# 1 Introduction

In the three decades prior to the global nancial crisis, household income inequality increased in a large majority of OECD countries. Emerging countries have income inequality signi- cantly higher than the OECD average, although some countries (such as Brazil, Indonesia and, on some indicators, Argentina) have recorded signicant progress in reducing inequality over the past 20 years (OECD, 2011).

In addition, during the late 20<sup>_th_</sup> century there was a general increase in the informal economy in many countries around the world (see Schneider and Enste (2000)). Heintz and Pollin (2005), for example, show that within a data set of 23 countries, 19 showed increases in informality. Similarly, ILO data show that from 2002 self-employment increased in all developing regions, and world-wide it increased from about one-quarter to one-third of nonagricultural employment during 1980-2000 (ILO, 2013). The high incidence of informality is an issue of concern especially in developing countries, where on average, more than 50 percent of the labor force is informal.<sup>1</sup> Among the drivers of rising informality, the conventional view blames trade liberalization for being responsible for the fall in wages for unskilled and low-income workers, as well as the rise in informal and less protected forms of employment. Therefore, despite its uncontroversial expansionary eects on global growth, trade expansion has not always been translated into more equal incomes and better working conditions.<sup>2</sup> In these circumstances, an ecient tax system is indeed an important tool for addressing rising inequality and informality and restoring robust economic growth. On the one side, taxation is a powerful policy tool to redistribute income and make the post-tax income distribution less unequal. On the other side, taxation is a potential tool to lessen the costs of operating in the formal sector, since formality choices are very elastic to marginal tax rates. Indeed, a targeted and well-balanced tax code is an essential element in making further progress in achieving the Sustainable Development Goals by providing a stable funding base for high-quality public services for all and eective transfers targeted to those most in need.

In this context, our analysis contributes to the literature by investigating whether taxation may be an ecient policy tool to support labor formalization in a globalized economy without widening income disparities. Our analysis is based on a Dynamic Stochastic General Equilibrium (DSGE) model with two asymmetric countries: a developed and an emerging country. These two countries dier according to the size of the informal sector in the intermediate-good sector. The informal sector is characterized by a more exible labor market (i.e. rapid entry and exit and more exible adjustment to change in demand) and lower productivity. In this respect, our paper relates to the recent theoretical literature embedding the informal sector in DSGE models (e.g. Conesa et al. (2002), Busato and Chiarini (2004), Orsi et al. (2014), Pappa et al. (2015), Dellas et al. (2017)). Within this strand

> 1In many Latin American countries informal employment exceeds 50 percent of total urban labor force (Gasparini and Tornarolli (2007)). Estimates for Sub-Saharan Africa and Asia are even higher (Jütting et al. (2008)). For an overview on job quality in emerging economies, see OECD (2015).

> 2For a more comprehensive discussion, see Bacchetta et al. (2009).

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