Informality: the Doorstep of the Legal System

Many entrepreneurs operate informally because starting and running a business legally is costly. Using a dynamic model of industry equilibrium, I show that these costs associated to the legal system can rationalize the cross country variability of size of the informal economy. The model implies that the business start-up costs matter more than taxes and labor market regulations. Small, less productive, entrepreneurs, facing high entry costs, can only start informally, waiting to become more productive before legalizing. Informality is just the doorstep of the legal system.