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The Informal Sector

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  • Aureo de Paula
  • Jose A. Scheinkman

Abstract

This paper investigates the determinants of informal economic activity. We present two equilibrium models of the determinants of informality and test their implications using a survey of 50,000+ small firms in Brazil. We define informality as tax avoidance; firms in the informal sector avoid tax payments but suffer other limitations. In the first model there is a single industry and informal firms face a higher cost of capital and a limitation on size. As a result informal firms are smaller and have a lower capital-labor ratio. These implications are supported by our empirical analysis. A novel theoretical contribution in this paper is a model that highlights the role of value added taxes in transmitting informality. It predicts that the informality of a firm is correlated to the informality of firms from which it buys or sells. The model also implies that higher tolerance for informal firms in one production stage increases tax avoidance in downstream and upstream sectors. Empirical analysis shows that, in fact, various measures of formality of suppliers and purchasers (and its enforcement) are correlated with the formality of a firm. Even more interestingly, when we look at sectors where Brazilian firms are not subject to the credit system of value added tax, but instead the value added tax is applied at some stage of production at a rate that is estimated by the State, this chain effect vanishes.
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Suggested Citation

  • Aureo de Paula & Jose A. Scheinkman, 2006. "The Informal Sector," Levine's Bibliography 122247000000001030, UCLA Department of Economics.
    • Handle: RePEc:cla:levrem:122247000000001030
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • H2 - Public Economics - - Taxation, Subsidies, and Revenue
    • H3 - Public Economics - - Fiscal Policies and Behavior of Economic Agents
    • K4 - Law and Economics - - Legal Procedure, the Legal System, and Illegal Behavior

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