Law Enforcement and the Size of the Informal Sector

Abstract

I assemble new cross-country evidence showing that contrary to the standard view, the relationship between the size of the informal sector and tax rates is, at best, ambiguous. Law enforcement and informality also show no clear relation. Motivated by these findings, I augment a standard two-sector (formal and informal) small open economy model with endogenous law enforcement that depends on the size of the informal sector (measured by its assets) and government expenditure. I use a micro-dataset from Colombia to show that both taxes and law enforcement are necessary to match the the size of the informal sector observed in the data. In the absence of law enforcement, tax evasion incentives imply a counterfactually large informal sector. However law enforcement motivates households to reduce the supply of capital to the informal sector, decreasing the probability of detection. The dependence of the latter on government expenditure creates a non-linearity between tax rates and the size of the informal sector through a Laffer curve. The model implies that lowering tax rates would not necessarily reduce the size of the informal sector since there is a trade-off with law enforcement capability.