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The Informal Sector, Second Version

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  • Aureo de Paula

    () (Department of Economics, University of Pennsylvania)

  • Jose A. Scheinkman

    () (Department of Economics, Princeton University)

Abstract

This paper investigates the determinants of informal economic activity. We present two equilibrium models of informality and test their implications using a survey of 48,000+ small firms in Brazil. We define informality as tax avoidance; firms in the informal sector avoid tax payments but suffer other limitations. In the first model there is a single industry and informal firms face a higher cost of capital and a limitation on size. As a result informal firms are smaller and have a lower capital-labor ratio. When education is an imperfect proxy for ability, we show that the interaction of the manager’s education and formality has a positive correlation with firm size. These implications are supported by our empirical analysis. A novel theoretical contribution in this paper is a model that highlights the role of value added taxes in transmitting informality. It predicts that the informality of a firm is correlated to the informality of firms from which it buys or sells. The model also implies that higher tolerance for informal firms in one production stage increases tax avoidance in downstream and upstream sectors. Empirical analysis shows that, in fact, various measures of formality of suppliers and purchasers (and its enforcement) are correlated with the formality of a firm. Even more interestingly, when we look at sectors where Brazilian firms are not subject to the credit system of value added tax, but instead the value added tax is applied at some stage of production at a rate that is estimated by the State, this chain effect vanishes.

Suggested Citation

  • Aureo de Paula & Jose A. Scheinkman, 2007. "The Informal Sector, Second Version," PIER Working Paper Archive 07-035, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania, revised 17 Oct 2007.
  • Handle: RePEc:pen:papers:07-035
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    Cited by:

    1. Nicoletta Batini & Young-Bae Kim & Paul Levine & Emanuela Lotti, 2009. "Informal Labour and Credit Markets: A Survey," School of Economics Discussion Papers 0609, School of Economics, University of Surrey.
    2. Alexander Libman & Janis N. Kluge, 2017. "Sticks or Carrots? Comparing Effectiveness of Government Shadow Economy Policies in Russia," Working Papers 364, Leibniz Institut für Ost- und Südosteuropaforschung (Institute for East and Southeast European Studies).
    3. Keen, Michael, 2008. "VAT, tariffs, and withholding: Border taxes and informality in developing countries," Journal of Public Economics, Elsevier, vol. 92(10-11), pages 1892-1906, October.
    4. Gabrieli, T. & Galvao Jr, A. F. & Montes-Rojas, G., 2010. "Who benefits from reducing the cost of formality? Quantile regression discontinuity analysis," Working Papers 10/07, Department of Economics, City University London.
    5. Marcus H Böhme & Rainer Thiele, 2014. "Informal–Formal Linkages and Informal Enterprise Performance in Urban West Africa," The European Journal of Development Research, Palgrave Macmillan;European Association of Development Research and Training Institutes (EADI), vol. 26(4), pages 473-489, September.
    6. Arvin-Rad, Hassan & Basu, Arnab K. & Willumsen, Maria, 2010. "Economic reform, informal-formal sector linkages and intervention in the informal sector in developing countries: A paradox," International Review of Economics & Finance, Elsevier, vol. 19(4), pages 662-670, October.
    7. Naudé, Wim, 2011. "Entrepreneurship is Not a Binding Constraint on Growth and Development in the Poorest Countries," World Development, Elsevier, vol. 39(1), pages 33-44, January.
    8. Michael Keen, 2012. "Taxation and Development; Again," IMF Working Papers 12/220, International Monetary Fund.
    9. Fajnzylber, Pablo & Maloney, William F. & Montes-Rojas, Gabriel V., 2011. "Does formality improve micro-firm performance? Evidence from the Brazilian SIMPLES program," Journal of Development Economics, Elsevier, vol. 94(2), pages 262-276, March.
    10. Rita Almeida & Pedro Carneiro, 2012. "Enforcement of Labor Regulation and Informality," American Economic Journal: Applied Economics, American Economic Association, vol. 4(3), pages 64-89, July.
    11. Belal Fallah, 2014. "The Pros and Cons of Formalizing Informal MSES in the Palestinian Economy," Working Papers 893, Economic Research Forum, revised Dec 2014.
    12. Rand, John & Torm, Nina, 2012. "The Benefits of Formalization: Evidence from Vietnamese Manufacturing SMEs," World Development, Elsevier, vol. 40(5), pages 983-998.
    13. Loayza, Norman V. & Rigolini, Jamele, 2011. "Informal Employment: Safety Net or Growth Engine?," World Development, Elsevier, vol. 39(9), pages 1503-1515, September.
    14. Hsu, Minchung & Huang, Xianguo & Yupho, Somrasri, 2015. "The development of universal health insurance coverage in Thailand: Challenges of population aging and informal economy," Social Science & Medicine, Elsevier, vol. 145(C), pages 227-236.

    More about this item

    Keywords

    Informal Sector; VAT; Tax Avoidance;

    JEL classification:

    • H2 - Public Economics - - Taxation, Subsidies, and Revenue
    • H3 - Public Economics - - Fiscal Policies and Behavior of Economic Agents
    • K4 - Law and Economics - - Legal Procedure, the Legal System, and Illegal Behavior

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