We examine the effects of international trade in the presence of a set of domestic distortions giving rise to informality, a prevalent phenomenon in developing countries. In our quantitative model, the informal sector arises from burdensome taxes and regulations that are imperfectly enforced by the government. Consequently, smaller, less productive firms face fewer distortions than larger, more productive ones, potentially leading to substantial misallocation. We show that in settings with a large informal sector, the gains from trade are significantly amplified, as reductions in trade barriers imply a reallocation of resources from initially less distorted to more distorted firms. We confirm findings from earlier reduced-form studies that the informal sector mitigates the impact of negative labor demand shocks on unemployment. Nonetheless, the informal sector can exacerbate the adverse welfare effects of economic downturns, amplifying misallocation. Last, our research sheds light on the relationship between trade openness and cross-firm wage inequality.
We build an equilibrium model of a small open economy with labor market frictions and imperfectly enforced regulations. Heterogeneous firms sort into the formal or informal sector. We estimate the model using data from Brazil, and use counterfactual simulations to understand how trade affects economic outcomes in the presence of informality. We show that: (1) Trade openness unambiguously decreases informality in the tradable sector, but has ambiguous effects on aggregate informality. (2) The productivity gains from trade are understated when the informal sector is omitted. (3) Trade openness results in large welfare gains even when informality is repressed. (4) Repressing informality increases productivity, but at the expense of employment and welfare. (5) The effects of trade on wage inequality are reversed when the informal sector is incorporated in the analysis. (6) The informal sector works as an “unemployment,” but not a “welfare buffer” in the event of negative economic shocks.