Developing economies have large informal sectors made up of small firms that avoid taxation and rely predominantly on cash. Poorer households purchase a larger proportion of their consumption bundle from informal firms. We develop a general equilibrium model with a formality decision by firms and consumption bundle decision by households that matches these facts and calibrate it to evaluate the implications of different revenue-equivalent choices of consumption taxes and inflation for aggregate output, the size of the informal sector, and fiscal progressivity.

The classic result by Magill and Quinzii (1996) for incomplete market economies with infinitely-lived assets shows that a competitive equilibrium may not exist when debt constraints or transversality conditions are used to prevent Ponzi schemes. By replacing the former with credit constraints targeting the amount of borrowing, we determine levels of liquidity under which a competitive equilibrium always exists. Our results include debt contracts with unbounded delivery streams and we do not require uniform impatience, although we must assume that preferences may be represented by time and state separable utility functions.