Misallocation, Informality and Human Capital

Abstract: We develop a theory of total factor productivity to understand differences in productivity and human capital across countries. In our model, firms face capital market imperfections and costs of operating in the formal sector. Formal firms have a larger set of production opportunities but informal firms can avoid the costs of formalization. These firm level distortions give rise to endogenous formal and informal sectors and more importantly, affect the demand for skilled workers. The model predicts that countries with a low degree of debt enforcement and high costs of formalization are characterized by low allocative efficiency and a larger informal sector, lower measured TFP and lower stocks of skilled workers. We find that this mechanism is important in generating the skill distribution observed in developing countries. Moreover, formal sector entry costs and financial frictions are complementary and their joint effect is the main driver of the differences between the US and the developing countries in terms of human capital, informality and TFP. The complementarity effect is generated by the introduction of skilled workers which increase the labor substitution incentives, moving the firm closer to the financial constraint.