On the Aggregate Implications of Removing Barriers to Formality

This article examines the aggregate implications of several policies aimed at removing barriers to formality. To this end, we build a dynamic equilibrium model in which heterogeneous agents choose to work for a wage or operate a technology in the formal or informal sector, based on the costs and ben...

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Bibliographic Details
Published in:Review - Federal Reserve Bank of St. Louis 2020-01, Vol.102 (2), p.203-220
Main Authors: Granda, Catalina, Hamann, Franz
Format: Article
Language:English
Subjects:
Barriers
Costs
Developing countries
Earnings
Efficiency
Employment
Enforcement
Entrepreneurs
Equilibrium
Fees & charges
Finance
GDP
Gross Domestic Product
Income distribution
Income taxes
Informal economy
Labor
Labor market
LDCs
Minimum wage
Occupational choice
Payroll taxes
Productivity
Punishment
Redistribution
Registration
Regulation
Regulation of financial institutions
Securities markets
Side effects
Simulation
Tax rates
Taxation
Technology
Welfare
Workers
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Summary:This article examines the aggregate implications of several policies aimed at removing barriers to formality. To this end, we build a dynamic equilibrium model in which heterogeneous agents choose to work for a wage or operate a technology in the formal or informal sector, based on the costs and benefits associated with these occupational choices. Formality entails compliance with taxes, a minimum wage scheme, and firm operation costs but has a productivity advantage stemming from access to external finance and legal enforcement mechanisms. Informal activities avoid taxes and regulations without detection or punishment. The simulation results suggest that eliminating formal operation fees leads to firm formalization, earnings redistribution, and increases in total factor productivity and welfare. In addition, eliminating the income tax reduces labor informality. These two policies, taken together, generate full formalization and gains in redistribution, efficiency, and welfare that are even greater than when all the barriers to formality are jointly removed. In contrast, eliminating the minimum wage has strong adverse effects on labor formalization and little impact on productivity. Eliminating the payroll tax leaves the occupational composition nearly unchanged and productivity and welfare as well. (JEL E26, H20, J30, L26, O17)
ISSN:0014-9187
2163-4505
DOI:10.20955/r.102.203-20