Informality, Inflation, and Fiscal Progressivity in Developing Countries

We develop a dynamic general equilibrium model with heterogeneous households and a cash-intensive informal sector that replicates two empirical patterns: the negative relationship between informality and firm productivity, and the declining share of informal consumption with household wealth. The non-homotheticity of informal consumption implies that tax incidence is heterogenous: poor households pay less consumption taxes but are more exposed to inflation. We use the model to study the distributional effects of financing government revenue through seigniorage versus consumption taxes. Calibrated to Peru – where informality accounts for around half of economic activity – the model shows that informal purchases provide significant savings through lower prices, particularly for poor households, who save up to 11% compared to purchasing the same bundle formally. The model also uncovers substantial variation in preferences over revenue-neutral combinations of inflation and consumption taxes: households in the top expenditure decile would like inflation to be as high as 12%, while those in the bottom favor inflation below 5%. This disagreement grows with the size of the informal sector.