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.     

Regulation of entry, labor market institutions and the informal sector

This paper develops a two-sector matching model that incorporates the main features of Latin American labor markets. It has an innovation in its matching structure that makes it more consistent with some key stylized facts of the informal sector in these countries. The model is numerically solved using Brazilian data and several policy simulations are performed. Reducing formal sector's entry cost significantly reduces the size of the informal sector and improves overall labor market performance. Increasing enforcement significantly reduces informality but has strong adverse effects on unemployment and welfare. Thus, the results indicate that the tradeoff between lower informal employment and higher unemployment rates is not present when one looks at policies that aim at reducing the costs of being formal, as opposed to policies that simply increase the costs of being informal.     

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.     

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.     

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.     

Informality: Causes,consequences and policy responses

A stylized prediction of the development economics discourse is that informality will disappear with development, and yet in the last 20 years conventional measures of informality, far from declining, have either remained stagnant or have actually increased. This includes countries such as India where economic growth has been at historically high levels. What exactly is informality and what are its magnitudes and trends? What are the causes of informality and why is it not decreasing as predicted by standard theories of development? What are the consequences for inclusive economic growth of a large and increasing informal sector? What are feasible and desirable policy responses to informality? These are the questions that motivate this broad based overview of informality. The questions will be addressed based on recent and ongoing research on India and globally.     

Internal trade,productivity and interconnected industries: A quantitative analysis

Does trade within a country affect welfare and productivity? What are the magnitude and consequences of costs to such trade? To answer these questions, we exploit unique Canadian data to measure internal trade costs in a variety of ways—they are large and vary across sectors and provinces. To quantify their consequences for welfare and productivity, we use a recent multi‐sector trade model featuring rich input–output relationships. We find interprovincial trade is an important contributor to Canada's GDP and welfare, though there are significant costs to such trade. Reducing interprovincial trade costs by 10% yields aggregate gains of 0.9%; eliminating our preferred estimates of costs, gains average between 3% and 7%—equivalent to real GDP gains between $50 billion and $130 billion. Finally, as policy reforms are often sector specific, we liberalize sectors one at a time and find gains are largest in highly interconnected industries.     

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.     

Opening the Pandora's box? Trade openness and informal sector growth

This article constructs a labour transition model combining the features of job loss and job creation in the formal sector of an economy. The theoretical model examines the impact of trade liberalization on net job transition from formal to informal sector. In the light of our model we establish certain pre-conditions based on simulations under which trade liberalization is accompanied by rising informal sector. The model outcome conforms to the empirical evidence of rising informality with openness which we find in 18 Central Eastern European and Former Soviet Union countries.     

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.     

From family security to the welfare state: Path dependency of social security on the difference in legal origins

We provide a new framework to analyze law and public finance from the perspective of difference in legal origins. The size of the welfare system differs from country to country. The security net provided by the family and other informal institutions also varies. Our two-sector model links these phenomena. We consider two cases of security. The first considers security achieved through intra-household resource redistribution in the traditional sector. The second case considers the welfare state, which taxes the modern sector. Switching from intense family security to an extensive welfare state model enhances growth because state taxation on the modern sector harnesses the potential productivity of the entire economy. In contrast, countries with low levels of family security should transition to a small welfare state model to sustain growth. This finding explains the different trends of welfare benefits in civil law and common law countries. The different sizes of the welfare state have their origins in family law, which differently stipulates family security between civil law and common law countries.     

Cross-country causes and consequences of the crisis: An update

We update [13] and [Rose and Spiegel, 2010] and search for simple quantitative models of macroeconomic and financial indicators of the “Great Recession” of 2008–09. We use a cross-country approach and examine a number of potential causes that have been found to be successful indicators of crisis intensity by other scholars. We check a number of different indicators of crisis intensity, and a variety of different country samples. While countries with higher income and looser credit market regulation seemed to suffer worse crises, we find few clear reliable indicators in the pre-crisis data of the incidence of the Great Recession. Countries with current account surpluses seemed better insulated from slowdowns.     

Gains from commitment in monetary policy: Implications of the cost channel

Many empirical studies find robust evidence that marginal cost of production directly depends on the nominal rate of interest. This relationship induces a cost channel for monetary policy transmission. Although the empirical literature provides ample evidence for a cost channel, studies that evaluate the welfare gains from monetary policy commitment have so far entirely ignored its presence. This study shows that, overlooking the cost channel, one significantly underestimates the welfare gains from monetary policy commitment. I find that there is a robust positive relationship between the size of the cost channel and welfare gains from monetary policy commitment. Using a version of the new Keynesian model calibrated to the US economy, I find that failure to take into account the presence of a cost channel leads to an understatement of the gains from monetary policy commitment by an amount equivalent to a 0.48 percentage points permanent cut in quarterly inflation.     

Informal self-employment and macroeconomic fluctuations

Informal self-employment is a major source of employment in developing countries. Its cyclical behavior is important to our understanding of the functioning of LDC labor markets, but turns out to be surprisingly complex. We develop a flexible model with two sectors: a formal salaried (tradable) sector that may be affected by wage rigidities, and an informal (non tradable) self-employment sector faced with liquidity constraints to entry. This labor market is then embedded in a standard small economy macro model. We show that different types of shocks interact with different institutional contexts to produce distinct patterns of comovement between key variables of the model: relative salaried/self-employed incomes, relative salaried/self-employed sector sizes and the real exchange rate. Model predictions are then tested empirically for Argentina, Brazil, Colombia and Mexico. We confirm episodes where the expansion of informal self-employment is consistent with the traditional segmentation views of informality. However, we also identify episodes where informal self-employment behaves “pro-cyclically”; here, informality is driven by relative demand or productivity shocks to the non tradable sector.     

Formal and informal quota enforcement

I study renewable resource use and compliance in a dynamic model with both informal and formal modes of enforcement. Agents obtain utility from both resource use and from behaving according to a norm of quota compliance. The users can exceed their quota at the risk of being detected and formally punished, but they also risk informal sanctions in the form of social disapproval and guilt. I find that when accounting for informal enforcement, there is an indirect effect of regulatory change in addition to the intended direct effect. When policy change, such as tougher enforcement, makes individuals more compliant, the norm of compliance is gradually strengthened, which in turn induces more compliant behavior. I study the implications of policy change on compliance level, quota prices, and the norm of compliance, and show how the properties of the punishment function have important implications for the outcome.     

Would a North-South Free Trade Agreement Hurt Unskilled Labor in the North?

I present a simple model to examine the impact of international outsourcing on the welfare of skilled and unskilled labor. In this model, specialized business services are to facilitate manufacturing production, creating additional welfare gains in the presence of positive production externalities. Policies that favor the business service sector contribute to the development of a larger bundle of specialized business services, generating more welfare gains to not only skilled but also unskilled labor. Thus, a country’s unskilled labor is not necessarily worse off with open trade if the country is prosperous in business service provisions.     

Fiscal policy and the structure of production in a two-sector developing economy

This paper develops a two-sector model of a developing economy and examines the role of the informal sector in limiting the government's ability to increase tax revenues. A key feature is the introduction of auditing of the informal sector and degree of tax enforcement in that sector. We emphasize the interdependence between tax policy and enforcement in achieving a developing economy's fiscal objectives and show that by judicious policy choices the presence of the informal sector need not hinder its ability to raise tax revenues. We supplement the formal analysis with numerical simulations highlighting the contrasting intertemporal tradeoffs implied by higher tax rates and tax-enforcement levels.     

The impact of product market regulation on productivity through firm churning: Evidence from European countries

Productivity performance in European countries has been a policy concern for several decades. This paper shows that productivity can be enhanced by product market policies which, by increasing competition and efficiency, facilitate higher rates of firms’ entry and exit (i.e. firm churning). Drawing on annual country-sector data for the period 2000–2014 across the EU countries, we find that: (i) competition-enhancing regulation is associated with a higher rate of firm churning; (ii) firm churning, in turn, appears to be positively related to higher total factor productivity at the sector level by facilitating the entry of new competitive firms and the exit of less productive ones. Overall, we conclude that stringent product market regulation can be indirectly associated, via its impact on business dynamism, with the somewhat weak productivity performance in a number of EU countries. Thus, our results point towards substantial productivity gains that could follow from the introduction of further competition-enhancing measures in product markets.     

A PROTECTIONIST BIAS IN MAJORITARIAN POLITICS: AN EMPIRICAL INVESTIGATION

Do politics affect trade policy? Despite an extensive literature examining the relationship between trade policy and some political factors, relatively few studies have explored the role of a country's electoral system, arguably one of the most fundamental characteristics of a nation's political landscape. This paper examines the empirical relationship between tariffs and electoral systems across countries and over time. The broad theoretical framework is provided by Grossman and Helpman, which predicts a bias towards a non‐zero average tariff, i.e. a “protectionist bias”, in countries with majoritarian systems, since politicians in a majoritarian system aim to maximize the welfare of their home districts, as opposed to the welfare of the nation as a whole. I compare average tariffs of countries with majoritarian systems to those with proportional systems, using methods that address the omitted variables/sample selection problem inherent to this analysis. I find that countries with majoritarian systems do indeed appear to have higher average tariffs than do countries with proportional systems. This result holds after controlling for other country‐specific characteristics, such as a country's legal origins, colonial history, and geographic location.