DP5545 Inequality and Informality

Author(s): Alberto Chong, Mark Gradstein
Publication Date: March 2006
Keyword(s): inequality, informal sector, institutional quality, shadow economy
JEL(s): D70, O15, O17
Programme Areas: Public Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5545

This paper presents theory and evidence on the determinants of the size of the informal sector. We propose a simple theoretical model in which it is positively related to income inequality, more so under weak institutions, and is negatively related to the economy's wealth. These predictions are then empirically validated using different proxies of the size of the informal sector, income inequality, and institutional quality. The results are shown to be robust with respect to a variety of econometric specifications. We also find that government interventions through taxes and regulations lose much of their robustness in the presence of the above factors.