Informality, tariffs, and welfare

We analyze the effects on aggregate welfare, inequality and the specialization pattern of increasing trade integration in the case of a small country characterized by the presence on informality. We being presenting some new empirical evidence on informality based on Latin American countries. In particular, we document the existence of an inverted U-shape relation between informality and openness and a positive relation between openness and the formal/informal wage ratio. Then we present a simple model able to account for this empirical evidence. Three are the main features of the model: 1) workers’ consume both formal and informal goods; 2) informality is (partly) a voluntary phenomenon as suggested by the empirical evidence presented in Maloney (2004) and Bosh et al.(2007); 3) the government uses tariff revenues to purchase formal goods. We show under which conditions tariff reduction may increase informality and that the maximization of income requires a positive level of tariff protection.