An import competing firm allocates production between a high wage formal and a low wage informal segment. Illegal use of labour in the informal sector is characterized by a probability of punishment which depends on the size of informal employment. In such a structure, as tariff comes down, total employment contracts but the informal sector expands. Once we bring in working capital, lowering of interest rate, again an indicator of reformatory policies, tends to reduce the size of the informal segment. Our theoretical result matches with a recent empirical evidence on the response of the informal sector to trade liberalization.