SMU SOE Seminar Series (August 19, 2026): Learning in the Shadows: Informality and Entrepreneurship in Brazil

TOPIC:

ABSTRACT

We study the role of the informal sector as a stepping stone for entrepreneurs. Using Brazilian data, we document two novel empirical facts. First, around one-third of high-income entrepreneurs operate their businesses in the informal sector, and they closely resemble their formal sector counterparts across a range of characteristics. Second, high-income entrepreneurs are more likely to transition into the formal sector over time. These observations raise a central question: Why do these highly productive individuals choose to start out informally and only later formalize? To interpret these findings, we develop a quantitative model featuring imperfect information and learning. Individuals choose between wage employment and entrepreneurship without fully knowing their business potential. Within this framework, the informal sector endogenously arises as a cost-effective platform for entrepreneurial experimentation. Individuals operate informally to gradually learn about their business quality. Entrepreneurs who discover they are highly productive subsequently transition into the formal sector to expand production and access financial markets. The calibrated model replicates the observed transition patterns from informality to formality and generates policy counterfactuals consistent with historical reforms in Brazil. Specifically, the model shows that reducing entry costs alone has limited effects on formalization. In contrast, combining entry-cost reductions with temporary tax relief leads to substantially larger declines in informality. Importantly, the resulting increase in formal-sector firms is driven primarily by the formalization of existing informal businesses rather than by the creation of new formal firms.

Keywords: Informality, Entrepreneurship, Learning, Formalization Policy, Occupation Misallocation.

JEL: E26, O17, L26, D80, H20.

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