Optimal Taxation in a Monetary Search Model with Informal Markets

This paper considers a search theoretic model of money in the tradition of Lagos and Wright (2005) where sellers can choose to produce in the formal or informal market. There is continuum of types of producers that differ in their managerial ability, as in Lucas span of control model. Producers in the formal market can make deposits and receive intererst payments, which makes credit possible for buyers. However, formal market transactions are subject to taxation. Informal market transactions are not subject to taxation. However, no access to credit or deposits is possible. Moreover, informal producers must pay a cost for hiding of the fiscal authority that increases with firm size. We find that the size of the informal sector grows as fiscal taxes increase, and declines with inflation. Optimal fiscal and monetary policy in this model requires substantial deviations from the Friedman rule. JEL Codes: E41, E50.