Informality and Optimal Public Policy

26 Pages Posted: 16 Feb 2016

See all articles by David Bardey

David Bardey

Universidad de los Andes, Colombia - Department of Economics

Daniel Mejia

Universidad de los Andes, Colombia - Department of Economics

Date Written: January 5, 2016

Abstract

This article tackles the feature of optimal public policy such as the level of enforcement and the supply of public goods in an economy characterized by a huge informal sector. We consider informality as the group of productive activities which, before hand, do not comply (totally or partially) with government regulations. The Government intervenes as a Stackelberg leader and has to decide how to allocate public expenditures, collected through the tax system, between the provision of a public good, which can only be used for formal activities, and enforcement effort, aimed at detecting informal firms that evade taxes. Taking the public policy as given, a representative family, owner of a representative firm, decides how to split a fix amount of labour supply between formal and informal activities. Our results show that the greater are the distortions in the process of tax collection, the larger is the size of the informal sector. Finally we derive the properties of the optimal public policy. In particular, we show that the shadow cost of public fund represent the rationale of enforcement spending. We also point out that the size of the tax distortion (e.g. the shadow cost of public funds) is inversely related to total income, the tax rate and the provision of the public good.

Keywords: Informality, public good and enforcement

JEL Classification: K10, K20, K42, O17

Suggested Citation

Bardey, David and Mejia, Daniel, Informality and Optimal Public Policy (January 5, 2016). Documento CEDE No. 2016-01, Available at SSRN: https://ssrn.com/abstract=2732663 or http://dx.doi.org/10.2139/ssrn.2732663

David Bardey (Contact Author)

Universidad de los Andes, Colombia - Department of Economics ( email )

Carrera 1a No. 18A-10
Santafe de Bogota, AA4976
Colombia

Daniel Mejia

Universidad de los Andes, Colombia - Department of Economics ( email )

Carrera 1 No. 18 A - 10
Bogotá, AA4976
Colombia
57(1)3394949 ext 3737 (Phone)
57(1)3324492 (Fax)

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