Publication: Tax rates, governance, and the informal economy in high-income countries
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2007-12
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Abstract
This paper studies the mechanisms behind the informal economy in high-income countries.
About 16.3% of output in high-income OECD countries was produced informally in 2001-02. In
a recent paper Davis and Henrekson [2004] show that there exists a positive relationship
between tax rates and the informal economy for high-income OECD countries. Existing models
of the informal economy mostly focus on developing countries. To account for the informal
economy in high-income countries, build a model economy, following Lucas [1978], in which
agents of different managerial abilities decide to become workers, managers of informal firms,
or managers of formal firms. In contrast to formal managers, managers of informal firms do not
pay taxes but run the risk of getting caught, taxed, and fined. A calibrated version of the model
economy is able to generate the observed differences in informal economy of 21 high-income
countries. Although tax rates are crucial for explaining the observed differences in informal
economy, the quality of governance, the extent to which these tax rates are enforced, also plays
an important role. Policy experiments show that by improving the enforcement of their tax
policies countries can reduce informality. A smaller informal economy is accompanied by larger
firms and higher productivity.
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Informal economies, High-income countries, Tax rates, Governance