Optimal Policies and the Informal Sector

This paper characterizes optimal policies in the presence of tax evasion and undocumented workers. Equilibrium can be characterized as segmented or non-segmented, depending on whether domestic workers work exclusively in the formal sector (segmented) or also in the informal sector (non-segmented). Surprisingly, in equilibrium, wages are always equalized between domestic and undocumented workers, even if they do not work in the same sectors of the economy. This is driven by the interaction of firm level decisions with optimal government policy. We also find that enforcement may not always be decreasing in its cost, and that governments will optimally enforce segmentation if enforcement costs are not too high.