Labor Income Tax Progressivity with a Large Informal Sector (Discussion Paper)

We study labor income tax progressivity in an economy with a large informal sector. When the cost of informality rises with productivity, greater progressivity can simultaneously reduce inequality and enhance efficiency. We extend a standard heterogeneous-agent incomplete markets model to include workers choice between formal and informal employment, calibrating it to Brazilian data. The informal sector features a distinct productivity process and partial tax avoidance, consistent with empirical evidence. A policy experiment shows that increasing progressivity lowers inequality and raises GDP without reducing government
revenues. The results offer a novel rationale for progressive taxation in economies with widespread informality.