Tax rates, governance, and the informal economy in high-income countries

Zoë Kuehn ()
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Zoë Kuehn: Universidad Carlos III de Madrid

No 2010-07, Working Papers from Instituto Madrileño de Estudios Avanzados (IMDEA) Ciencias Sociales

Abstract: Approximately 16.7% of output in high-income OECD countries is produced informally. There exists a positive (negative) relation between tax rates (governance quality) and informality across high-income OECD countries. While existing models of the informal economy mostly focus on developing countries, this paper studies the mechanisms behind the informal economy in high-income countries. I build a model economy where agents can become workers or entrepreneurs. Entrepreneurs decide how much of their production to declare as formal and to report for tax purposes and how much to keep informal and hidden. Informal economic activity carries a risk of getting caught, taxed, and fi ned. Simulations show that differences in tax rates alone can only account for approximately 23% of informality across high-income countries while differences in governance quality, the extent to which tax rates are enforced seem to play a more important role. Adding differences in governance quality, the model can account for 72% of informality in high-income countries. Policy experiments show that if all countries attained Finland's governance quality, average informality would drop by around 5 percentage points. I estimate average costs of this policy to be equivalent to 6:5% of the average tax administration's budget and find gains in net tax revenues to be on average around three times larger than these costs.

Keywords: informal economies; high-income countries; tax rates; governance (search for similar items in EconPapers)
JEL-codes: E26 H2 H26 J24 (search for similar items in EconPapers)
Date: 2010-05-12, Revised 2011-10-22
New Economics Papers: this item is included in nep-pbe and nep-pub
Note: This paper is included in the IMDEA Social Sciences Working Paper Series through the Bank of Spain Excellence Programme
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