Formal sector enforcement and welfare

Abstract

Higher tax enforcement is consistently associated with lower informality in the literature, whereas the evidence is mixed for other factors affecting informality. We review the literature on the effect of tax enforcement on informality and provide further evidence in the form of subsample tests of the effect of tax enforcement identified in Liu-Evans and Mitra (Econ Lett 182:122–125, 2019). We find Rule of Law, the most commonly used proxy for tax enforcement, has a significant and robust negative effect on informality according to the continuous treatment test due to Belloni et al. (Rev Econ Stud 81:608–650, 2014). Using a stylized general equilibrium model for developing economies, with credit constrained formal and informal firms, we conduct numerical simulations to study the enforcement-welfare relationship for varying levels of enforcement costs. We show that tax-enforcement is only desirable as a policy tool for reducing informality when, contrary to evidence for developing economies in the literature, enforcement costs are very low (almost zero).