The informal sector and tax on employment: A dynamic general equilibrium investigation

Policy Research Working Paper Series, 1994

Large informal sectors are an important characteristic of developing countries. The authors build a dynamic model in which the informal sector exists when overregulation (high tax rates and high cost for entering the formal sector) is coupled with an inefficient and corrupt ...

Economic Papers: A journal of applied economics and policy, 2016

The paper presents a general equilibrium model of a developing economy with a capital intensive formal sector and a large informal sector with sectorspecific capital to analyse the effects of investments on the sectoral returns to capital, sectoral wage rates, and composition of output and employment. Beginning with capital market disequilibrium (unequal sectoral rates of return) and labour market distortion (formal-informal wage gap), the model traces the evolution of the economy till capital market equilibrium is attained. The investments in the formal sector equalise the wages (a "turning point" in growth a la Lewis) and reduces the size of the informal sector. The sectoral rates of returns equalise only if there is no factor intensity reversal, otherwise the economy specialises in the production of formal goods. The investments in the informal sector equalise the rates of return, do not affect the size of the formal sector and finally, a formal-informal wage gap persists provided factor intensities are not reversed.

Journal of Development Economics, 2003

In this note we develop a simple heterogeneous-agent model with incomplete markets to explain the prevalence of a large, low-productivity, informal sector in developing countries. In our model, taxes levied on formal sector agents are used to finance the provision of a productive public infrastructure, which creates a productivity premium from formalization. Our model offers endogenous differentiation of rich and poor countries. Complete formalization is an equilibrium only in countries with the appropriate initial conditions. We discuss existence of this equilibrium and highlight the ambiguous effect of taxes.

Journal of Institutional and Theoretical Economics

We examine whether an economy can have a bad (small or no formal sector, high taxes) as well as a good (small or no informal sector, low taxes) equilibrium. When the government maximizes instantaneous formal sector welfare, this can occur if the elasticity of average to marginal cost for the public good is less than one. More regard for the informal sector leads to a worse equilibrium, and a higher prevalence of multiple equilibria.

Revue Algérienne de Finances Publiques, 2016

Taxation is generally considered as a factor motivating people to carry out informal economic activities as wage workers or self-employed, however there is no evidence confirming, in absolute terms, the existence of a causal nexus, nor of a direct proportion, between tax increase and informal economy's growth. The analysis of elements strictly related to the informality, such as tax noncompliance and institutional conflict between tax rules and individuals' perception, is also unable to lead to the result that taxation is a cause of the informal economy unless in the cases in which avoiding tax payments is the main reason for working informally. Nevertheless, a causal nexus may arise by considering taxation as an impulse to the effective formalisation and by identifying its presence in all those tax measures which contribute to the restoration of the confidence towards the governing system and encourage the shift to the formal economy.

CSAE working paper, University of Oxford

This paper analyses the factors that give rise to the existence of the informal economy and how it evolves over time. Using an occupational-choice model the paper shows that at early stages of development, informal and formal markets coexists, but in the long-run the size of the informal economy can decline depending on the initial distribution of wealth. The model shows that the higher the initial wealth inequality the larger the size of the informal economy and the higher the wealth inequality will be in the long run. The paper calibrates the model using numerical simulations.

2017

We show that in a exogenous growth model with informal economy calibrated to Bulgarian data under the progressive taxation regime (1993-2007), the economy exhibits equilibrium indeterminacy due to the the presence of an unofficial production. These results are in line with the findings in Benhabib and Farmer (1994, 1996) and Farmer (1999). Also, the findings in this paper are in contrast to Guo and Lansing (1988) who argue that progressive taxation works as an automatic stabilizer. Under the flat tax regime (2008-14), the economy calibrated to Bulgarian data displays saddle-path stability. The decrease in the average effective tax rate addresses the indeterminacy issue and eliminates the ”sink” dynamics. JEL classification: H22, J46, D51, D91, O41

2006

This paper explores aspects of increased informalization in developing countries with the help of a modified specific factors model with a fixed nominal wage in the formal sector, which is assumed to have a "lighthouse" effect on the informal sector wage. Both sectors produce a tradable good each, with informal sector production being embedded in international production networks. Comparative dynamic exercises that attempt to simulate recent economic developments in many developing countries yield plausible results, and suggest various channels for increased informalization. Contrary to standard sticky wage models, wage suppression in the formal sector leads to informalization. Changes in factor endowments create a conflict of interest between the owners of capital in the two sectors, unlike the canonical specific factors model where the conflict is between the owners of capital and labor. Finally, factors that lead to informalization are also likely to result in greater i...

RePEc: Research Papers in Economics, 2016

We show that in a exogenous growth model with informal economy calibrated to Bulgarian data under the progressive taxation regime (1993-2007), the economy exhibits equilibrium indeterminacy due to the the presence of an unofficial production. These results are in line with the findings in Benhabib and Farmer (1994, 1996) and Farmer (1999). Also, the findings in this paper are in contrast to Guo and Lansing (1988) who argue that progressive taxation works as an automatic stabilizer. Under the flat tax regime (2008-14), the economy calibrated to Bulgarian data displays saddle-path stability. The decrease in the average effective tax rate addresses the indeterminacy issue and eliminates the "sink" dynamics.

Personal Wealth from a Global Perspective, 2008

This paper documents four key facts about informal economic activities: 1) the size of the informal sector varies greatly across nations, 2) this size is strongly correlated with economic development, the tax burden, and the rule of law, 3) the informal sector emphasizes small-scale, self-financed and unskilled labor intensive economic activities, and 4), while financial markets are generally segmented along formal/informal lines in developing nations there is no compelling evidence that this is true for labor markets. We review the existing theoretical literature on the informal sector and describe a simple model with a tradeoff between tax evasion and access to formal sources of outside finance which is consistent with much of the existing evidence. Finally, the paper discusses the challenges associated with measuring informal sector assets. and erwan.quintin@dal.frb.org. The views expressed in this paper are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of Dallas or the Federal Reserve System. We would like to thank Jim Davies and Basudeb Guha-Khasnobis for many helpful comments and suggestions.