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Taxation, public services, and the informal sector in a model of endogenous growth

  • Braun, Juan
  • Loayza, Norman V.

Large informal sectors are an important characteristic of developing countries. The authors build a dynamic model in which the informal sector exists when overregulation (high tax rates and high cost for entering the formal sector) is coupled with an inefficient and corrupt system of compliance control. They consider a production technology in which public services are essential and subject to congestion. The public services are financed by taxes collected from the formal sector. Informal producers evade taxes and, because of their illegal status, can use only some public services, cannot use capital or insurance markets, and are subject to stochastic penalties. The authors find that the relative size of the informal sector is negatively related to the severity of the penalties and positively related to tax rates and the extent of informal use of public services. They also find that economies with larger informal sectors have lower capital return and growth rates because the contribution of public services to productivity decreases with informality. They argue that self-interested bureaucracies create an economic environment that makes informality attractive or simply unavoidable because they profit from the presence of the informal sector.

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Paper provided by The World Bank in its series Policy Research Working Paper Series with number 1334.

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Date of creation: 31 Aug 1994
Date of revision:
Handle: RePEc:wbk:wbrwps:1334
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  1. Barro, Robert J. & Sala-i-Martin, Xavier, 1992. "Public Finance in Models of Economic Growth," CEPR Discussion Papers 630, C.E.P.R. Discussion Papers.
  2. Alm, James & McClelland, Gary H. & Schulze, William D., 1992. "Why do people pay taxes?," Journal of Public Economics, Elsevier, vol. 48(1), pages 21-38, June.
  3. Rauch, James E., 1991. "Modelling the informal sector formally," Journal of Development Economics, Elsevier, vol. 35(1), pages 33-47, January.
  4. Allingham, Michael G. & Sandmo, Agnar, 1972. "Income tax evasion: a theoretical analysis," Journal of Public Economics, Elsevier, vol. 1(3-4), pages 323-338, November.
  5. Gupta, Manash Ranjan, 1993. "Rural-urban migation, informal sector and development policies A theoretical analysis," Journal of Development Economics, Elsevier, vol. 41(1), pages 137-151, June.
  6. Lucas, Robert Jr., 1988. "On the mechanics of economic development," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 3-42, July.
  7. Sergio T. Rebelo, 1990. "Long Run Policy Analysis and Long Run Growth," NBER Working Papers 3325, National Bureau of Economic Research, Inc.
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