Informal sector and economic development

In this dissertation, I study the relationship between the informal sector and economic development. The informal sector is defined as the sector of the economy that is beyond the radar of the government. I focus on one aspect of informality: the possibility for firms to avoid taxes by operating in this sector. I use a dynamic general equilibrium model (DGE) to show that when firms are not allowed to do this, there are quantitatively important gains in aggregate output, aggregate capital and productivity.;First, I provide a motivation of the issue. I review the existing literature and present data on the characteristics of the informal sector for a typical developing country. The analysis is done for the case of Mexico, because this country has a large informal sector and good data is available. The data suggests that informal firms are small and tend to operate in industries where small scale is plausible.;Then, I build a DGE model where establishments have heterogeneous productivity levels, there is an institution that collects taxes with limited enforcement, and there is capital accumulation. I calibrate the model to match important aspects of the Mexican economy and simulate what would happen to Mexico if its institutions change so that firms are not allowed any more to avoid taxes through informality. My main finding is that this change would increase aggregate output by 17%, aggregate capital by 45%, and total factor productivity (TFP) by 4%.;I identify four distortions associated with the presence of incomplete tax enforcement: First, idiosyncratic distortions across establishments are introduced since the most productive establishments pay taxes while least productive ones don't; second, a group of low-productivity entrepreneurs find it attractive to enter into the market once they consider the possibility to avoid taxes; third, informal establishments inefficiently reduce the amount of capital hired in order to remain undetected by the government; and fourth, higher taxes are needed in order to collect a given revenue. The removal of these distortions, when I simulate the introduction of complete enforcement, is what constitutes the source of the gains in aggregate outcomes.