2.5 TFP Gains from Reversing Informality

Turning to the aggregate implications of the distortions, figure 2.5 illustrates the TFP gains associated with the removal of all distortions. To do so, we start from each country’s distorted stationary equilibrium and then compute a new equilibrium if all distortions were lifted. Then, we measure the TFP in this undistorted equilibrium relative to the initial one. It is important to remember that in this undistorted equilibrium, the informal employment share would have declined to the calibrated value for the US, equal to 8 percent.

Figure 2.5 uncovers sizable gains from dismantling distortions and reducing informality.

Naturally, TFP gains decrease with economic development, as do the underlying distortions. In India, the aggregate gains amount to 16 percent; between the poorest and richest countries, the aggregate gains range from 0 percent to 25 percent.

An interpretation of the TFP gains from reducing informality is that, while sizable, these surely do not capture the overall welfare gains from formalizing the labor force, and that these gains need not manifest as improvements in aggregate productivity. Most likely, the biggest sources of welfare arise from the many benefits associated with formal jobs, such as having access to social safety nets, credit markets, and insurance; these mechanisms are not accounted for in the model. So, while there are many efficiency gains to be reaped from reversing policies that promote informality, it is very likely that these are simply lower bounds to the overall welfare improvement of the workforce.

FIGURE 2.5 TFP Gains from Reversing Informality

Sources: TFP gains calculated from the model’s equilibrium; the logarithm of gdP per capita stems from the Penn world Table database, version 10.0. Note: TFP = total factor productivity.