This paper analyses the factors that give rise to the existence of the informal economy and how it evolves over time. Using an occupational-choice model the paper shows that at early stages of development, informal and formal markets coexist, but in the long-run the size of the informal economy can decline depending on the initial distribution of wealth. The model shows that the higher the initial wealth inequality, the larger the size of the informal economy and the higher the wealth inequality will be in the long-run. The paper calibrates the model using numerical simulations.
CSAE Economics Department, University of Oxford, Oxford, UK. CSAE WPS/2010-07, 33 pp.