This paper aims to understand the pattern of the labor share of income during the development
process. We highlight a U-shapped relationship between development and the labor share.
Our theory emphasizes the interplay between firms’monopsony power and the size of the informal
sector when the formal labor market has frictions. The size of the informal sector parameterizes
workers’outside opportunities in wage setting. In the first stage of development, productivity gains
are not compensated by wage increases, as most of workers’outside opportunities depend on the informal
sector whose productivity remains unchanged. The labor share decreases as a result. In the
second stage of development, outside opportunities rely more on productivity in formal firms as the
formal sector expands. Consequently, the labor share increases. We then use a policy experiment,
namely capital account liberalization episodes, in order to determine the causal impact of economic
development on the labor share.