Misallocation, Informality, and Human Capital

We develop a theory of total factor productivity to understand differences in pro- ductivity and human capital across countries. In our model, firms face capital market imperfections and costs of operating in the formal sector. Formal firms have a larger set of production opportunities and the ability to employ skilled workers, but informal firms can avoid the costs of formalization. These firm-level distortions give rise to endogenous formal and informal sectors and, more importantly, affect the demand for skilled workers. The model predicts that countries with a low degree of debt enforcement and high costs of formalization are characterized by low allocative efficiency and a larger informal sector, lower measured TFP, and lower stocks of skilled workers. We find that this mechanism plays an important role in generating the differences observed between the US and de- veloping countries in the human capital stock. Moreover, formal sector entry costs and financial frictions are complementary and their joint effect is the main driver of the dif- ferences between the US and developing countries in terms of human capital, informality, and TFP. The complementarity effect is generated by the introduction of skilled workers, which increases the labor substitution incentives, which in turn moves the firm closer to the financial constraint.