Informality, Tax Evasion and the Quality of Business Environment: Evidence from South Caucasian Countries

In many transition countries, a considerable part of economic activity takes place in the informal sector. On the other hand, tax evasion constitutes a major problem and causes improvements to all levels of the informal sector in which the volume of the informal sector in transition countries is much higher than in developed countries. Previous works have examined separately both the determinants of the size of the informal sector and the determinants of tax evasion for transition countries. But, this paper complements these significant works by examining cross sectional analysis based on firm-level data for South Caucasian countries. In addition, our paper has a new contribution to previous works by providing some empirical evidence for informality and tax evasion with the quality of business environment. Building on a simple analytical framework, we test the channels affecting the degree of informality in South Caucasian countries and vice versa, the channels affecting the degree of tax evasion. We use instrumental variable OLS and find that the extent of informality is determined by tax evasion, as well as the extent of tax evasion is determined by the informality for these countries. In addition, we find that the business environment has implications for both informal economy and tax evasion. These results suggest generally ameliorating the business environment in South Caucasian countries, while strengthening an access to land and financial sources, adequate provision of public capital such as telecommunication, transport and electricity infrastructure will reduce informality, reigning the corruption, tax administration and labor regulation will reduce tax evasion and ultimately lead to increasing government revenue collections.