Job search and mobility in developing countries. Theory and policy implications

A labor market model is developed in which the formal sector is characterized by search frictions whereas the informal sector is competitive. We show that there exists a unique steady-state equilibrium in this dual economy. We then consider different policies financed by a tax on firms' profits. We find that reducing the unemployment benefit or the firms' entry cost in the formal sector induces higher job creation and formal employment, reduces the size of the informal sector but has an ambiguous effect on wages. We also find that an employment/wage subsidy policy and a hiring subsidy policy have different implications. In particular, the former increases the size of the informal sector while the latter decreases it.     

Start up costs, limited enforcement, and the hidden economy

This paper examines how much of the difference in the size of the informal sector and in per capita income across countries can be accounted by regulation costs and enforcement of financial contracts. It constructs and solves numerically a general equilibrium model with credit constrained heterogenous agents, occupational choices over formal and informal businesses, financial frictions and a government sector which imposes taxes and regulations on formal firms. The benefit from formalization is better access to outside finance. The quantitative exercises suggest that: (i) regulation costs and not the level of enforcement account for differences in the size of the informal sector between United States and Mediterranean Europe; (ii) for a developing country like Peru, however, contract enforcement and regulation costs are equally important in accounting for the size of the informal sector; and (iii) regulation costs and contract enforcement do not account for most of the income differences observed among countries.     

Taxing multinationals: The scope for enforcement cooperation

Policymakers seeking to raise more tax revenues from multinational enterprises have two alternatives: to raise tax rates or to devote more resources to improve tax compliance. Tougher tax enforcement increases the cost of profit shifting, and thus mitigates tax competition. We present a tax-competition model with two policy instruments (the corporate tax rate and the tightness of tax enforcement). In line with the Organisation for Economic Cooperation and Development's Base Erosion and Profit Shifting project, we analyze the scope for enforcement cooperation among asymmetric countries, considering that taxes are set noncooperatively. We show that the low-tax country may fail to cooperate if asymmetry is large enough and that tax havens would never agree to cooperate. Then we identify two drivers for enforcement cooperation. The first driver of cooperation is the complementarity of enforcement actions across countries. This is because the efficiency loss from enforcement dispersion is greater under complementarity. The second driver of cooperation is tax leadership by the high-tax country, which acts as a level-playing field in the tax competition and reduces the extent of disagreement on enforcement.     

Informality,enforcement and growth

This paper develops a two-sector growth model with formal and informal sectors for an economy that cares about redistribution and illustrates its relationship with the enforcement level. The technology gap and labour rigidity explicate the duality. The state can tax the formal sector to subsidise informal income and finance public infrastructure. Alternatively, enforcement, which is costly and corresponds to a variety of discrete components from the security of property rights and integrity of contracts to control of corruptions, can be chosen to favour the formal sector and discourage the informal sector. It is observed that weaker enforcement required to accommodate some degree of informality, which releases tax burden from the formal sector needed for redistribution, can accelerate growth rate. However, sufficiently weaker enforcement dampens the formal sector expansion and growth rate. The growth rate registers an inverted-U shaped relationship against the enforcement level. The optimum enforcement can, however, be higher without formal labour union and subsidisation. This must be higher for welfare maximisation than that of growth rate, especially when the consumer cares about the quality of enforcement.     

Entrepreneurship in the shadows

I develop a dynamic model of forward-looking entrepreneurs, who decide whether to operate in the formal economy or informal economy and choose how much to invest in their businesses, taking government policy as given. The government has access to two policy tools: taxes on formal business activity and enforcement (or policing) discouraging informality. The main focus of the paper is on transitional dynamics under different initial wealth levels. Whether an initially small business will be trapped in the informal economy and remain small forever or grow quickly and become a large formal business depends on tax and enforcement policies. High tax rates accompanied by loose enforcement – which is mostly the case in less-developed countries (LDCs) – induce tax avoidance, discourage investment in formal businesses, and drive the entrepreneurial activity towards the informal sector even though the initial wealth level is high. Lowering taxes on formal activity joined with strict enforcement can help reducing the magnitude of poverty traps in LDCs – such as the MENA region, Latin America and developing Asia.     

Tax collection,the informal sector,and productivity

An important determinant of informality in a country is its tax enforcement capacity, which some authors argue further distorts the decisions of firms and creates inefficiency. In this paper, I assess the quantitative effect of incomplete tax enforcement on aggregate output and productivity using a dynamic general equilibrium framework. I calibrate the model using data for Mexico, where the informal sector is large. I then investigate the effects of improving enforcement. I find that under complete enforcement, Mexico's labor productivity and output would be 19% higher under perfect competition and 34% higher under monopolistic competition. The source of this gain is the removal of the distortions induced by incomplete enforcement of taxes. These distortions affect the economy in three ways: by reducing the capital–labor ratios of informal establishments; by allowing low-productive entrepreneurs to enter; and by misallocating resources towards low-productive establishments. As a result, TFP and capital accumulation are reduced, and hence output. I decompose the gains following the guidelines of five leading papers in the literature of resource misallocation across plants. I isolate the effects of pure factor misallocation, distorted occupational choices, capital accumulation, and complementarities. I also study marginal improvements in enforcement and find that there is an inverted-U relationship between the size of the informal sector and output. This reflects the fact that improving enforcement entails a tradeoff: more taxes vs. fewer distortions.     

Contract enforcement and the size of the informal economy

This paper describes a model where the size of the informal sector decreases as the degree to which financing contracts can be enforced in the formal sector rises. Agents who choose to operate in the informal sector can evade taxes, but they have no access to official means of contract enforcement. Numerical simulations of the model suggest that lax tax enforcement alone does not suffice to generate a large informal sector. Contractual imperfections, on the other hand, can generate a large informal sector and account for several distinguishing features of the organization of production in developing economies. I would like to thank Tim Kehoe, Ed Prescott and Manuel Santos for their guidance, and seminar participants at ITAM, the Universidad Torcuato di Tella and the University of Montréal for their valuable comments. The views expressed herein are those of the authors and may not reflect the views of the Federal Reserve Bank of Dallas or the Federal Reserve System.     

A quantitative theory of tax evasion

I present a simple, unified approach to study the tax evasion practices often observed in developing countries. I develop a general equilibrium model where heterogeneous establishments optimally select themselves into informality, tax compliance, and formal tax evasion. Informal firms evade taxes by staying small, while larger, formal firms can engage in costly tax evasion. In equilibrium, tax revenues rely on medium-sized firms, which are scarce. In a calibration exercise using data from Mexico, I find that reducing the returns to tax evasion by formal firms increases tax revenues by up to 68%. However, economies where such returns are too high face a trade-off between tax collection and aggregate efficiency, as cracking down on formal tax-evading firms pushes some firms into informality. Last, as the economy develops, the informal sector shrinks, while the tax-evading sector expands, thus limiting potential collection. If lower informality is a byproduct of development, and not vice versa, a solid tax base can be achieved by fiscal authorities effectively by focusing on formal tax evasion.     

(In)Effective tax enforcement and demand for cash

Cash holdings have increased worldwide in recent years. It is well known that a higher tax burden is typically an important factor in explaining an increase in cash holdings. However, the role of tax enforcement is less known. To explore the effect of tax enforcement on cash holdings, we study fiscal reform carried out in a large, developing country. In mid-2013, Mexico tried to raise tax revenues by enrolling more taxpayers and introducing electronic invoices to counter a secondary market in illegal invoices. Based on a transaction-based model of money demand, we find an ambiguous effect of tougher tax enforcement on money holdings. If institutions are ineffective, the model predicts an increase in cash holdings after tougher enforcement. To test this issue empirically, we propose a vector error correction (VEC) specification for money demand. The results suggest that a tax enforcement policy implemented under a weak institutional framework can exacerbate cash holdings.     

A THEORY OF KLEPTOCRACY WITH PROBABILISTIC SURVIVAL AND REPUTATION*

We develop a positive theory of kleptocracy, in which the incumbent ruler's concern about his survival probability can induce him to pursue relatively benevolent policies. But, this effect can lower the equilibrium tax rate only until the time-consistency requirement becomes a binding constraint on the equilibrium tax rate. The minimum time-consistent tax rate in a reputational equilibrium is lower the more that the ruler values prospective future revenues, but the value of prospective future revenues itself depends on the ruler's survival probability. The analysis reveals that, if a relatively benevolent tax policy is both necessary and sufficient for a high survival probability, then equilibrium tax policy is relatively benevolent. Until two or three hundred years ago, it was characteristic almost     

Size,trend, and policy implications of the underground economy

We study the underground economy within a dynamic and stochastic general equilibrium framework. Our model combines limited tax enforcement with an otherwise standard two-sector neoclassical stochastic growth model. The Bayesian estimation of the model based on Italian data provides evidence in favor of an important underground sector in Italy, with a size that has increased steadily over the whole sample period. We show that this pattern is due to a steady increase in taxation. Fiscal policy experiments suggest that a moderate tax cut, along with a stronger effort in the monitoring process, causes a sizeable reduction in the size of the underground economy and provides a positive stimulus for the regular economy. Both of these effects jointly increase total fiscal revenues.     

Aid and public sector fiscal behaviour in failing states

This paper looks at interactions between foreign aid and the public sector in developing countries, especially those considered to be fragile or failing states. A model is proposed which employs actual budgetary appropriations and revenue estimates (rather than estimated target variables) and allows for asymmetric preferences. Variants of the model are estimated using time-series data for Papua New Guinea (PNG). PNG is classified as a fragile state by the international community owing to perceived policy and institutional inadequacies. Results obtained suggest that foreign aid increases consumption and investment expenditures and decreases tax revenues and the level of borrowing.     

The extension of social security coverage in developing countries

We study the dynamic general equilibrium effects of introducing a social pension program to elderly informal sector workers in developing countries who lack formal risk sharing mechanisms against income and longevity risks. To this end, we formulate a stochastic dynamic general equilibrium model that incorporates defining features of developing countries: a large informal sector, private transfers as an informal safety net, and a non-universal social security system. We find that the extension of retirement benefits to informal sector workers results in efficiency losses due to adverse effects on capital accumulation and the allocation of resources across formal and informal sectors. Despite these losses recipients of social pensions experience welfare gains as the positive insurance effects attributed to the extension of a social insurance system dominate. The welfare gains crucially depend on the skill distribution, private intra-family transfers and the specific tax used to finance the expansion.     

Public external debt,informality and production efficiency in developing countries

This paper proposes an alternative approach to investigate the non-linear effect of external debt on growth. In the theoretical part, we develop an endogenous growth model with formal and informal sectors to analyse the effect of the public external debt on the production efficiency. We show that an increase of the public external debt share increases the production efficiency through a positive externality effect. However, it generates an opposite effect via the reduction of the formal sector’s size in favour of a less efficient informal sector. The resultant effect becomes negative beyond an optimal level. Besides, we show that a large stock of public external debt reduces the production efficiency when it leads to a tight fiscal policy which reduces the formal sector size. Empirically, using a stochastic frontier technique with unobserved heterogeneity, for a panel of 27 developing countries for the period of 1970–2005, we confirm that the turning point associated to the effect of the share external public debt is apparent at 84%.     

Evidence on the impact of minimum wage laws in an informal sector: Domestic workers in South Africa

What happens when a previously uncovered labor market is regulated? We exploit the introduction of a minimum wage in South Africa and variation in the intensity of this law to identify increases in wages for domestic workers and no statistically significant effects on employment on the intensive or extensive margins. These large, partial responses to the law are somewhat surprising, given the lack of monitoring and enforcement in this informal sector. We interpret these changes as evidence that strong external sanctions are not necessary for new labor legislation to have a significant impact on informal sectors of developing countries, at least in the short-run.     

Fiscal Federalism and Legislative Malapportionment: Causal Evidence from Independent but Related Natural Experiments

We exploit three natural experiments in Argentina in order to study the role of legislative malapportionment on the biased federal tax sharing scheme prevalent in the country. We do not find support to attribute it to legislative malapportionment during periods when democratic governments were in place; nor did we find any evidence that the tax sharing distribution pattern became less biased under centralized military governments. We argue that these results are at least partly attributable to two of Argentina's institutional characteristics: first, the predominance of the executive branch over the legislature (main fiscal decisions are the outcome of a bargaining process among executive authorities); and, second, the lack of any significant difference in the pattern of geographic representation in the executive branch under democratic and autocratic governments. Thus, the observed biases in the distribution of tax revenues among the Argentine provinces are not caused by legislative malapportionment, but are probably the result of a more structural equilibrium that transcends the geographic distribution of legislative representation and even the nature of the political regime. Our findings illustrate the importance of informal institutions and de facto mechanisms to study fiscal federalism in developing countries.     

Choosing the size of the public sector under rent seeking from state coffers

This paper incorporates rent seeking from state coffers into a general equilibrium model of economic growth and endogenous policy. Self-interested individuals try to extract, for personal benefit, part of tax revenues that could be used to finance public investment. We solve for a non-cooperative Nash equilibrium in individual agents' behavior. The determinants of rent seeking in general equilibrium are identified and we consider the efficient size of public sector given the rent-seeking activity. Cross-country data from 108 rich and developing countries provide support for our predictions.     

Cross‐Subsidies,and the Elasticity of Informality to Social Expenditures: The Case of Mexico's Seguro Popular

How is the size of the informal sector affected when the distribution of social expenditures across formal and informal workers changes? How is it affected when the tax rate changes along with the generosity of these transfers? In our search model, taxes are levied on formal‐sector workers as a proportion of their wage. Transfers, in contrast, are lump‐sum and are received by both formal and informal workers. This implies that high‐wage formal workers subsidize low‐wage formal workers as well as informal workers. We calibrate the model to Mexico and perform counterfactuals. We find that the size of the informal sector is quite inelastic to changes in taxes and transfers. This is due to the presence of search frictions and to the cross‐subsidy in our model: for low‐wage formal jobs, a tax increase is roughly offset by an increase in benefits, leaving the unemployed approximately indifferent. Our results are consistent with the empirical evidence on the recent introduction of the “Seguro Popular” healthcare program.     

Job-search and foreign capital inflow — A three-sector general equilibrium analysis

The purpose of this paper is to extend the Fields' (1989) multi-sector job-search model in a three-sector general equilibrium framework by introducing international trade and capital as input. The three sectors are the rural sector, the urban informal sector and the urban formal sector. The rural sector and the urban informal sector use one type of mobile capital while the urban formal sector uses a sector-specific capital. We find that the effects of an inflow of foreign capital in the urban formal sector on unemployment and social welfare crucially hinge on the relative factor intensities of the rural sector and the urban informal sector. We show that there is a possibility of trade-off between the government's twin objectives of improvement in social welfare and mitigation of the urban unemployment problem. These results are extremely crucial from the view point of policymaking in an unemployment plagued, low-income developing economy.     

Are labor markets segmented in developing countries? A semiparametric approach

We test the hypothesis that observably similar workers earn higher wages in the formal sector than in the informal sector in developing nations. Using data from Argentina's household survey and various definitions of informal employment, we find that on average, formal wages are higher than informal wages. Parametric tests suggest that a formal premium remains after controlling for individual and establishment characteristics. However, this approach suffers from several econometric problems, which we address with semiparametric methods. The resulting formal premium estimates prove either small and insignificant, or negative. Neither do we find significant differences in measures of job satisfaction between the two sectors. We invoke these results to question the mainstream view that labor markets are segmented along formal/informal lines in developing nations such as Argentina.