A quantitative theory of tax evasion

I present a simple, unified approach to study the tax evasion practices often observed in developing countries. I develop a general equilibrium model where heterogeneous establishments optimally select themselves into informality, tax compliance, and formal tax evasion. Informal firms evade taxes by staying small, while larger, formal firms can engage in costly tax evasion. In equilibrium, tax revenues rely on medium-sized firms, which are scarce. In a calibration exercise using data from Mexico, I find that reducing the returns to tax evasion by formal firms increases tax revenues by up to 68%. However, economies where such returns are too high face a trade-off between tax collection and aggregate efficiency, as cracking down on formal tax-evading firms pushes some firms into informality. Last, as the economy develops, the informal sector shrinks, while the tax-evading sector expands, thus limiting potential collection. If lower informality is a byproduct of development, and not vice versa, a solid tax base can be achieved by fiscal authorities effectively by focusing on formal tax evasion.     

Unemployment Compensation and the Allocation of Labor in Developing Countries

This paper studies the effects of the introduction of unemployment compensation (UC) in countries characterized by pervasive informality. We provide a simple framework to analyze the impact of UC on the allocation of workers between formal and informal activities, as well as the allocation of workers between sectors featuring different incentives to go informal. We show that a reasonable amount of UC may reduce informality, while larger amounts of UC induce large disincentives to go formal because of the level of taxation involved. We also argue that the financing of UC should be part and parcel of a well‐conceived UC system. We show that UC finance based on payroll taxes is likely to entail an excess level of informality resulting from cross‐subsidies between heterogenous sectors. The introduction of a simple layoff tax meant to finance the UC system is then shown to reduce informality, hence highlighting how a well‐designed financing scheme may be used as a supplementary instrument to curb informality.     

Job creation and job destruction in the presence of informal markets

In developing economies, the fraction of informal workers can be as high as 70% of total employment. For economies with significant informal sectors, business cycle fluctuations and labor market policy interventions can have important effects not only on the unemployment rate, but also on the allocation of workers across regulated and unregulated jobs. In this paper, using worker flows data from Brazil, we build, calibrate, and simulate a two-sector search and matching labor market model, in which firms have the choice of hiring workers formally or informally. We show that our model can explain well the main cyclical patterns that lead to those cyclical reallocations. We also show how the effect of government interventions in the labor market depend on the magnitude of the reallocation of labor across regulated and unregulated sectors. For our calibration, policies that decrease the cost of formal jobs, or increase the cost of informality, raise the share of formal employment while reducing unemployment.     

The labor market effects of introducing unemployment benefits in an economy with high informality

Unemployment benefit systems are nonexistent in many developing economies. Introducing such systems poses many challenges which are partly due to the high level of informality in the labor markets of these economies. This paper studies the consequences on the labor market of implementing an unemployment benefit system in economies with large informal sectors and high flows of workers between formality and informality. We build a search and matching model with endogenous destruction, on-the-job search, and intersectoral flows, where agents in the economy decide optimally whether or not to formalize jobs. We calibrate the model for Mexico, and show that the introduction of an unemployment benefit system, where workers contribute when employed in the formal market and collect benefits when they lose their jobs, even if they obtain informal jobs, can lead to an increase in formality in the economy, while also producing small increases in unemployment. The exact impact of incorporating such benefits depends on the relative strength of two opposing effects: the generosity of the benefits and the level of the contributions that finance those benefits. We also show important policy complementarities with other interventions in the labor market. In particular, combining the unemployment benefit program with policies that reduce the cost of formality, such as lower employment taxes and firing costs, can produce greater decreases in informality and lower impacts on unemployment than when the program is applied in isolation.     

Informal sector: The credit market channel

We build a model of firms' choice between formality and informality. Complying with costly registration procedures allows the firms to benefit from key public goods, enforcement of property rights and contracts, that make the participation in the formal credit market possible. In a moral hazard framework with credit rationing, their decision is shaped by the interaction between the cost of entry into formality, and the relative efficiency of formal versus informal credit mechanisms and their related institutional arrangements. The model is consistent with existing stylized facts on the determinants of informality.     

Informal sector: The credit market channel

We build a model of firms' choice between formality and informality. Complying with costly registration procedures allows the firms to benefit from key public goods, enforcement of property rights and contracts, that make the participation in the formal credit market possible. In a moral hazard framework with credit rationing, their decision is shaped by the interaction between the cost of entry into formality, and the relative efficiency of formal versus informal credit mechanisms and their related institutional arrangements. The model is consistent with existing stylized facts on the determinants of informality.     

Informal Employment and the Structure of Wages in India: A Review of Trends

The “alternative”, “atypical” or “informal” workforce has grown in developed and developing countries alike. One of the more recent evolutions of informal employment has been of informal employment within formal enterprises. In the interest of flexibility and cost‐reduction, many formal firms increasingly resort to hiring workers on a temporary or informal basis. Alongside, and perhaps, as a result of the persistence and pervasiveness of informal employment, issues relating to inequality have come to the fore. This paper is motivated by these two intertwining aspects of Indian labor market—informality and wage inequality. Using nationally representative sample data, the paper examines trends in wage inequality among various forms of informal workers, overlaying these findings with broader trends in inequality. Using a regression based inequality decomposition, the paper compares the sources of wage inequality across different employment groups and the reasons for differences in wage inequality.     

Informality in an economy with active labour courts

Job regulations and the justice branch interfere on several aspects of labour contracts. We build a model which explores the role of labour courts on the wage distribution in both formal and informal sectors. We obtain that the presence of active labour courts produces a negative relation between the wage gap and the productivity of the worker, a regularity documented in the empirical literature. Active labour courts also reduce informality of unskilled workers but do not have an impact on informality of skilled workers. Some elements and implications of our model are tested using Brazilian data.     

Flexible Labor Regulations and Informality in Egypt

Do more flexible labor market regulations reduce informal employment in formal firms? This paper examines the effects of changes in labor regulations on the incidence of formal employment. Using the case of Egypt, we study the effects of the introduction of more flexible labor regulations in 2003 on the probability that non‐contractual workers will be granted a formal employment contract. To identify the effect of the law and control for potential confounding factors, we use a difference‐in‐difference estimator that measures the difference in the pre‐ and post‐law probability of obtaining a formal contract across a treatment group of non‐contractual workers initially employed in formal firms and a comparison group of non‐contractual workers initially employed in informal firms. The latter serve as a useful comparison group since informal firms are unlikely to formalize as a result of the law, so that the only way their workers can become formal is to move to another firm. Our findings show that the passage of the new labor law did in fact increase the probability of transitioning to formal employment for non‐contractual workers employed in formal firms by about 3–3.5 percentage points, or the equivalent of at least a fifth of informal workers in formal firms.     

Political change and informality

This paper examines informality during the political and economic turmoil that accompanied the Arab Spring revolution in Egypt. The paper focuses on unprotected employment and the extent to which it changed by educational level immediately after the January Uprising of 2011. We find that over time and particularly after the revolution, informal employment has increased for both high‐ and low‐educated workers, albeit through different paths: high‐educated workers were more likely to be stuck in informality, while low‐educated formal workers were more likely to lose their contracts. The increase in informal employment in the wake of the Arab Spring is more pronounced for the high‐educated. The results suggest a high level of rigidity in the Egyptian labour market, even in the wake of the Arab Spring.     

Entrepreneurship in the shadows

I develop a dynamic model of forward-looking entrepreneurs, who decide whether to operate in the formal economy or informal economy and choose how much to invest in their businesses, taking government policy as given. The government has access to two policy tools: taxes on formal business activity and enforcement (or policing) discouraging informality. The main focus of the paper is on transitional dynamics under different initial wealth levels. Whether an initially small business will be trapped in the informal economy and remain small forever or grow quickly and become a large formal business depends on tax and enforcement policies. High tax rates accompanied by loose enforcement – which is mostly the case in less-developed countries (LDCs) – induce tax avoidance, discourage investment in formal businesses, and drive the entrepreneurial activity towards the informal sector even though the initial wealth level is high. Lowering taxes on formal activity joined with strict enforcement can help reducing the magnitude of poverty traps in LDCs – such as the MENA region, Latin America and developing Asia.     

Opening the Pandora's box? Trade openness and informal sector growth

This article constructs a labour transition model combining the features of job loss and job creation in the formal sector of an economy. The theoretical model examines the impact of trade liberalization on net job transition from formal to informal sector. In the light of our model we establish certain pre-conditions based on simulations under which trade liberalization is accompanied by rising informal sector. The model outcome conforms to the empirical evidence of rising informality with openness which we find in 18 Central Eastern European and Former Soviet Union countries.     

Trapped in Informality: The Big Role of Small Firms in Russia’s Statist-patrimonial Capitalism

Manifestations of patrimonialism such as corruption and state predation on business are widespread in many emerging economies. This paper presents the case of Russian political economy, dubbed ‘statist-patrimonial capitalism’, which is marked by state threats to private property rights through bureaucratic extortion or legal harassment. How can we explain the resilience of Russia’s statist-patrimonial capitalism? Predominant accounts focus on the lack of institutional constraints on state predation. The paper offers a different perspective by exploring the often-overlooked contribution of small- and medium-sized enterprises (SMEs). First, statistical data show a steady rise of SMEs in the 2000s despite increasing state predation, suggesting that SMEs are not simply subjugated by the state. Second, in-depth interviews with Russian entrepreneurs reveal that business contributes to the maintenance of the statist-patrimonial system through the mechanism of the ‘informality trap’: firms that choose the informal strategy have difficulties to return to the legal sphere and get stuck in informality. The drivers of informality include firm-specific characteristics, institutional factors and socio-cultural factors dubbed ‘normality’. The mechanism of the ‘informality trap’ highlights the agency of firms in corrupt polities and may be applicable to other emerging economies.     

The effect of non-employment-based health insurance program on firm's offering of health insurance: Evidence from the social health insurance system in China

To achieve universal health insurance coverage, many developing countries have established a segmented health insurance system, which contains separate programs for workers with formal employment and residents without formal employment. A potential concern with such a segmented system is that the establishment of a non-employment-based insurance program may generate a disincentive for firms to provide health insurance benefits to workers. In this study, we empirically examine this crowd-out effect of a non-employment-based insurance program, the Urban Residents Basic Medical Insurance (URBMI), in China. Exploiting city-by-year variations in the roll-out process of the program and utilizing a unique administrative dataset on Chinese firms, we find that the enactment of URBMI reduced a firm's offering of an employment-based health insurance program by a statistically significant 0.94-1.29 percentage point. This crowd-out effect was stronger among domestic private firms, new firms, and firms that are individual-owned.     

Size and Implication of Informal Economy in African Countries: Evidence from a Structural Model

This paper presents estimates of the informal economy in 41 African countries, including North Africa, Southern Africa, East Africa, Central Africa and West Africa during the period 2007–2013. Using a structural equation model with latent variables, the empirical results indicate that the average size of the informal economy in Africa (in% of formal gross domestic product) in 41 countries is 42.9%, 39.9% in 5 countries in North Africa, 40.02% in 11 countries in southern Africa, 43.24% in 6 countries of East Africa, 45.5% in 7 countries of Central Africa and 45.21% in 12 countries in West Africa. We suggest economic policy recommendations to solve the dilemma of the informal economy not only in the regions but also in different countries such as: identifying the causes of informality, the barriers to formalization and how to eliminate them; developing policies, procedures and institutions that can help informal activities meet market economy requirements, reforming legal systems and ensuring equal access for all; and finally, establishing affordable social benefits for workers.     

Informality and Long‐Run Growth

One of the most salient features of developing economies is the existence of a large informal sector. In this paper, we use quantitative theory to study the dynamic implications of informality on wage inequality, human capital accumulation, child labor, and long‐run growth. Our model can generate transitory informality equilibria or informality‐induced poverty traps. Its calibration reveals that the case for the poverty‐trap hypothesis arises: although informality serves to protect low‐skilled workers from extreme poverty in the short run, it prevents income convergence between developed and developing nations in the long run. Then we examine the effectiveness of different development policies to exit the poverty trap. Our numerical experiments show that using means‐tested education subsidies is the most cost‐effective single policy option. However, for longer time horizons, or as the economy gets closer to the poverty trap threshold, combining means‐tested education and wage subsidies is even more effective.     

Structural Change,Expanding Informality and Labor Productivity Growth in Russia

Strong growth, intensive structural change, and expanding informality have characterized many developing and emerging economies in recent decades. Yet most empirical investigations into the relationship between structural change and productivity growth overlook informality. This paper includes the informal sector in an analysis of the effects of structural changes in the Russian economy on aggregate labor productivity growth. Using a newly developed dataset for 34 industries covering the period 1995–2012 and applying three alternative approaches, aggregate labor productivity growth is decomposed into intra-industry and inter-industry contributions. All three approaches show that the overall contribution of structural change is growth enhancing, significant, and decreasing over time. Labor reallocation from the formal sector to the informal sector tends to reduce growth through the extension of informal activities with low productivity levels. Sectoral labor reallocation effects are found to be highly sensitive to the methods applied.     

Government policy in the formal and informal sectors

The paper quantitatively investigates, in general equilibrium, the interaction between the firms' choice to operate in the formal or the informal sector and government policy on taxation and enforcement, given a level of regulation. A static version of Ghironi and Melitz's (2005) industry model is used to show that firms with lower productivity endogenously choose to operate in the informal sector. I use cross-country data on taxes, measures of informality, and measures of regulation (entry and compliance costs, red tape, etc.) to back out how high the enforcement levels must be country by country to make the theory match the data. The welfare gains from policy reforms are on average 1.2% (measured in terms of consumption) for OECD countries. I also find that the welfare gains from reducing regulation are on average 2.1%. Finally, performing a similar decomposition to that of Hall and Jones (1999), I find that distortions associated with informality account for a factor of 1.5 of the output per capita difference between the richest and the poorest countries.     

ALTERNATIVE STRATEGIES FOR FIRMS IN OPPRESSIVE AND CORRUPT STATES: INFORMALITY OR FORMALITY VIA BUSINESS ASSOCIATIONS?

Firms operating in oppressive conditions such as those in the transition countries often take advantage of informality, making unofficial payments to officials and underreporting their sales for tax purposes. This paper argues that business associations may constitute a more transparent, efficient, and formal alternative. Empirical support for the argument is provided based on firm level data on several thousand firms from the Business Environment and Enterprise Performance Surveys in 25 transitions countries for 2002 and 2005. We show that, despite their often rather bad reputation, business associations tend to play a rather positive role, helping firms to reduce both having to make unofficial payments and underreporting of sales for tax purposes. ( JEL D2, D7, L2, P2, P3)     

Informality,enforcement and growth

This paper develops a two-sector growth model with formal and informal sectors for an economy that cares about redistribution and illustrates its relationship with the enforcement level. The technology gap and labour rigidity explicate the duality. The state can tax the formal sector to subsidise informal income and finance public infrastructure. Alternatively, enforcement, which is costly and corresponds to a variety of discrete components from the security of property rights and integrity of contracts to control of corruptions, can be chosen to favour the formal sector and discourage the informal sector. It is observed that weaker enforcement required to accommodate some degree of informality, which releases tax burden from the formal sector needed for redistribution, can accelerate growth rate. However, sufficiently weaker enforcement dampens the formal sector expansion and growth rate. The growth rate registers an inverted-U shaped relationship against the enforcement level. The optimum enforcement can, however, be higher without formal labour union and subsidisation. This must be higher for welfare maximisation than that of growth rate, especially when the consumer cares about the quality of enforcement.