Labor share, Informal sector and Development

This paper aims to understand the pattern of the labor share of income during the devel- opment process. We highlight a U-shapped relationship between development and the labor share. Our theory emphasizes the interplay between rms'monopsony power and the size of the informal sector when the formal labor market has frictions. The size of the informal sector parameterizes workers'outside opportunities in wage setting. In the rst stage of development, productivity gains are not compensated by wage increases, as most of workers'outside opportunities depend on the in- formal sector whose productivity remains unchanged. The labor share decreases as a result. In the second stage of development, outside opportunities rely more on productivity in formal rms as the formal sector expands. Consequently, the labor share increases. We then use a policy experiment, namely capital account liberalization episodes, in order to determine the causal impact of economic development on the labor share.