Recent estimates indicate that around 10% of gross domestic product (GDP) in the United States is produced by individuals or firms that evade taxes (Schneider and Enste 2000). In Latin America, approximately 50% of all salaried employees work informally. An important question is, therefore: What are the determinants of informality? Unfortunately, three decades of research have not yet yielded a consensus opinion on this point.
The traditional explanation, initiated with the work of Lewis (1954), assumes the existence of segmented labor markets in which some workers do not have access to jobs in the regulated, formal sector. These workers are forced to accept lower-paying informal-sector jobs that usually involve inferior working conditions. While this view has become prevalent in the development literature, direct empirical tests of the premise that informal workers would expect higher wages in the formal sector yield mixed results. For instance, Magnac (1991), Maloney (2004), and Pratap and Quintin (2004) do not find compelling evidence of segmentation between the formal and the informal sectors using data from Colombia, Mexico, and Argentina, respectively. It is, nonetheless, certainly plausible that the presence of unions might segment the labor market (Layard et al. 1991). However, even if we believe that unionization has been an important factor in determining labor-market segmentation in the past, the pronounced decline of unionization throughout Latin America over the last two decades seems to be a less satisfactory explanation of the phenomenon at the present time, especially since informality increased in most countries in Latin America during the same period (Gasparini and Tornarolli 2006).
Another approach emphasizes the role of labor-market regulation and taxation as the main cause of informality. A pioneering study by De Soto (1989) describes how informal workers develop their own laws and institutions to make up for the shortcomings of the official legal system. It is certainly true that the size of the shadow economy is affected by the burden of taxes and social security contributions, as well as by the many other regulations governing the official economy. The problem with adopting this explanation of informality unreservedly, however, is that it overlooks the fact that workers have nonpecuniary preferences for the sector they work for, and these preferences play a role in determining the equilibrium level of formality of an economy. In particular, workers in the informal sector are not eligible for socially mandated benefits.
Three stylized facts characterize informality: (1) small firms tend to operate informally while large firms tend to operate formally; (2) unskilled workers tend to be informal while skilled ones have formal jobs; (3) ceteris paribus, secondary workers (a worker other than the household head) are less likely to operate formally than primary workers. In this paper, we present a model of an economy in which the sizes and wages of the formal and informal sectors are endogenously determined that accounts for these three facts. Our model entails a continuum of types on both sides of the labor market (i.e., firms and workers). Firms choose whether to operate formally or informally and workers choose in what sector they work. In equilibrium, managerial talent determines size dualism at the firm level, and human capital is the factor that determines whether workers are employed in the formal or informal sector. In our model, both heterogeneous firms and workers have preferences over the sectors they operate and choose optimally whether to function formally or informally. By contrast, a prominent feature of the preexisting literature is the idea that workers' decisions play no role in determining the equilibrium of the economy. Thus, our model is the first one in which policies that affect workers' preferences (as well, of course, as firm preferences) over the formal or the informal sector such as pension plans, public health issues, and unemployment and any social benefits will affect the sizes and wages of the formal and the informal sectors. …