Digitalisation, Governance and the Informal Sector

This paper shows the effect of dgitalisation, which improves the governance, on size of informality. We build a simple model with heterogeneous labour markets where the productive firms meet the tax burden to produce in the formal sector and the rest manages to survive in the informal sector by incurring extra-legal cost to avoid tax burden. The difficulty to avoid the tax budget depends on the level of digitalisation, which requires public investment. The government faces a trade-off to spend between digitalisation and other public goods and services. The digitalisation that increases the chances of being caught the informal transactions encourages the formal activities directly. On the other hand, it demands higher taxation that works on the opposite direction. The relative strength of these two forces determines the size of informality. The positive relation between taxation and digitalization leads to result in an U-shape of informal size against the level of digitalization. The negative impact gets stronger under the improved governance with better rule of laws and judiciary system. If minimum wage or productivity are targeted to a higher level exogeneosly, it may result in higher informality. The econometric results from a cross-country panel data for around 148 countries for the period 1990-2017 confirm such conjectures.