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Informality and optimal public policy

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  • Bardey, David
  • Mejía, Daniel

Abstract

This article explores optimal public policy, in terms of the level of tax enforcement and the supply of public goods, in an economy characterized by a huge informal sector. We define informality as the set of productive activities that do not comply (totally or partially) with government regulations. The government intervenes as a Stackelberg leader and has to decide how to allocate public expenditures, using funds collected through the tax system, between the provision of a public good, which can only be used for formal activities, and enforcement effort, aimed at detecting informal firms that evade taxes. Taking the public policy as given, a representative household, owner of a representative firm, decides how to divide a fixed supply of labor between formal and informal activities. Our results show that the greater the distortions in the tax collection process, the larger is the informal sector. Finally, we derive the properties of the optimal public policy. In particular, we show that the shadow cost of public funds represents the rationale of enforcement spending.

Suggested Citation

  • Bardey, David & Mejía, Daniel, 2019. "Informality and optimal public policy," LSE Research Online Documents on Economics 123299, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:123299
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    References listed on IDEAS

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    1. Robin Boadway & Motohiro Sato, 2009. "Optimal Tax Design and Enforcement with an Informal Sector," American Economic Journal: Economic Policy, American Economic Association, vol. 1(1), pages 1-27, February.
    2. Rafael La Porta & Andrei Shleifer, 2014. "Informality and Development," Journal of Economic Perspectives, American Economic Association, vol. 28(3), pages 109-126, Summer.
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    Cited by:

    1. Andres García-Suaza & Fernando Jaramillo & Marlon Salazar, 2023. "Tax policies, informality, and real wage rigidities," Borradores de Economia 1245, Banco de la Republica de Colombia.
    2. Salazar, M., 2021. "Tax policies, informality, and real wage rigidities," Documentos de trabajo - Alianza EFI 20044, Alianza EFI.
    3. Acosta-Henao, Miguel, 2023. "Law enforcement and the size of the informal sector," Economic Modelling, Elsevier, vol. 126(C).

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    More about this item

    Keywords

    informality; public good; enforcement;
    All these keywords.

    JEL classification:

    • K10 - Law and Economics - - Basic Areas of Law - - - General (Constitutional Law)
    • K20 - Law and Economics - - Regulation and Business Law - - - General
    • K42 - Law and Economics - - Legal Procedure, the Legal System, and Illegal Behavior - - - Illegal Behavior and the Enforcement of Law
    • O17 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements

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