The informal sector, which produces legal goods but does not comply with government regulations, is a functioning part of all economies, with a proportion of the labor force ranging from 17 percent in OECD countries to 60 percent in developing countries. Using a dynamic model that includes an informal sector, this paper illustrates the natural dynamics of the sector, describes how tax policy affects its size, and quantifies the costs of having it. Simulations yield movements in informal employment and output consistent with empirical observations. We find that the U.S. informal sector accounts for about 5 percent of U.S.labor hours and produces about 3 percent of U.S. GDP in steady state. Strategies for reducing the size of the sector are discussed. We find, however, that the distortion from this sector in terms of lifetime loss in an economy's capital stock, is minimal--supporting those who want to keep the informal sector as a functioning part of society.
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Last update: August 14, 2001