Taxes, Inequality and the Size of the Informal Sector Sylvain Dessy St´ ephane Pallage July 2001 Abstract In this note we develop a simple heterogeneous-agent model with incomplete markets to explain the prevalence of a large, low-productivity, informal sector in developing countries. In our model, taxes levied on formal sector agents are used to finance the provision of a productive public infrastructure, which creates a productivity premium from formalization. Our model offers endogenous differentiation of rich and poor countries. Complete formalization is an equilibrium only in countries with the appro- priate initial conditions. We discuss existence of this equilibrium and highlight the ambiguous effect of taxes. Keywords: informal sector, technology adoption, infrastructure, inequality, taxation, development JEL classification: O14, O17, H54 1 Introduction Dualism in the organization of production activities is very pervasive in developing countries, with informal, low-productivity methods of production coexisting with higher-productivity, formal methods. While 17% of the work force in OECD countries operates in the informal sector, this figure, in developing countries, rises to 60% (Ihrig and Moe, 2000). In this note, we ask why such a significant proportion of the economy-wide resources remains trapped in the low-productivity, informal sector. We address the issue of policy responses towards informal organization of production and emphasize the ambiguous effect of taxation. We do so within a heterogeneous-agent model in which the existence of strategic complementarities generates multiple, Pareto-ranked, equilibrium formal sector sizes. Our model has four main assumptions: (i) the provision of public infrastructure creates a productivity premium from formalization. Formalizing production does not just mean taking an old technology and making it legal, it implies switching from low- to high-productivity technologies to take advantage of the availability of public infrastructures. 1 (ii) The productivity premium from formalization increases with infrastructure quality; (iii) this quality depends on the level of public funds collected from the formal sector; and (iv) markets are incomplete, i.e. agents cannot buy or sell assets in response to exogenous changes in their environment. Dessy: D´ epartement d’ ´ Economique and CR ´ EFA, Universit´ e Laval. Pallage: D´ epartement des Sciences ´ Economiques and CREF ´ E, Universit´ e du Qu´ ebec ` a Montr´ eal, QC, Canada; tel: 514-987-3000 (ext 8370); email: pallage.stephane@uqam.ca. We thank Jean-Yves Duclos, Bernard Fortin, Michael Sadler, Pierre-Daniel Sarte and two referees for very insightful comments. 1 High-productivity technologies rely on mass production, which requires marketing, itself in need of infrastructures for shipping and handling.