Optimal Policies with an Informal Sector

This paper characterizes optimal policies in the presence of tax evasion and undocumented workers. In equilibrium, domestic workers may work exclusively in the formal sector or also in the informal sector. Surprisingly, in equilibrium, wages are always equalized between domestic and undocumented workers, even if they do not work in the same sectors of the economy. This is driven by the interaction of firm level decisions with optimal government policy. We also find that enforcement may not always be decreasing in its cost, and that governments will optimally enforce labour market segmentation if enforcement costs are not too high.

Research highlights▶ We model an informal sector with tax evasion and undocumented workers. ▶ We characterize optimal enforcement and tax policies and public good provision. ▶ Labor market segmentation will optimally be enforced if enforcement costs are low. ▶ Optimal policies always ensure equal wages across the formal and informal sectors. ▶ Optimal enforcement may be increasing in its costs.