FORMALIZATION AND ECONOMIC DEVELOPMENT

Abstract

A novel general equilibrium model of formal and informal sectors of a dualistic developing economy is proposed to enable both supply-side and demand-side analyses of formalization and welfare. In a multi-region setting with perfect labor mobility, a consumer taste for diversity, skill heterogeneity, and regional disparity in regulatory and trade costs, high-skill entrepreneurs self-select to pay the regulatory costs in the formal sector to trade globally and lower-skill entrepreneurs choose the informal sector to trade locally to avoid the regulatory costs. In equilibrium, formalization reflects the balance between consumption diversity, which expands with local informal entrepreneurship, and productivity, which increases with formal-sector employment. The equilibrium accounts for the sectoral disparity in entrepreneur skill, labor productivity, and firm size documented in La Porta and Shelifer (2014). It further accounts for the concurrent rises in education, export, and formalization and for regional sorting of formal entrepreneur skill found in Indonesia. An extended model is calibrated to Indonesia data to show the impact of an income-tax-rate reduction on formalization, welfare, and regional tax revenue.