Income Concentration, Market Size and Informal Sector in Africa

Abstract

In this study, we analyze the link between income concentration and the size of the informal sector. We construct a simple model where income concentration determines demand and firms decide whether to operate in the formal or the informal economy is outlined. The government collects taxes and returns them to society either as a productive public good for its use by formal firms or as transfers to the poor. It is further postulated that income distribution affects the response of the informal sector to different fiscal policies, either demand or supply-orientated. In this case, redistribution towards the middle class decreases the size of the informal sector and increases the capacity of fiscal instruments to reduce informality. Data concerns 38 Africans’ countries in which the characteristic of income distribution is similar across countries. Using this comparable macro-level panel data between 1991 and 2013, we find strong evidence that high-income concentration leads to a large informal sector. Furthermore, an economic policy, including the effective application of the tax and regulatory procedures, should help to keep down the size of the informal economy.