Economic Theory

, Volume 37, Issue 3, pp 395–416

Contract enforcement and the size of the informal economy

Research Article

Abstract

This paper describes a model where the size of the informal sector decreases as the degree to which financing contracts can be enforced in the formal sector rises. Agents who choose to operate in the informal sector can evade taxes, but they have no access to official means of contract enforcement. Numerical simulations of the model suggest that lax tax enforcement alone does not suffice to generate a large informal sector. Contractual imperfections, on the other hand, can generate a large informal sector and account for several distinguishing features of the organization of production in developing economies.

Keywords

Limited enforcement Informal sector Economic development 

JEL Classification

O17 O10 

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Copyright information

© Springer-Verlag 2007

Authors and Affiliations

  1. 1.Research DepartmentFederal Reserve Bank of DallasDallasUSA

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