Financing Infrastructure in the Presence of Informality

Public infrastructure investment plays a pivotal role in fostering economic development, yet low-income countries characterized by high informality make limited investments. The literature underscores that informality induces maintaining tax rates low, depleting the already limited funds available for public infrastructure. Within a framework that accounts for heterogeneous labor, we study the optimal labor-income taxation aimed at financing infrastructure. We develop the analysis with and without the presence of a binding legal minimum wage. Our findings reveal that the minimum wage increases the optimal tax rate, raises the income (and income share) of low-skilled workers, and induces higher infrastructure investments for a wide range of parameter settings. Furthermore, we show that in the presence of minimum wage, no clear relationship emerges between the beneficial impact of infrastructure on informal sector productivity and the share of the informal economy.