A Structural Model of Informality with Constrained Entrepreneurship

This paper presents and estimates a partial equilibrium model of informality and entrepreneurship using data from Cameroon. The model accounts for institutional factors such as registration costs, probability of detection of informal activity, credit constraints, and taxes in the formal sector. I show that the propensity to formalize increases with skills only after a critical threshold corresponding to secondary school completion in the data. This is because high formalization costs are affordable only to the most productive entrepreneurs, who are typically those with higher skills. The estimated model is used to simulate the counterfactual impact of changes in registration costs, taxation, and enforcement, which are found to substantially affect formalization, aggregate income, and government revenues. However, none of these policies is able to reduce the size of informality to less than 20%–30%. This suggests that alternative policies beyond these standard formalization schemes should be considered to address informality in Africa.