Dynamic Selection with the Informal Sector
Abstract
This paper studies how the informal sector affects long-run growth and welfare rather than only the static allocation of resources. I develop a tractable firm-dynamics model that jointly determines the firm-size distribution and the growth rate, with both an extensive margin—whether a firm is formal—and an intensive margin—partial compliance within formal firms. By sheltering low-productivity firms, informality changes dynamic selection and therefore the growth rate, a mechanism absent from steady-state frameworks. Calibrated to Mexico, the model shows that a lower formal-sector tax rate raises growth but compresses the firm-size distribution and lowers the level of output, while formalization raises consumption, public goods, and welfare. The two margins operate in opposite directions, and the growth channel matters for the extensive margin but not the intensive margin.