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To tax or not to tax? When does it matter for informality?

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  • Mitra, Shalini

Abstract

Theoretical models generally always predict or assume that higher taxes lead to larger informal sectors. Empirically, however, there is considerable debate on the effect of taxes on informality. In this paper I show that whether a positive, negative or non-relation arises between tax rates and informality depends on the degree of tax enforcement and the level of credit market development in an economy. Higher enforcement implies a higher probability of detection and punishment while more credit implies better formal sector access to finance. Both are incentives to become formal. In a two-sector dynamic general equilibrium model with borrowing constraints, I show that informality rises with the tax rate up to a threshold level of tax enforcement beyond which it falls as tax increases. This enforcement threshold depends negatively on the level of credit in the economy.

Suggested Citation

  • Mitra, Shalini, 2017. "To tax or not to tax? When does it matter for informality?," Economic Modelling, Elsevier, vol. 64(C), pages 117-127.
  • Handle: RePEc:eee:ecmode:v:64:y:2017:i:c:p:117-127
    DOI: 10.1016/j.econmod.2017.02.024
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    1. repec:ebl:ecbull:eb-18-00930 is not listed on IDEAS
    2. repec:dug:actaec:y:2017:i:6:p:323-333 is not listed on IDEAS

    More about this item

    Keywords

    Taxation; Informality; Financial frictions; Tax enforcement; Financial development;

    JEL classification:

    • E26 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Informal Economy; Underground Economy
    • E60 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General
    • H26 - Public Economics - - Taxation, Subsidies, and Revenue - - - Tax Evasion and Avoidance
    • O11 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Macroeconomic Analyses of Economic Development
    • O17 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements

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