Informality, Innovation, and Aggregate Productivity Growth





Document Type



informality, innovation, productivity growth, total factor productivity


DOI: 10.1111/rode.12626


This paper investigates how the costs of innovation in the formal sector temper or magnify the impacts of traditional policy levers such as taxation on sectoral choice. I embed a decision whether to operate formally or informally into a richer, general equilibrium model. Formal firms are subject to taxation, but they can improve their productivity through process innovation. Informal firms can potentially avoid taxation, and their productivity is determined by productivity growth in the formal sector. I find that changing tax rates from 50% to 60% decreases formal‐sector participation by 20.9%; however, this percentage falls by 10% when the cost of innovation is lower in the formal sector. The model also illustrates how changes in tax policy affect total factor productivity growth by limiting both the number of formal‐sector firms and the intensity of innovation. These results indicate a potential mechanism to induce firms to operate formally or mitigate harmful impacts of necessary tax changes.

Published in

Review of Development Economics

Citation/Other Information

Schipper, T.C. (2020). Informality, Innovation, and Aggregate Productivity Growth. Review of Development Economics, 24(1), 125-143. https://doi.org/10.1111/rode.12626

Creative Commons License

Creative Commons Attribution 4.0 International License
This work is licensed under a Creative Commons Attribution 4.0 International License.