Pollution and Informal Sector: A Theoretical Analysis

We present a three-sector general equilibrium model with an informal sector, which produces an intermediate input for the formal sector, to analyze the effects of different policies on the environmental standard of the economy. The formal sector is made to pay a pollution emission tax for any pollution level higher than the permissible level that is determined by the regulatory authority. Since the informal manufacturing sector creates pollution, increase in the use of informal sector output in the formal sector raises the level of pollution and widens the discrepancy between actual and permissible levels of pollution, so that the emission tax payable by the formal sector also increases. The efficiency of a representative worker is inversely related to the level of pollution. In this framework, we show that even if the permissible level of pollution is reduced, the polluting informal sector may expand and worsen the environmental standard. On the other hand, an inflow of foreign capital may reduce the pollution level. These results are new in the literature of trade and environment.