Occupational Choice and Investments in Human Capital in Informal Economies

Abstract Informality is pervasive in many developing countries and it can affect occupational and educational decisions. Cross-country data shows that the rate of entrepreneurship as well as the gap between the skill premium for entrepreneurs and for workers increase with the size of the informal economy. Also, in countries with larger informal sectors the fraction of high-skilled individuals that choose to be entrepreneurs is larger. To explain these facts, I develop a model economy with human capital investments, occupational choice and an informal sector, in which the investment in human capital improves the efficiency of labor as well as managerial skills, and the technology to produce goods exhibits capital-skill complementarity. Model predictions can account for cross-country evidence and also shed light on the mechanisms at work when the level of informality in the economy increases. In particular, a higher level of informality discourages human capital investments for workers while it incentivizes these investments for the case of some managers, mostly informal but talented.