid paying taxes, but have no access to credit markets. In addition, technology in the informal sector is both less productive and more labor intensive than that in the formal sector. We calibrate the model to the Brazilian economy, and evaluate the impact of credit frictions and taxation on occupational choices, aggregate output and inequality. Removing all distortions can improve aggregate efficiency considerably, largely because this induces entrepreneurs to switch to the formal sector, where technology is superior. Most of this effect comes from removing credit market frictions, but taxes on formal businesses are also important. The elimination of distortions can also reduce inequality, but this comes from credit constraints and labor income taxation. Reducing taxes on formal businesses actually increases inequality in the model.