Tax Enforcement and Welfare

Abstract

While higher tax enforcement may be seen as the way to move more production and employment from the untaxed and unregulated informal sectors of the economy to the more regulated and taxed formal sectors, it may lead to a decrease in welfare. The key idea is that the informal sector is composed of consumption maximizing entrepreneurs as opposed to profit maximizing firms. This implies, higher tax enforcement that lowers informal output by raising the expected cost of production in these sectors also lowers consumption of these entrepreneurs. In the presence of large informal sectors, as in many developing economies, the decline in informal sectors’ consumption with enforcement is large enough that aggregate consumption (our measure of welfare) falls. Greater formal sector access to finance mitigate the negative impact of enforcement on welfare. Novel empirical evidence supports our model’s results and implications.