Financial Frictions and Firm Informality: A General Equilibrium Perspective

Abstract

This paper assesses the extent to which financial development and informality are related, and how this relation translates into differences in GDP and TFP across countries. To this end, we develop a quantitative life-cycle general equilibrium model of occupational choice with imperfect tax enforcement, in which informal entrepreneurs have no access to credit and face an endogenous probability of being caught for tax evasion. Our quantitative analysis shows that the degree of financial frictions of a country is crucial in shaping the firm’s incentives to evade taxation, a feature that, in the aggregate, results into a non-linear relationship between financial development and both the size of informality and GDP per capita. We test these model’s predictions with cross-country data and find supporting evidence in favour of both non-linearities.