Informal Enterpreneurship in a General Equilibrium Model: A Carrot and Stick Approach

Activity: Unpublished and/or developing manuscriptsInternal Projects working documents


This paper presents a general equilibrium framework that incorporates heterogeneous firms with idiosyncratic productivity and endogenous informality to examine the impact of tax policy on welfare in the face of productivity and entry cost shocks to the formal sector. Our results show that policies aimed at increasing the benefits of formalization and the costs of operating in the informal sector can lead to an increase in overall welfare. We analyze optimal policies for the steady state and business cycle and find that higher tax rates do not necessarily lead to higher rates of informality in some regions of the long-run state space. Instead, optimal policy follows a mix of incentives and punishments, and tax policy rules can improve welfare when the economy faces shocks to aggregate productivity and entry costs in the formal sector. Our research contributes to the existing literature on informality and provides important insights for policymakers seeking to promote formalization and improve welfare in the face of economic shocks.
Period1 Oct 2023