INFORMAL ECONOMY IN A DYNAMIC POLITICAL FRAMEWORK

Ceyhun Elgin

Macroeconomic Dynamics, 2015, vol. 19, issue 3, 578-617

Abstract: I develop a dynamic political economy model with an informal sector and two political parties alternating in office. In equilibrium, if the incumbent political party faces a higher probability of staying in office, it sets a higher tax rate on the formal economy to invest more in productive public capital, while spending less for current office rent. Moreover, I argue that public capital is mainly utilized by the formal sector, and this implies that countries in which incumbent parties are more likely to stay in power have a higher tax burden but a smaller informal sector. I also present some empirical evidence that supports the main results of the model.

Date: 2015
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