Working Paper: NBER ID: w13486
Authors: Ureo de Paula; José A. Scheinkman
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. The second model 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 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, this chain effect vanishes.
Keywords: Informal Sector; Value Added Tax; Firm Size; Brazil
JEL Codes: H2; K4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher cost of capital (G31) | smaller firm sizes (L25) |
| higher cost of capital (G31) | lower capital-labor ratios (D29) |
| managerial ability (proxied by education) (J24) | increased formality (O17) |
| managerial ability (proxied by education) (J24) | larger firm sizes (L25) |
| state-level simplified tax programs (simples) (H71) | increased probability of formalization (O17) |
| firm informality (L20) | informality of suppliers and purchasers (L14) |
| increased tolerance for informal firms in one production stage (L59) | greater tax avoidance in related sectors (H26) |