Perceptions on Governance Effectiveness and Informality: A Self-fulfilling Equilibrium

Motivated by empirical evidence suggesting a close link between weak institutional quality and informality, this paper proposes a game-theoretical model that explores how perceived governance effectiveness in public service provision determines a firm’s decision to be formal or informal under incomplete information with regard to other firms’ perceptions. By deploying a “global games” approach, the model characterises the size of informality as a unique self-fulfilling equilibrium outcome, which increases as governance effectiveness declines. The results indicate that, for a range of governance effectiveness level, informality arises inefficiently as a result of a coordination failure; that the effect of tax increase on the size of informality exhibits a U-shaped relationship, low and high tax rates being associated with a greater size of informality; and that the optimal fiscal policy maximising the ex ante welfare of the representative firm results with excessive taxation.