ON THE SIZE AND THE EVOLUTION OF THE INFORMAL SECTOR IN DEVELOPING COUNTRIES: THE CASE OF TURKEY

This paper studies a three-sector growth model with households differentiated in their factor endowments, resulting in asset and income inequality among the households. Production occurs in agricultural, formal, and informal sectors. In particular, household preferences display Engel effects in two of the goods: agricultural and informally produced goods. Income elasticity of demand for formally produced goods, on the other hand, is equal to one. The model is calibrated to Turkish National data for 1997, and the simulation results indicate that as the economy transitions into the long-run equilibrium with the process of capital accumulation, the importance of agricultural and informal sectors diminish, and that of the formal sector increases, given any degree of inequality. However, with higher degrees of asset inequality, the results show that in the long-run, the economy ends up with a larger informal sector output and a smaller formal sector output. Furthermore, it is shown that lowering the labor taxes in the formal sector yields favorable results in terms of capital stock, income, and formal sector output in both transition and the long-run.