# **1 Introduction**

Poor transportation infrastructure is a common characteristic of cities in developing countries. For instance, in Mexico City, it takes a typical low-skilled worker approximately two to three hours to commute to work in the center of the city. In recent decades, governments around the world have spent billions of dollars on infrastructure projects to facilitate commuting. Recent research examines the aggregate gains from public transit improvements, assuming perfectly efficient economies. However, perfectly competitive models may fail to capture key features of developing economies, where labor market frictions and other economic distortions are salient.<sup>1</sup> In this paper, I study the economic impacts of transit infrastructure in Mexico City, while considering both its direct effects in perfectly efficient economies and the role played by distortions on allocative efficiency.

Labor market informality is one of the most significant sources of distortions in low- and middleincome countries, with important implications for aggregate efficiency. Within developing countries, 50 to 60 percent of total employment is informal. Informal firms are less productive than formal ones, avoid paying taxes, and do not make social security contributions to their workers.<sup>2</sup> As a result, the informal sector creates input wedges that cause factor misallocation, which ultimately lowers aggregate total factor productivity (TFP) (Banerjee and Duflo, 2005; Hsieh and Klenow, 2009; Restuccia and Rogerson, 2008). These intersectoral distortions between the formal and informal sectors imply that any policy or shock that impacts informality may have first-order effects on aggregate welfare through an allocative efficiency margin.<sup>3</sup> This study explores the link between transit improvements, informality, and aggregate efficiency at the city level. I test whether infrastructure projects that facilitate transit within a city improve allocative efficiency by reallocating workers from the informal to the formal economy. As a result, aggregate gains from these projects can be larger relative to those demonstrated by standard urban models that assume perfectly efficient economies. The core intuition is that in cities in developing countries, workers in remote locations prefer to work in low-paid informal jobs near their home rather than incurring the high cost of commuting to formal employment. Transit improvements may thus provide better access to formal jobs, leading to an expansion of the formal sector and a more labor allocation.

The paper makes two main contributions. First, I combine rich administrative microdata with a transit shock to provide new empirical evidence on the effect of urban transit improvements on worker reallocation across the formal and informal sectors. Second, I rationalize these results through the lens of a quantitative spatial model. To this end, I extend recent work (Ahlfeldt et al., 2015;

> 1See e.g., Atkin and Khandelwal (2019) for a recent review of market distortions in the context of the gains from market integration, and Busso et al. (2012); Levy (2018) for the effect of distortions on total factor productivity in the Mexican context.

> 2See Gollin (2002, 2008) and La Porta and Shleifer (2008, 2014) for the relationship between the prevalence of the informal sector and economic development.

> 3See, e.g., McCaig and Pavcnik (2018) and Dix Carneiro et al. (2018) for the case of trade policies and their effect on the informal economy and the aggregate gains from trade. The former paper studies the effect of the Free Trade Agreement between the US and Vietnam, and the latter the impact of the Brazilian trade liberalization episode.

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