Law enforcement and the size of the informal sector

Abstract

This study presents cross-country evidence indicating that the relationship between the size of the informal sector and tax rates is ambiguous. Motivated by this finding, a standard two-sector model is augmented with endogenous law enforcement, which depends on the size of the informal sector and government expenditure. Additionally, based on microdata from Colombia, taxes and law enforcement are necessary to match the observed size of the informal sector. Meanwhile, the dependence of law enforcement on government expenditure creates a non-linearity in the form of a Laffer curve. Therefore, lowering tax rates would not necessarily reduce the size of the informal sector.