Optimal Income Taxation and Formalization of the Informal Economy

Tax revenues, particularly in developing countries, play a crucial role in driving economic development, and formalizing the informal economy offers significant potential for raising revenues, given the large size of the informal economy and the limited role of personal income taxes in tax collection. However, effective formalization also requires sufficient redistributive incentives for a smooth transition to the formal economy. By addressing both formalization and redistribution simultaneously, this study examines the impact of formalizing the informal economy on an optimal tax schedule using an extended Mirrlees model, and identifies an optimal tax formula that incorporates formalization of the informal economy. Quantitative analysis shows that formalization increases tax revenue and income transfers when the tax schedule is optimized together with formalization. Conversely, these benefits diminish when the tax schedule remains unchanged and is not fine-tuned for formalization. This study improves our understanding of the informal economy and provides valuable insights into the implications for designing optimal tax policies with formalization.