__wPSI33 POLICY RESEARCH WORKING PAPER 1334 Taxation, Public Services, The informal when overregulabon {high and the Informal Se, oC "" ttor ax raes and a high cmt for in a Model ol' Endogenous entering the formal sector) is in a Model of Endogenous pe niefin coupled with an inefficient Growth and corrupt system of compliance control. Informality adversely affects Juan Braun economic growth because Norman V. Loayza the contribution of public seriices to productvity deaeases as the infomal sector expands. TheWorldBank Policy Research Departnment Macroeconomics and Growti Division August 1994 | POLICY RESEARCH WORKING PAPER 1334 Summary findings Large informal sectors are an important characteristic of Braun and Loayza find that the relative size of the devdloping countries. Braun and Loayza build a dynamic informal sector is negatively related to the severity of the model in which dhe informal sector exists when penalties and positively related to tax rares and the overregulation (high tax rates and a high cost for extent of informal use of public services. entering the formal sector) is coupled with an inefficient They also find that economtcs with larger informal and corrupt system of complianee control. sectors have lower capita return and growth rates They consider a production technology in which because the contribution of public services to public services are essential and subject to congestion. productivity decreases with informality. The public services are financed by taxes collected from They argue that self-interested bureaucracies cream an the formal sector. Informal producers evade taxes and, economic environment that makes informality attractive because of their illegal status, can use only some public or simply unavoidable because they profit from the services, cannot use captal or insurance markets, and are presence of the informal sc6tor. subject to stochastic penalties. This paper - a product of the Macroeconomics and Growth Division, Policy Research Department - is part of a larger effort in thedepartmentto study the effects of regulation oninequality and econcmic growth. Copiesof the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Rebecca Martir, roon N11-043, extension 39026 (39 pages). August 1994. TWe Polcy Research Woig Paper Seies disemieth jlndings of wrk i pross to encowge the exch_e of ida about development sse An objective of the serie s toge the m Oint cut quwicky. cuen if the presentations are less than fzlypolisybed T7he papers carny the names of the auths and sbold be used and citrd accordingly. The frndings. interpretationsm and concluions are the authors' own and shoul not be awtibued to the World Bank, its Executive Board of Diros, or any of its memcbr counfnes. Produced by the Policy Research Dissemination Center TAXATION, PUBLIC SERVICES, AND THE INFORMAL SECTOR IN A MODEL OF ENDOGENOUS GROWTH* Juan Braun Pontificia Universidad Catolica de Chile and Norman V. Loayza The World Bank JEL 011, 041, H26, H41 Keywords: Growth, Informal Economy, Tax-Evasion, Congestion Effects, Public Goods -We thank Alberto Alesina, Robert Barro, John Driscoll, Edward Glaeser, Debraj Ray, Jaume Ventua, and participants in the Economic Growth Workshop at Harvard University for helpful suggestions. "Address: The World Bank, 1818 H Street, N.W., Washington, D.C. 20433. Phone: (202) 458- 4767. Fax: (202) 522-1151. TAXATION, PUBLIC SERVICES, AND THE INFORMAL SECTOR IN A MODEL OF ENDOGENOUS GROWTH 1. INTRODUCTION The informal sector is tie. set of economic units which do not comply with one or more government-imposed taxes and regulations but whose product is considered as legal.' The presence of large informal sectors in all economic activities is one of the most important characterisdcs of developing countries: Informal sectors employ between 35 and 65 percent of the labor force and produce 20 to 40 percent of GDP.2 The informal sector arises when an excessive regulatory system is coupled with an inefficient and corrupt system of compliance control. An excessive regulatory system makes the formal economy costly and unatactive by imposing high entry costs to legality, through license fees and registration requirements, and high costs to remaining legal, through taxes, red tape, and labor, environmental, and various other regulations.? However, escaping taxes and regulations is not costless: An informal status entails many disadvantages. When an informal activity is detected, stiff penalties, in the form of pecuniary fines or capital confiscation, are applied. Furthermore, because of their illegal status, they do not enjoy full and enforceable property rights over their capital and product This has a number of deleterious consequences: First, informal producers are poorly protected by the police and the judicial courts from crimes committed against their property. Second, since they lack the capacity to enter into legally bindiag contaal obligations, their access to capital markets, for 'For an overview of the definition and characteristics of informal economies, see Chapter 1. 2Chickering and Salahdine (1991), p. 3. 3De Sowo (1989). -2- financial, insurance, and corporative purposes, is seriously limited. And third, they find obstacles to use some other public services, such as social welfare, skill training programs, and government-sponsored credit facilities. The bureaucracy, as the institution controlling and monitoring the regulatory system, plays a crucial role in the formation of informal economies. If the bureaucracy profits in some way from the presence of the informal sector, it will create an environment that makes informality attractive or simply unavoidable. In this paper we model the presence of informal sectors in the economy and their relationship to economic growth. To accomplish this goal, we use the framework of the endogenous growth literature.' Specifically, we use the work in which govermnent's participation in production, through the provision of public goods and services, is considered explicitly, as in Barro (1990), and Barro and Sala-i-Martin (1992). In the sense ihat the informal sector is modeled as not paying taxes, this paper can be considered as a general equilibrium model of tax evasion.5 However, we depart from the tax evasion literature by considering informality as an alternative to legality, entailing different production relations to government institutions and services, other firms, and capital markets. We also depart from the prevailing modelling approach to informal economies, approach which focuses on labor market segmentation and rural-urban migration.6 4See Romer (1986), Lucas (1988), Barro (1990), and Rebelo (1991). 5One of the earliest and most influential tieoretical papers on tax evasion is Allingham and Sandmo (1972). Cowell (1990) and Tanzi and Shome (1993) survey the recent theoretical and empirical literature on the subject. Alm, McClelland, and Schulze (1992) present experimental evidence on the individual reasons for tax compliance. 6See Chaudhury (1989), Rauch (1991), Gupta (1993), and Chapter 3. -3- In a general sense, we follow the methodology outlined by Becker (1968) to the study of illegal behavior: Economic agents in our model are interested in optimizing the expected value of intertemporal utility and choose, accordingly, whether or not to belong to the informal sector. In Section II we set up the model. We consider a production technology in which publicly-provided goods and services are essential to private production and are financed by tax revenues from the formal sector. Examples of these publicly-provided goods are transportation facilities, public utilities, education and health programs, judicial courts, public credit agencies, and domestic security (police, prisons). These public services are rival (subject to congestion) and to some extent excludable: Informal producers can only use some of them. In Section III we study the steady state of the economy, a state when both formal and informal sectors grow at the same constant rate. We find that the relative size (in terms of capital or output) of the informal sector is negatively related to the severity of the penalties and positively related to tax rates, the extent of informal use of public services, and the exogenous productivity of the economy. Furtiermore, we find that the return on capital and, thus, the economic growth rate is negatively affected by the relative size of the informal sector; this is so because of the inherent disadvantages of informal activities and because the informal sector does not contribute to financing productive public services. Finally, we find that the presence of entry costs into the formal economy produces a steady state with a larger relative size of the informal sector and a lower rate of economic growth, when compared to the case with no access costs to fornality. In Section IV we analyze government's behavior. We first assume that government is optimizing a given social welfare function, and we find that the social optimum involves the disappearance of the informal sector. We then analyze the case when government is partially controlled by a sel-interested bureaucracy, which profits from the presence of the informal sector -4- through the appropriation of penalty revenues. We argue that short-sighted and socially- unaccountable bureaucracies are the most harmful to economic growth and social welfare. In Section V we introduce uncertainty in production to study how the inability to use insurance and capital markets, which allow risk diversification, makes informality less attractive. Section VI concludes. 1L. PRODUCTION TECHNOLOGY AND UTILITY OPTIMIZATION The economy is populated by a continuum of agents in the interval [0,11. Each of them is endowed with a (possibly different) starting level of a broad measure of capital, which is meant to include physical as well as human capital. They can operate a basic technology to produce a single good in the form of consumables or capital. Raw labor is not an input of production. Agents maximize$i expected value of discounted utility (U): U Eofu(c(t))e -Pdt () There are two different sectors in the economy to vWhich agents choose to belong: the formal and the informal sectors. We refer to the people belonging to each sector as the "formals" and "informals," respectively. Formals pay taxes in the form of a proportional income tax, the proceeds of which are used to finance the provision of public services. The net-of-tax flow of output to formal producers is given by7 7The superscripts F and I correspond to the formal and informal sectors, respectively. Agents are indexed by the subscript i- Aggregate quantities omit this subscript. -5- yl = aFki (2) where aF is the net-of-tax expected return on capital, i.e. flow of production per unit of capital. For informal producers, the flow of output is given by Y = a'Ikc (3) where a' denotes the return on capital in the informal sector. lnformals do not pay taxes. However, they must pay a penalty when caught. Penalties consist of a fracdon of the capital belonging to informal agents. We assume that the proceeds from penalties are appropriated by government officials (the bureaucracy) for their own good (we expand on this issue in section V); therefore, penalty revenues are not used to finance public services. We follow Barro and Sala-i-Martin (1992) in assuming that the net-of-tax retrn on capital depends on the available amount of public services relative to aggregate production: y )/ ccs = ) where A is an exogenous productivity parameter, g is the flow of public services, r is the tax rate, f is the fraction of public services used by informal producers, and y' = (1-7)4 + ey is aggregate production which congests public services8. Informals have access to the same basic technology, but they use only the fraction e, OO P. is related to the decrease in utility due to expete capital expropriation. The function gOJ can be thoug,ht of as the difference in utilities before fines. - -13- . . ~ ~ ~ ~ ~ ~ ~ ~ ~ r By the same token, in the steady state formals want to move to the informal sector when g02 P. In order for the informal sector to be present in the economy, at least g(,=O) has to be positive and greater than P, that is, P 10[e - -.r)i> - (16) A Note that the left-hand side of (16) is increasing in the tax rate. This means that, given the other parameters, the tax rat has to be high enough if there is to be an informal sector. The intaition for this is clear: The only advantage of being in the informal sector is not paying taxes. Figure 1 shows g(6) as a function offl for the case where (16) obtains. Since P and A are both positive, the inequality in (16) implies [e - (1-r)J >0, which is the condition for * ' < O. The negative slope of the function g(1) means that an increase in congestion (through an increase in O1) affects the informal sector rate of return more severely than it affects the formal sector one. Figure 1 helps us identify- the stay-state level of P and how it is affected by changes in the parameters; Figure I is not used to describe transitional dynanics. In the steady state, any individual is indifferent between the two sectors. This occurs when ihe ratio of formal to -informal production is. , where g(fi) =P."), The growdt rates of bodL secors adjust so as to keep ,B equal to ,B; as we explain below, this requires a net flow of capital from the informal to the formal sector. Not that values -of ,B lower than ,B do not represent steady states because at those points g*0)> P, which means that all individuals prefer to be in the informal sector, dtus creating a change in $3. By the same- token, for values of ,B higher than P", g6B) ? - - @ 1 s zCe"-(l-s)] 1 .. ~~~~~(18) EP~~~ The effect of changes in different parameters on the value offK can be explained using Figure 1. An increase in the probability of being caught (X) or in the size of the penalty (b) incases P, thus producing a decline in the relative size of the informal sector. Higher tax rates hurt formals- relative to- infornals; and hence when r goes up, g60) moves upwards and to the right, thus increasingf#. In fact, considering,B -as a function of tax rates,f> is 0 for 7 70 (see Figure 2).. When informal producers can use a higher fraction -of available public services (higher e), the relative size of the informal sector in the steady state obviously increases. A somewhat less obvious result is that improvements in exogenous'productivity,'measured by the parameter A, result in a relatively bigger infornal sector. The reason for this result is that for high tax rates and. given (e -(1-T)] >0, the infornml sector capures a relatively larger faction of the productivity improvemenLt -15- Growth Recall the definition of i, y (l = -T) cF-kF =Ea Then for d/dt = 0, the growti rates of the formal and informal sectors have to be the same. From equations. (9) and (14), we know that if no capitl flows from one sector to the other, y- F= g(Pf)-Ab = -ALlog(1-b)+b] > 0 This means that if no capital switches sectors, the growti rate of informal capital is greater than that of formal capital, and, thus, ,B increases. This situation can not correspond to a steady state- Therefore, in steady state there will be a constant movement of capital from the informal to the formal sector. The amount of capital that switches sectors, le, is obtained from the condition of equal growth rates and is given by V l= og(l -b) +b] AZ C Note that the first order approximation for log(l-b) is given exactly by -b, thus if b is small k' will be very close to 0. The growth rate of the economy is given by =1 - - P>0 Substtuting forf' in the expression for cit -16- ..~~ (l-ijP r _F= e--t) (20) Assume that b is small enough so that the growth rate is very close to cf-p. Given the negative effect of ,B on af, the growth rate is decreasing in,f whenpl >0. Hence, as can be seen in equation (20), when f > 0, the growth rate decreases with r and e and increases with X and b. When the steady-state size of the informal sector is 0 (Trr9), the model collapses to the one analyzed by Barro and Sala-i-Martin (1992), in which a", as function of r, is first increasing, reaches a maximum at r=/ =aO/(1+aq), and then dedines. In our model, te behavior of a" with respect to r depends on whether r. is bigger or smaller than r? Figures 3A and 3B graph aF for T.<-r and C>T, respectively. In both cases, for > 70, ciFalways decines with r. Note that,the rate of-return (a"),'and, thus, the growth rat, is always decliniing with the tax rae when tere is an informal seor in the economy >0), even in the case when higher taxes could have positive- effects on productivity, in the absence of an informal sector (see Figure 3A). The case when T0 0, it must be .the -case that at increases proportionally more than a"; clearly, this is not a steady-se equilibrium (gP)='-aF is no longer equal to F). Utilities are equalized across :7 - . sectors only when /i increases so much that i/ is lower than it was before taxes went up. Entry Costs to Formality We model the access costs to formality as a one-time fee paid to government; this fee is assumed to be proportional to the capital to become formal. As explained in the introduction, this access cost reflects regulations imposed by govermnent and its bureaucracy. These regulations serve no direct purpose, and, hence, they are a waste of resources from the social perspective. Let this one-time cost be given by the fraction 6 of capital, where 0<5 <1. informals will switch to the formal sector when fornal utility less entry costs exceeds informal utility; that is, when W (k S VF((I'_a)k or, g(r) P (W) where, P' = P + plog(1-8) < p Note that P' can be positive or negative. Since formAls face no entry costs to the informal sector, they will switch to the informal sector when g(u) P Hence, there is a zone of inaction, where nobody wants to switch sectors. -18- There are two cases to consider. The first occurs when the entry cost rate (6) is low enough so that P>P'> Xb. In this case, we assume that g(=O)>P'." This case is presented in Figure 4A.3 The steady state level of a is given by tie intersection of g'3) and P'. At , no formal agents want to move to the informal sector. On the other hand, informal agents are indifferent between the two sectors. Note that if no capital flows from one sector to the other, the informal sector will grow at a faster rate (g(fl) > Xb). Therefore, in order to keep ,B constant, there will be a constant flow of capital from the informal to the formal sector, as is the case when there are no access costs. The ratio of infonnal to formal production in the steady stat (B-) is given by O 0r 13*= A E-1-)a 1 (/l E(P1 where, A The second case occurs when the entry cost rate (a) is high enough so that P> )b 2P'. in this case, we assume that gg3=O)>Xb.1' This second case is presented in Figure 4B. aljs given by the intersection of g03) and Xb. In this steady state, neither formal nor infonnal agents "This assumption is analogous to the one in equation (16) for the case of no entry costs; it makes possible the presence of an infonnal sector in steady sate. 121 j drawing Figures 4A and 4B, we assume that P' is positive. The analysis is the same if P' is negative. "See foomote 11. -19- want to switch sectors, and both of them grow at the same rate (g(fl) =Xb). We have not modeled the transition to the steady state; nevertheless, the following is a rough characterization of the trnsition in a neighborhood around the steady state, neighborhood in which there is no flow of capital from one sector to the ocher: In Pigure 4B, betweenfl1 andfl2 no agent switches sectors; however, between 1, and B, g6B)> Xb, so that i> 'yF implying that ,B approaches p; and, between Po and 2, gO Xb, so that -y" 0), individual utility obtained in the formal sector is equal to that in the informal sector; therefore, r=BP. If the informal sector does not exist (f'=0), obviously every individual's utility depends on e. In either case, maximizing welfare amounts to maximizing BF From the expression for oplmal individual utility in the formal sector (equation (7)), we see that B' is a positive function of oF. Therefore, maximizing welfare is equivalent to maximiizing ci. As -was shiown in the section on aggregate growth, the growth rate is for all practical purposes equal to acl-p, and, thus, it is optimized by maxiniizing a'. Therefore, maximizing welfare is approximately equivalent to maximizing growth. From now on, when analyzing "Note that since the optinal choice of parameters does not depend on the current distribution or level of capital, the optimal solution is time consistent. -21- opimal welfare and growth, we concentrate on the maximization of at. There are a number of parameters in the model. We are going to assume that four of them are policy parameters. They are the tax rate (r), the penalty rate (b), the fraction of public services used by informals (e), and the registration-cost rate (6). They seem to be the parameters that most realistically would be under government control.'5 Note, however, that assuming that these four are the only policy parameters does not mean that we are restricted to suboptimal outcomes; in fact, as we show shortly, using these four parameters appropriately allows us to attain the optimal outcome. From the perspective of social welfare, it is clear that 6 must be set equal to zero. What abOUt r, b, and e? Consider the relationship between aF and r for given b and e. This is represented in Figures 3A and 3B. We see that of reaches a maximum at r9 when To 0, (1+C), = Ap[-(l-r) + 1-T)2 + 2;P$}] (34) Note dtat 70 is implicitly given by equation (34) when ,P =0; and as before, if 7<-r then j'=O. The growth rate is given by the same expression as in the case of no uncertainty (equation 19), although the switching term is slightly different. The qualitative implication for growth and -32- welfare are similar to those of the simpler model. VI. CONCLUDING REMARKS This paper studies the emergence of informal sectors and their impact on growth and welfare. We argue that the rise of informal sectors is a natural consequence of the restrictions imposed by governments on optimizing agents. An informal satus entails many disadvantages; namnely, inability to use the capital and insurance markets, lack of access to important public services, and propensity to suffer penalties and expropriations. Nevertheless, despite those disadvantages, some economic agents choose to become informal because the restrictions government imposes on them, by way of taxes and regulations, are overwhelming. Economies with larger informal sectors are more inefficient because of the disadvantages inherent to infornality and because the loss of tax revenues hurts the provision of public goods and services. In this paper, we show that such inefficiency is reflected in low rates of return to all investmenit, stagnant growth, and suboptimal social welfare. What explains government's socially inefficient behavior? It has been argued that such behavior can be explained by the inertia of bad laws, designed to meet the social needs of offier times and places. However, this explanation begs the question: what explains such inertia? We believe that bad laws, far from being removed, are put forward because they benefit groups in power. In this paper, we have identified such groups with government bureaucracy, which controls public services and has the power to expropriate capital from informnal agents. It thus follows that bureaucrats, having a vested interest in a large and growing informal sector, create the incentives for informality. In reality, the bureaucracy is not the only interest group in society. Many groups would -33- like government to legislate regulations on their behalf. As those special regulations are implemented, informal sectors, trying to avoid them, arise. With widespread informality, society at large suffers. -34- REFERENCES Allingham. M. G. and A. Sandmo (1972), "Income Tax Evasion: A Theoretical Analysis," Journal of Public Economics, November. Alm, J., G. McClelland, and W. Schulze (1992), 'Why Do People Pay Taxes?," Journal of Public Economics, June. Banerji, A. (1991), "Tax Evasion, Enforcement, and Intertemporal Choice," Proceedings, 1991 National Tax Association Conference, Williamsburg, pp. 90-100. Barro, R. (1990), "Goverment Spending in a Simple Model of Endogenous Grordth," Joural of Political Economy, October, supplement. Barro, R. and X. Sala-i-Martin (1992), "Public Finance in Models of Economic Growth," The Review of Economic Studies, October. Becker, G. (1968), "Crime and Punishment An Economic Approach," Journal of Poliical Economy, Vol. 76, No. 2. Chaudhury, T. (1989), "A Theoretical Analysis of the Informal Sector," World Development, March. Chickering, A. and M. Salahdine (1991), "Introduction," in The Silent Revolion, ed. A. Chickering and M. Salahdine, International Center for Economic Growdt, San Francisco. Ccwell, F. (1990), Cheating the Government: The Econonmcs of Evasion, M1T Press, Cambridge. De Soto, H. (1989), The Other Path, Harper & Row, New York. Gupta, M. (1993), "Rural-Urban Migration, Informal Sector, and Development Policies: A Theoretical Analysis," The Journal of Development Economics, June. Loayza, N. (1993a), "A Brief Introduction to Informal Economies," mimeo, Harvard University, November. Loayza, N. (1993b), "Labor Regulations and the Informal Sector," mimeo, Harvard University, November. Lucas, R. (1988), "On the Mechanics of Economic Development," Journal of Monetary Economics, July. -35- Rauch, J. (1991), "Modelling the Informal Sector Formally," The Journal of Development Economics, January. Rebelo, S. (1991), "Long-Run Policy Analysis and Long-Run Growth," Joumat of Political Economy, June. Romer, P. (1986), "Increasing Retums and Long-Run Growth," Journal of Political Economy, October. Shleifer, A. and R. Vishny (1993), 'Corruption," 7he Quarterly Journal of Economics, August. Tanzi, V. and P. Shome (1993), "A Primer on Tax Evasion," International Monetary Fund, Working Paper No. 93/21, March. -36- PIGURE 1 \r P \~~~~~~~ I bet* betx FIGURE 2 '*1~~~~tn 11 ta I~~~Iu ':~~~~~~~~~~~~~~~~~~~~~~~~~ FIGURE 3A dphF tauO t,- 1 tau II iIGUTRE 3B I I I I taut tanO 1 ton ( , ~ ~ ~~~~~~~I\ FIGURE 4A p PR L-- LImibda'b beb' ba FIGURE 4B p I la_)s*b I I I g~~~~~~~~~ammd') bet be".* beM2 beta 1 Policy Research Working Paper Series Contact Title Author Date for paper WPS1319 The Financial Syslem and Public Ash Demirgdq-Kunt July 1994 B. Moore Enterprise Relorm: Concepts and Ross Levine 35261 Cases WPS1320 Capital Structures in Developing Asil Demirgucg-Kunt July 1994 B. Moore Countries: Evidence from Ten Vojislav Maksimovic 35261 Countries WPS1321 instilutions and the East Asian Jose Edgardo Campos July ,994 B. Moore Miracle: Asymmetric Information, Donald Uen 35261 Rent-Seeking, and the Deliberation Council WPS1322 Reducing Regulatory Barriers to Barbara Richard July 1994 M. 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