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A Theory Of The Informal Sector

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  • YOSHIAKI AZUMA
  • HERSCHEL I. GROSSMAN

Abstract

In many countries, especially poor countries, a heavy burden of taxes, fees, bureaucratic hassles, and bribes drives many producers into an informal sector. This paper shows that we can attribute the existence of a large informal sector to the fact that, because productive endowments contain important unobservable components, the state cannot adjust the amounts that it extracts from producers in the formal sector finely according to each producer's endowment. Given this fact, we find that if the endowment of well-endowed producers is sufficiently large relative to poorly endowed producers, or if their number is relatively large, or if the quality of public services is sufficiently low, then the state extracts a large enough amount from producers in the formal sector that poorly endowed producers choose to work in the informal sector. This result obtains both for a proprietary state, which maximizes its own net revenue, and for a hypothetical benevolent state, which would maximize total net output. But, we also find that there exist combinations of the distribution of endowments and the quality of public services such that the policies of a proprietary state, but not the policies of a hypothetical benevolent state, would cause poorly endowed producers to work in the informal sector. Copyright 2007 Blackwell Publishing Ltd..

Suggested Citation

  • Yoshiaki Azuma & Herschel I. Grossman, 2008. "A Theory Of The Informal Sector," Economics and Politics, Wiley Blackwell, vol. 20(1), pages 62-79, March.
  • Handle: RePEc:bla:ecopol:v:20:y:2008:i:1:p:62-79
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    References listed on IDEAS

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    1. Loayza, Norman V., 1996. "The economics of the informal sector: a simple model and some empirical evidence from Latin America," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 45(1), pages 129-162, December.
    2. R. Hirschowitz, 1989. "The Other Path: The Invisible Revolution in the Third World," South African Journal of Economics, Economic Society of South Africa, vol. 57(4), pages 266-272, December.
    3. Marcouiller, Douglas & Young, Leslie, 1995. "The Black Hole of Graft: The Predatory State and the Informal Economy," American Economic Review, American Economic Association, vol. 85(3), pages 630-646, June.
    4. Grossman, Herschel I. & Noh, Suk Jae, 1994. "Proprietary public finance and economic welfare," Journal of Public Economics, Elsevier, vol. 53(2), pages 187-204, February.
    5. Herschel I. Grossman, 2000. "The state: Agent or proprietor?," Economics of Governance, Springer, vol. 1(1), pages 3-11, March.
    6. Friedman, Eric & Johnson, Simon & Kaufmann, Daniel & Zoido-Lobaton, Pablo, 2000. "Dodging the grabbing hand: the determinants of unofficial activity in 69 countries," Journal of Public Economics, Elsevier, vol. 76(3), pages 459-493, June.
    7. Herschel I. Grossman & Suk Jae Noh, 1990. "A Theory Of Kleptocracy With Probabilistic Survival And Reputation," Economics and Politics, Wiley Blackwell, vol. 2(2), pages 157-171, July.
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    Cited by:

    1. Titas Kumar Bandopadhyay, 2007. "Trade Reform, Capital Mobility, and Efficiency Wage in a Harris-Todaro Economy," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 46(2), pages 163-174.
    2. Sanchez-Pages Santiago & Straub Stéphane, 2010. "The Emergence of Institutions," The B.E. Journal of Economic Analysis & Policy, De Gruyter, vol. 10(1), pages 1-38, September.
    3. Olaf J. de Groot & Anja Shortland, 2010. "Gov-arrrgh-nance: Jolly Rogers and Dodgy Rulers," Economics of Security Working Paper Series 39, DIW Berlin, German Institute for Economic Research.
    4. Olaf J. de Groot & Matthew D. Rablen & Anja Shortland, 2011. "Gov-aargh-nance - "even criminals need law and order"," CEDI Discussion Paper Series 11-01, Centre for Economic Development and Institutions(CEDI), Brunel University.
    5. Prado, Mauricio, 2011. "Government policy in the formal and informal sectors," European Economic Review, Elsevier, vol. 55(8), pages 1120-1136.
    6. Dabla-Norris, Era & Gradstein, Mark & Inchauste, Gabriela, 2008. "What causes firms to hide output? The determinants of informality," Journal of Development Economics, Elsevier, vol. 85(1-2), pages 1-27, February.
    7. repec:wsi:jdexxx:v:12:y:2007:i:03:n:s108494670700071x is not listed on IDEAS
    8. Straub, Stéphane, 2005. "Informal sector: The credit market channel," Journal of Development Economics, Elsevier, vol. 78(2), pages 299-321, December.
    9. Antunes, Antonio R. & Cavalcanti, Tiago V. de V., 2007. "Start up costs, limited enforcement, and the hidden economy," European Economic Review, Elsevier, vol. 51(1), pages 203-224, January.
    10. Gary A. Dymski, 2013. "The Crisis of the Core Seen through the Eyes of the Periphery: A Schelling Model of the Global-South Megacity and the European Crisis," Panoeconomicus, Savez ekonomista Vojvodine, Novi Sad, Serbia, vol. 60(4), pages 433-455, June.
    11. D’Hernoncourt, Johanna & Méon, Pierre-Guillaume, 2012. "The not so dark side of trust: Does trust increase the size of the shadow economy?," Journal of Economic Behavior & Organization, Elsevier, vol. 81(1), pages 97-121.
    12. Gatti, Roberta & Honorati, Maddalena, 2007. "Informality among Formal Firms: Firm-level, Cross-country Evidence on Tax Compliance and Access to Credit," CEPR Discussion Papers 6597, C.E.P.R. Discussion Papers.
    13. Dario Cziraky & Max Gillman, 2004. "Inflation and Endogenous Growth in Underground Economies," wiiw Balkan Observatory Working Papers 50, The Vienna Institute for International Economic Studies, wiiw.

    More about this item

    JEL classification:

    • H0 - Public Economics - - General
    • K4 - Law and Economics - - Legal Procedure, the Legal System, and Illegal Behavior

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