The Informal Sector

53 Pages Posted: 19 Oct 2007

See all articles by Aureo de Paula

Aureo de Paula

University College London - Department of Economics

José A. Scheinkman

Columbia University; Princeton University - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: August 27, 2007

Abstract

This paper investigates the determinants of informal economic activity. We present two equilibrium models of informality and test their implications using a survey of 48,000+ 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. When education is an imperfect proxy for ability, we show that the interaction of the manager's education and formality has a positive correlation with firm size. 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.

Keywords: Informal Sector, VAT, Tax Avoidance

JEL Classification: H2, H3, K4

Suggested Citation

de Paula, Aureo and Scheinkman, José, The Informal Sector (August 27, 2007). PIER Working Paper No. 07-033, Available at SSRN: https://ssrn.com/abstract=1022956 or http://dx.doi.org/10.2139/ssrn.1022956

Aureo De Paula (Contact Author)

University College London - Department of Economics ( email )

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José Scheinkman

Columbia University ( email )

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Princeton University - Department of Economics ( email )

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HOME PAGE: http://www.princeton.edu/~joses

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