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A Theory of the Informal Sector

In many countries, especially poor countries, a heavy burden of taxes, bribes, and bureaucratic hassles drives many producers into the informal sector. Is this situation explicable only as a consequence of either the ignorance or the ineptitude of the state authorities? On the contrary 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 according to each producer's endowment. Given this fact we find that, if either the distribution of endowments is sufficiently inegalitarian or the production of private substitutes for public services is sufficiently easy, then the state would extract a large enough amount from producers in the formal sector that poorly endowed producers would 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 the total net income of producers. But, we also find that a proprietary state would create an informal sector for a larger set of combinations of parameter values than would a hypothetical benevolent state.

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Paper provided by Brown University, Department of Economics in its series Working Papers with number 2002-07.

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Date of creation: 2002
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Handle: RePEc:bro:econwp:2002-07
Contact details of provider: Postal: Department of Economics, Brown University, Providence, RI 02912

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  1. 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.
  2. 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 630-46, June.
  3. 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.
  4. 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, 07.
  5. 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.
  6. Herschel I. Grossman, 1999. "The State: Agent or Proprieter," Working Papers 99-3, Brown University, Department of Economics.
  7. 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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