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Optimal Income Taxation and Formalization of the Informal Economy

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  • Hirofumi Takikawa

    (Faculty of Economics and Business Administration, Goethe University Frankfurt, GERMANY and Junior Research Fellow, Research Institute for Economics & Business Administration (RIEB), Kobe University, JAPAN)

Abstract

The United Nations' "2030 Agenda for Sustainable Development" highlights the importance of formalizing the informal economy, which could potentially increase tax revenues in developing countries. This paper investigates the impact of formalization on optimal tax schedules, emphasizing the need for redistributive incentives alongside formalization. Extending the Mirrlees model to incorporate government intervention against the informal economy, we propose an optimal tax formula. Quantitative analysis shows that aligning the tax schedule with formalization increases tax revenue and income transfers while maintaining social welfare. The result can be interpreted as an implicit cost of welfare-neutral formalization in terms of tax revenues and income transfers. Conversely, leaving the tax schedule unchanged undermines these benefits. This research provides insights into the design of optimal tax policies that incorporate formalization.

Suggested Citation

  • Hirofumi Takikawa, 2024. "Optimal Income Taxation and Formalization of the Informal Economy," Discussion Paper Series DP2024-18, Research Institute for Economics & Business Administration, Kobe University.
    • Handle: RePEc:kob:dpaper:dp2024-18
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    File URL: https://www.rieb.kobe-u.ac.jp/academic/ra/dp/English/DP2024-18.pdf
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    References listed on IDEAS

    as
    1. Rocha, Rudi & Ulyssea, Gabriel & Rachter, Laísa, 2018. "Do lower taxes reduce informality? Evidence from Brazil," Journal of Development Economics, Elsevier, vol. 134(C), pages 28-49.
    2. Raj Chetty, 2012. "Bounds on Elasticities With Optimization Frictions: A Synthesis of Micro and Macro Evidence on Labor Supply," Econometrica, Econometric Society, vol. 80(3), pages 969-1018, May.
    3. Mikhail Golosov & Aleh Tsyvinski & Nicolas Werquin, 2014. "A Variational Approach to the Analysis of Tax Systems," NBER Working Papers 20780, National Bureau of Economic Research, Inc.
    4. Pratap, Sangeeta & Quintin, Erwan, 2006. "Are labor markets segmented in developing countries? A semiparametric approach," European Economic Review, Elsevier, vol. 50(7), pages 1817-1841, October.
    5. J. A. Mirrlees, 1971. "An Exploration in the Theory of Optimum Income Taxation," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 38(2), pages 175-208.
    6. Parkash Chander & Louis L. Wilde, 1998. "A General Characterization of Optimal Income Tax Enforcement," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 65(1), pages 165-183.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Informal economy; Formalization; Income tax; Redistribution;
    All these keywords.

    JEL classification:

    • E26 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Informal Economy; Underground Economy
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H26 - Public Economics - - Taxation, Subsidies, and Revenue - - - Tax Evasion and Avoidance
    • J46 - Labor and Demographic Economics - - Particular Labor Markets - - - Informal Labor Market
    • O17 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements

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