Taxation and Informal Sector Growth in Developing Countries
Author: Sophie Kristoffersen, ESOP Gender & Economics Scholarship Recipient 2011.
Over the past two decades, the state has slowly re-emerged as a central actor in the global development discourse. The development welfare state is in fashion, but it faces several challenges, among these, the presence of a big informal sector. Recent estimates show that informal sectors in most developing countries are very big, often constituting around half of official GDP, and have been growing during the last two decades. In the literature, a growing informal sector is generally regarded a response to an increased burden of taxation, social security contributions and labor market regulations. Further increases in taxes are expected to induce informal sector growth, eroding the tax base, such that tax revenue may in fact fall with higher tax rates. I find that these assumptions are primarily based on evidence from developed countries. Furthermore, I argue that while they may describe the situation in some high-income-high-tax countries fairly well, there are obvious differences in the structure of informal sectors in developed and developing countries. This suggests that a somewhat different story may be going on in the latter.
In this thesis, I modify a general equilibrium model of industrialization by Murphy et al. (1989), to investigate whether the structure of the informal sector in developing countries may cause a different relationship, than what is usually perceived, between taxation and informal sector growth, to arise. After some alterations to the model, I introduce a proportional consumption tax, redistributed evenly to all individuals as a uniform lump sum subsidy, and analyze the consequent changes in the relative sizes of the formal and informal sectors in the country. I find an unambiguously positive income effect of the tax on formal sector growth, and discuss under which circumstances this effect may dominate or modify potential displacement effects such as tax evasion. I further discuss the implications of these findings for poverty reduction and gender equality, and briefly outline a few extensions of the model.