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The Costs and Benefits of Informality

  • Nicoletta Batini

    (University of Surrey and IMF)

  • Paul Levine

    (University of Surrey)

  • Emanuela Lotti

    (University of Southampton and University of Surrey)

We explore the costs and benefits of informality associated with the informal sector lying outside the tax regime in a two-sector New Keynesian model. The informal sector is more labour intensive, has a lower labour productivity, is untaxed and has a classical labour market. The formal sector bears all the taxation costs, produces all the government services and capital goods, and wages are determined by a real wage norm. We identify two welfare costs of informalization: (1) long-term costs restricting taxes to the formal sector and (2) short-term fluctuation costs of tax changes to finance fluctuations in government spending. The benefit of informality derives from its wage flexibility. We investigate whether taxing the informal sector and thereby reducing its size sees a net welfare improvement.

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Paper provided by School of Economics, University of Surrey in its series School of Economics Discussion Papers with number 0211.

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Length: 34 pages
Date of creation: Jan 2011
Date of revision:
Handle: RePEc:sur:surrec:0211
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  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. Uribe, Martin & Yue, Vivian Z., 2006. "Country spreads and emerging countries: Who drives whom?," Journal of International Economics, Elsevier, vol. 69(1), pages 6-36, June.
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  13. Mathan Satchi & Jonathan Temple, 2008. "Labour Markets and Productivity in Developing Countries," Studies in Economics 0805, School of Economics, University of Kent.
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  17. Martha Alter Chen, 2007. "Rethinking the Informal Economy: Linkages with the Formal Economy and the Formal Regulatory Environment," Working Papers 46, United Nations, Department of Economics and Social Affairs.
  18. Ihrig, Jane & Moe, Karine S., 2004. "Lurking in the shadows: the informal sector and government policy," Journal of Development Economics, Elsevier, vol. 73(2), pages 541-557, April.
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