The Costs and Benefits of Informality

Nicoletta Batini, Paul Levine () and Emanuela Lotti ()

No 211, School of Economics Discussion Papers from School of Economics, University of Surrey

Abstract: We explore the costs and benefits of informality associated with the informal sector lying outside the tax regime in a two-sector New Keynesian model. The informal sector is more labour intensive, has a lower labour productivity, is untaxed and has a classical labour market. The formal sector bears all the taxation costs, produces all the government services and capital goods, and wages are determined by a real wage norm. We identify two welfare costs of informalization: (1) long-term costs restricting taxes to the formal sector and (2) short-term fluctuation costs of tax changes to finance fluctuations in government spending. The benefit of informality derives from its wage flexibility. We investigate whether taxing the informal sector and thereby reducing its size sees a net welfare improvement.

Keywords: Informal economy; labour market; tax policy; interest rate rules (search for similar items in EconPapers)
JEL-codes: E24 E26 E32 J65 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2011-01
New Economics Papers: this item is included in nep-dge
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (11)

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Persistent link: https://EconPapers.repec.org/RePEc:sur:surrec:0211

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