On the political economy of the informal sector and income redistribution

In this paper we analyze a general equilibrium model in which agents choose to be employed in formal or in the informal sector. The formal sector is taxed to provide income subsidies and the level of redistribution is determined endogenously through majority voting. The model is simulated to produce qualitative results and to illustrate the differences between economies with different distributional features. We show that a distortion in the democratic rule in favor of the rich reduces transfers while the size of the informal sector may remain at high levels. Despite a greater demand for redistribution in societies where the majority has few resources (skills), we find that political systems which work in favor of a rich minority will produce little redistribution. Our results call for pro-poor measures such as free training and education programs that should be offered to those who cannot afford it.