Tax rates , governance , and the informal economy in high - income countries by Zoë Kuehn May 2010

Approximately 16.7% of output in high-income OECD countries is produced informally. Across these countries, the size of the informal economy is positively related to tax rates and negatively related to governance quality. 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 fined. 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. Taking into account both, governance quality and tax rates, the model can account for 72% of informality in high-income countries. I run a policy experiment that raises governance quality in Greece, Italy, Spain, and Portugal to Finish standards. Informality across these countries is reduced by an average 13 percentage points and in case tax collection costs increase less than five fold, the policy also implies higher tax revenues. JEL classification: E26, H20, H26, J24