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

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.