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Tax rates, governance, and the informal economy in high-income countries

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  • Kuehn, Zoë

Abstract

This paper studies the mechanisms behind the informal economy in high-income countries. About 16.3% of output in high-income OECD countries was produced informally in 2001-02. In a recent paper Davis and Henrekson [2004] show that there exists a positive relationship between tax rates and the informal economy for high-income OECD countries. Existing models of the informal economy mostly focus on developing countries. To account for the informal economy in high-income countries, build a model economy, following Lucas [1978], in which agents of different managerial abilities decide to become workers, managers of informal firms, or managers of formal firms. In contrast to formal managers, managers of informal firms do not pay taxes but run the risk of getting caught, taxed, and fined. A calibrated version of the model economy is able to generate the observed differences in informal economy of 21 high-income countries. Although tax rates are crucial for explaining the observed differences in informal economy, the quality of governance, the extent to which these tax rates are enforced, also plays an important role. Policy experiments show that by improving the enforcement of their tax policies countries can reduce informality. A smaller informal economy is accompanied by larger firms and higher productivity.

Suggested Citation

  • Kuehn, Zoë, 2007. "Tax rates, governance, and the informal economy in high-income countries," UC3M Working papers. Economics we078551, Universidad Carlos III de Madrid. Departamento de Economía.
  • Handle: RePEc:cte:werepe:we078551
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    Cited by:

    1. Alessandro Di Nola & Georgi Kocharkov & Aleksandar Vasilev, 2017. "Productivity, Taxation and Evasion: An Analysis of the Determinants of the Informal Economy," Bulgarian Economic Papers bep-2017-04, Faculty of Economics and Business Administration, Sofia University St Kliment Ohridski - Bulgaria // Center for Economic Theories and Policies at Sofia University St Kliment Ohridski, revised Apr 2017.
    2. Dan Andrews & Aida Caldera Sánchez & Åsa Johansson, 2011. "Towards a Better Understanding of the Informal Economy," OECD Economics Department Working Papers 873, OECD Publishing.
    3. Aruoba, S. Borağan, 2021. "Institutions, tax evasion, and optimal policy," Journal of Monetary Economics, Elsevier, vol. 118(C), pages 212-229.
    4. Colin C. Williams, 2014. "Confronting the Shadow Economy," Books, Edward Elgar Publishing, number 15370.
    5. José M Durán‐Cabré & Alejandro Esteller‐Moré & Luca Salvadori, 2020. "Cyclical Tax Enforcement," Economic Inquiry, Western Economic Association International, vol. 58(4), pages 1874-1893, October.
    6. MIHĂILĂ, Teodora, 2016. "Considerations On The Distribution Of Informal Economy In The European Union," Studii Financiare (Financial Studies), Centre of Financial and Monetary Research "Victor Slavescu", vol. 20(2), pages 25-34.
    7. Colin C. Williams & Friedrich Schneider, 2016. "Measuring the Global Shadow Economy," Books, Edward Elgar Publishing, number 16551.
    8. Maiti, Dibyendu & Bhattacharyya, Chandril, 2020. "Informality, enforcement and growth," Economic Modelling, Elsevier, vol. 84(C), pages 259-274.
    9. Di Nola Alessandro & Kocharkov Georgi & Vasilev Aleksandar, 2019. "Envelope wages, hidden production and labor productivity," The B.E. Journal of Macroeconomics, De Gruyter, vol. 19(2), pages 1-30, June.
    10. Alonso-Ortiz, Jorge & Leal Ordonez, Julio, 2013. "The Elasticity of Informality to Taxes and Transfers," MPRA Paper 49568, University Library of Munich, Germany.
    11. Yilmaz Bayar & Omer Faruk Ozturk, 2016. "Financial Development and Shadow Economy in European Union Transition Economies," Managing Global Transitions, University of Primorska, Faculty of Management Koper, vol. 14(2 (Summer), pages 157-173.
    12. Laudo M Ogura, 2018. "Informality and exogenous regulations in regional economies," Economics Bulletin, AccessEcon, vol. 38(2), pages 892-900.
    13. Giorgio Brosio & Juan Pablo Jiménez & Roberto Zanola, 2014. "Alternative views on the origins and impact of the informal economy," Chapters, in: Francesco Forte & Ram Mudambi & Pietro Maria Navarra (ed.), A Handbook of Alternative Theories of Public Economics, chapter 21, pages 485-502, Edward Elgar Publishing.

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    More about this item

    Keywords

    Informal economies;

    JEL classification:

    • O17 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements
    • J22 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Time Allocation and Labor Supply
    • H2 - Public Economics - - Taxation, Subsidies, and Revenue

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