This paper investigates the role of microentrepreneurship as a substitute for unemployment insurance in emerging economies. Using microenterprise surveys from Latin American countries, I document that a significant proportion of microentrepreneurs—ranging from 15% to 39%—start firms because they do not find jobs. These necessity entrepreneurs operate smaller, less profitable firms and experience higher income gains when transitioning to wage employment. I propose a two-sector model of occupational choice with labor market frictions, where workers can become self-employed to avoid unemployment. I calibrate the model for Mexico and show that self-insurance through self-employment decreases unemployment by 1.2 p.p. and reduces welfare losses due to unemployment risk by 22%. Consequently, enforcing costly taxes and regulations among informal microenterprises might harm workers’ ability to self-insure. Despite the presence of this additional channel of insurance, introducing a non-contributory unemployment insurance system increases welfare and is strongly progressive.

The informal sector in developing economies has substantial implications for public finance. Its scale limits the effectiveness of standard tax instruments, often justifying the use of inflation as an alternative revenue source. Informality also has distributional consequences: informal businesses tend to be small, rely heavily on cash, and supply a larger share of goods to poorer households. In this paper, we present a general equilibrium model where firms decide on formality status, and households choose their consumption bundles, allowing us to examine these distributional aspects of informality. We use the model to study the trade-offs between different revenue-equivalent combinations of inflation and consumption taxes. We calibrate the model for Peru and find a notable disparity in effective tax rates across wealth levels under a benchmark 4% inflation rate and an 18% consumption tax: the bottom income quintile pays an effective tax rate equivalent to just 55% of that of the top quintile. Reducing inflation from 4% to 0% requires raising consumption taxes by 2.2 percentage points. This shift benefits the poorest 90.7% of households at the expense of the wealthiest 9.3%. This would increase the welfare of the bottom quintile by 0.25% in consumption-equivalent units, whereas the top quintile experiences a 0.01% decrease.