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Optimal Redistribution with a Shadow Economy

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  • Doligalski, Pawel; Rojas, Luis E.

Abstract

We examine the constrained efficient allocations in the Mirrlees (1971) model with an informal sector. There are two labor markets: formal and informal. The planner observes only income from the formal market. We show that the shadow economy can be welfare improving through two channels. It can be used as a shelter against tax distortions, raising the efficiency of labor supply, and as a screening device, benefiting redistribution. We calibrate the model to Colombia, where 58% of workers are employed informally. The optimal share of shadow workers is close to 22% for the Rawlsian planner and less than 1% for the Utilitarian planner. The optimal tax schedule is very different then the one implied by the Mirrlees (1971) model without the informal sector.

Suggested Citation

  • Doligalski, Pawel; Rojas, Luis E., 2016. "Optimal Redistribution with a Shadow Economy," Economics Working Papers ECO2016/11, European University Institute.
  • Handle: RePEc:eui:euiwps:eco2016/11
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    Cited by:

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    3. Håkan Selin & Laurent Simula, 2017. "Income Shifting as Income Creation? The Intensive vs. the Extensive Shifting Margins," CESifo Working Paper Series 6510, CESifo.

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    More about this item

    Keywords

    Shadow Economy; Informal Labor Market; Income Taxation; Redistribution;
    All these keywords.

    JEL classification:

    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H26 - Public Economics - - Taxation, Subsidies, and Revenue - - - Tax Evasion and Avoidance
    • J46 - Labor and Demographic Economics - - Particular Labor Markets - - - Informal Labor Market

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