A Model of the Informal Economy in the Transition Setting

Abstract

The informal economy has burgeoned in many transition economies but particularly in the Former Soviet Union. While the variation in the size of the informal economy has been related to differences in tax regimes and the degree of transparency in the legal and commercial system the causality is far from obvious and other factors -- such as the importance of non-monetary compensation or social benefits -- seem to be important. This paper sets up a model of a formal and informal sector where multiple job-holding is feasible. The informal sector can choose to employ part time labour or full time workers; the latter will be subject to payroll taxation. The informal sector in this model makes its decisions contingent on the behaviour of the formal sector and parameters, such as tax rates and the probability of being caught evading taxes. The model allows us to retrieve the ratio of the types of employment in each sector and their associated levels. With the closed form, a set of simulations are run that indicate the effect of shocks to demand and/or financing of social benefits on labour allocation. The distribution of employment across full and part time employment is very sensitive to the scale of subsidy given to benefits, as well as the tax regime and incidence.

JEL Classification: J23, J32, P31, 011