The Informal Sector

This paper investigates the determinants of informal economic activity. We present two equilibrium models of informality and test their implications using a survey of 48,000+ small firms in Brazil. We define informality as tax avoidance; firms in the informal sector avoid tax payments but suffer other limitations. In the first model there is a single industry and informal firms face a higher cost of capital and a limitation on size. As a result informal firms are smaller and have a lower capital labor ratio. When education is an imperfect proxy for ability, we show that the interaction of the manager's education and formality has a positive correlation with firm size. These implications are supported by our empirical analysis. The second model highlights the role of value added taxes in transmitting informality. It predicts that the informality of a firm is correlated to the informality of firms from which it buys or sells. The model implies that higher tolerance for informal firms in one production stage increases tax avoidance in downstream and upstream sectors. Empirical analysis shows that, in fact, various measures of formality of suppliers and purchasers (and its enforcement) are correlated with the formality of a firm. Even more interestingly, when we look at sectors where Brazilian firms are not subject to the credit system of value added tax, this chain effect vanishes.

Risk Price Dynamics

We present a novel approach to depicting asset pricing dynamics by characterizing shock exposures and prices for alternative investment horizons. We quantify the shock exposures in terms of elasticities that measure the impact of a current shock on future cash-flow growth. The elasticities are designed to accommodate nonlinearities in the stochastic evolution modeled as a Markov process. Stochastic growth in the underlying macroeconomy and stochastic discounting in the representation of asset values are central ingredients in our investigation. We provide elasticity calculations in a series of examples featuring consumption externalities, recursive utility, and jump risk.

Long Term Risk

In financial economics risk-return tradeoffs show how expected rates of return and consequently asset prices are altered in response to changes in the exposure to the underlying shocks that impinge in the economy. In these lectures we will: (i) Present some of the recent literature that is concerned with the effect of long run risk on returns and prices. (ii) Develop an analytical structure that reveals the long-run risk-return relationship in nonlinear continuous time Markov environments. This is done by studying a principal eigenvalue problem for a conveniently chosen family of valuation operators.ou

The Informal Sector ∗

∗ We thank Rita Almeida and Sandra Brandão for their help with the enforcement data, and Joana Monteiro and Juliano Assuncão for providing us with the ECINF dataset and clarifying its methodology. We also thank Julio Cacho, Paulo Natenzon, Justinas Pelenis and Glen Weyl for research assistance. We benefited from comments by seminar participants at several institutions and conferences and especially from conversations with William Maloney, Nicola Persico and Ken Wolpin. This material is based upo