Informality, Innovation, and Aggregate Productivity Growth

This paper investigates how the ability to innovate affects firms' decisions to operate informally and the aggregate consequences of their sectoral choice. I embed a sectoral choice model, where firms choose to operate in the formal or informal economy, into a richer general equilibrium environment to analyze the aggregate effects of firm-level decisions in response to government taxation. I calibrate the model and conduct simulations to quantify the impacts on the aggregate economy. I find that a change in tax rates from 50% to 60% leads to a 20.9% reduction in the size of the formal sector. This change is accompanied by a 0.07 percentage point reduction in TFP growth per year. Given that countries like Mali, Mexico, and Sri Lanka impose total tax rates near 50%, these findings have significant and applicable policy implications across a broad range of lesser developed countries. Even at lower tax rates, for instance 10%, a 10% increase, decreases the size of the formal sector by more than 7.7%.