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Government policy in the formal and informal sectors

  • Prado, Mauricio

The paper quantitatively investigates, in general equilibrium, the interaction between the firms' choice to operate in the formal or the informal sector and government policy on taxation and enforcement, given a level of regulation. A static version of Ghironi and Melitz's (2005) industry model is used to show that firms with lower productivity endogenously choose to operate in the informal sector. I use cross-country data on taxes, measures of informality, and measures of regulation (entry and compliance costs, red tape, etc.) to back out how high the enforcement levels must be country by country to make the theory match the data. The welfare gains from policy reforms are on average 1.2% (measured in terms of consumption) for OECD countries. I also find that the welfare gains from reducing regulation are on average 2.1%. Finally, performing a similar decomposition to that of Hall and Jones (1999), I find that distortions associated with informality account for a factor of 1.5 of the output per capita difference between the richest and the poorest countries.

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Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 55 (2011)
Issue (Month): 8 ()
Pages: 1120-1136

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Handle: RePEc:eee:eecrev:v:55:y:2011:i:8:p:1120-1136
DOI: 10.1016/j.euroecorev.2011.04.010
Contact details of provider: Web page: http://www.elsevier.com/locate/eer

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  1. James Andreoni & Brian Erard & Jonathan Feinstein, 1998. "Tax Compliance," Journal of Economic Literature, American Economic Association, vol. 36(2), pages 818-860, June.
  2. Friedrich Schneider & Dominik Enste, 1999. "Shadow Economies Around the World - Size, Causes, and Consequences," CESifo Working Paper Series 196, CESifo Group Munich.
  3. Simeon Djankov & Rafael LaPorta & Florencio Lopez-de-Silanes & Andrei Shleifer, . "The Regulation of Entry," Working Paper 19462, Harvard University OpenScholar.
  4. Dirk Niepelt, 2004. "Timing Tax Evasion," Working Papers 04.07, Swiss National Bank, Study Center Gerzensee.
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  7. Mark J. Melitz, 2002. "The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity," NBER Working Papers 8881, National Bureau of Economic Research, Inc.
  8. Ghironi, Fabio & Melitz, Marc, 2005. "International Trade and Macroeconomic Dynamics with Heterogeneous Firms," Scholarly Articles 3228377, Harvard University Department of Economics.
  9. Loayza, Norman A., 1997. "The economics of the informal sector : a simple model and some empirical evidence from Latin America," Policy Research Working Paper Series 1727, The World Bank.
  10. Yoshiaki Azuma & Herschel I. Grossman, 2002. "A Theory of the Informal Sector," NBER Working Papers 8823, National Bureau of Economic Research, Inc.
  11. Friedrich G. Schneider, 2006. "Shadow Economies and Corruption all over the World: What do we really know?," Economics working papers 2006-17, Department of Economics, Johannes Kepler University Linz, Austria.
  12. Abhijit V. Banerjee, 1997. "A Theory of Misgovernance," The Quarterly Journal of Economics, Oxford University Press, vol. 112(4), pages 1289-1332.
  13. Gordon, Roger & Li, Wei, 2009. "Tax structures in developing countries: Many puzzles and a possible explanation," Journal of Public Economics, Elsevier, vol. 93(7-8), pages 855-866, August.
  14. Allingham, Michael G. & Sandmo, Agnar, 1972. "Income tax evasion: a theoretical analysis," Journal of Public Economics, Elsevier, vol. 1(3-4), pages 323-338, November.
  15. James R. Tybout, 2000. "Manufacturing Firms in Developing Countries: How Well Do They Do, and Why?," Journal of Economic Literature, American Economic Association, vol. 38(1), pages 11-44, March.
  16. Áureo de Paula & Jose A. Scheinkman, 2010. "Value-Added Taxes, Chain Effects, and Informality," American Economic Journal: Macroeconomics, American Economic Association, vol. 2(4), pages 195-221, October.
  17. Banerjee, A.V., 1997. "A Theory of Misgovernance," Working papers 97-4, Massachusetts Institute of Technology (MIT), Department of Economics.
  18. Pierre-Daniel G. Sarte, 1999. "Informality and rent-seeking bureaucracies in a model of long-run growth," Working Paper 99-07, Federal Reserve Bank of Richmond.
  19. Andrew B Bernard & Jonathan Eaton & J. Bradford Jensen & Samuel Kortum, 2000. "Plants and productivity in international trade," Working Papers 00-08, Center for Economic Studies, U.S. Census Bureau.
  20. Fortin, Bernard & Marceau, Nicolas & Savard, Luc, 1997. "Taxation, wage controls and the informal sector," Journal of Public Economics, Elsevier, vol. 66(2), pages 293-312, November.
  21. Amaral, Pedro S. & Quintin, Erwan, 2006. "A competitive model of the informal sector," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1541-1553, October.
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  23. Rauch, James E., 1991. "Modelling the informal sector formally," Journal of Development Economics, Elsevier, vol. 35(1), pages 33-47, January.
  24. 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.
  25. Robert E. Lucas Jr., 1978. "On the Size Distribution of Business Firms," Bell Journal of Economics, The RAND Corporation, vol. 9(2), pages 508-523, Autumn.
  26. A. Mitchell Polinsky & Steven Shavell, 1999. "The Economic Theory of Public Enforcement of Law," NBER Working Papers 6993, National Bureau of Economic Research, Inc.
  27. Schneider, Friedrich G., 2007. "Shadow Economies and Corruption All Over the World: New Estimates for 145 Countries," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy (IfW), vol. 1, pages 1-66.
  28. 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.
  29. Robert E. Hall & Charles I. Jones, 1999. "Why do Some Countries Produce So Much More Output Per Worker than Others?," The Quarterly Journal of Economics, Oxford University Press, vol. 114(1), pages 83-116.
  30. Dominik H. Enste & Friedrich Schneider, 2000. "Shadow Economies: Size, Causes, and Consequences," Journal of Economic Literature, American Economic Association, vol. 38(1), pages 77-114, March.
  31. 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.
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  33. Robert E. Hall & Charles I. Jones, 1999. "Why Do Some Countries Produce So Much More Output per Worker than Others?," NBER Working Papers 6564, National Bureau of Economic Research, Inc.
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