Abstract
Despite the worldwide prevalence of informality, consensus on a reliable and consistent set of drivers and consequences of this phenomenon has been elusive to both researchers and policymakers. This study partly addresses this shortcoming by exploring the interactions between the informal economy and tax policy and how these are shaped by business cycle fluctuations. To this end, we identify robust determinants of both informality and taxation by means of an econometric analysis that accounts for bi-directional causality. Focusing on two different dimensions of informal activity and three tax policy instruments and employing numerous determinants over dozens of model combinations, we find that the significance of the relationship between informality and taxation depends on the specific tax instrument under consideration. Thus, informal economic activity may particularly affect the design of corporate taxes. Also, the business cycle may have distinctive influences on informality and tax policy, so direct taxes appear to be acyclical or countercyclical while indirect taxes are strongly procyclical. We conclude by noting how the cyclicality of the informal economy and taxation might allow to substantiate evidence on the role of informality in the adoption of potentially destabilizing fiscal policies.
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Notes
The informal economy—often called unofficial, shadow, hidden, black, parallel, second or underground economy (or sector)—is defined by Hart (2008) as a set of economic activities that take place outside the sphere of bureaucratic and institutional public and private sector establishments. Individuals operating in the informal economy usually do not pay taxes and social security contributions, nor do they comply with government regulations (including labor and environmental legislation). Yet this definition excludes unpaid private household production, voluntary non-profit (social) services and criminal activities.
Likewise, in regard to financial crises, Colombo et al. (2016) find evidence pointing at the informal sector as a powerful buffer that expands at times of banking disruptions and absorbs a large proportion of the fall in official output. Also, Colombo et al. (2019) show that the informal economy acts countercyclically by taking in workers in bad times (and vice versa), and as a crisis amplifier for the formal economy.
It is worth noting that corruption might be intricately associated with the informal economy in that the two activities might feed off each other. In this sense, the literature on the interdependence between corruption and informality posits how these may be substitutes as the informal economy can serve as an escape from predatory behavior by government officials. Alternatively, entrepreneurs pay bribes in order to be able to hide their operations, supporting a complementarity relationship. Yet corruption and informality share some of the same determinants and empirical evidence to resolve the substitution-complementarity issue is not conclusive (see Goel & Saunoris, 2019).
In fact, Vegh and Vuletin (2015) find some evidence of a procyclical policy for the value added tax rate in developed economies. Somewhat similarly, Srebrnik & Strawczynski (2016) show that, in both developed and developing countries, direct taxes do not follow a significant pattern over the business cycle, whereas indirect taxes (and, in particular, VAT) behave procyclically.
In a similar vein, Srebrnik & Strawczynski (2016) note that huge informal sectors in developing countries give rise to a harmful situation during recessions, when these economies especially need financing resources but the lack of opportunity for taxing the informal economy prevents their governments from raising taxes and discourages foreign lenders from making funds available.
A related analysis of the political economics of taxation can be found in Pickering and Rajput (2018). Their theoretical findings suggest that greater inequality monotonically leads to higher income taxes, whereas expenditure taxes first increase and then decrease with increasing inequality. Cross-country evidence supports their hypothesis, with these relationships holding most significantly in stronger democracies.
An alternative closely related approach is the system of equations technique. Yet the need for establishing a causal relationship independent from more endogenous variables leads to the accepted and generalized use of instrumental variables in economics (see Dufour & Hsiao, 2008).
Note that the previous literature on fiscal policy cyclicality adopts this technique as standard (Klemm, 2014).
Model uncertainty is a serious issue leading to false positives, that is, coefficients that appear as significant in a regression due to lack of information and model misspecification (Muñoz & Young, 2018). In this sense, using few model specifications increases the probability of inaccurate and misleading relationships among variables. As estimates depend on both the data and model specification, this may result in ignoring the true econometric model for the intended relations to be modeled. For these reasons, computational robustness analysis aids in the quest for consistent and precise coefficient estimates.
The IFRS are a set of principles aimed to improve disclosure of financial information, such that transparency and accountability within organizations, with stakeholders and society, becomes feasible. The adoption of IFRS requires government institutions, companies, consumers and citizens to accept, apply and promote a new way of doing business, so there is a learning by doing effect that we intend to capture through the use of the cumulative number of years of adopting these standards as an instrumental variable.
For details, see Baum et al. (2007).
See note 1.
While governments also resort to other taxes (e.g., social security, trade, wealth, and financial transactions taxes), Vegh and Vuletin (2015) note that value-added, corporate, and personal income taxes represent around 65% of total tax revenues in developing countries and almost 80% in industrial nations.
The dataset is publicly available at https://openknowledge.worldbank.org/handle/10986/29303.
For Costa Rica, Bolivia, Dominican Republic and Honduras, data from the Inter-American Center of Tax Administrations (CIAT) is included. For Gabon, we use data from the United States Agency for International Development. For Ethiopia and the Russian Federation, we modify the date of creation of the VAT tax in the original dataset in accordance with governmental and academic documents, respectively. For Kenya, we employ data found in Omondi (2013) and, in the case of Pakistan, we append data from Ahmed (2006).
For Brazil, we follow Vegh and Vuletin (2015) and assign zero values to the entire data series as in the U.S.
One natural criticism of using this interest rate as an instrument is that it might be endogenous in the case of the United States. To address this concern, all instrumental variable regressions exclude the U.S.
As regards the effect of corruption control, this result might be consistent with corruption and the informal economy behaving as substitutes and with the intuition that greater corruption lowers self-employment by acting as a tax or transaction cost of operating in the shadows. See note 3.
These results also are somewhat in line with the ones of Aizenman et al. (2019). These authors have found that OECD countries are procyclical in the value-added tax but countercyclical in corporate and personal income taxes, whereas non-OECD countries are acyclical in the value-added tax and related to procyclicality in corporate and personal income taxes.
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Acknowledgements
We would like to thank Cristina Fernández, Holguer Jara, Ilia Murtazashvili, seminar participants at CID-UNAL and the international conferences The Economics of Informality 2020 and The Shadow Economy, Tax Behaviour and Institutions, the editor (Ron Davies) and two anonymous referees for helpful comments and discussions. Ceyhun Elgin kindly shared the dataset on shadow economy size used. Andrés Acevedo and Estefanía Acosta provided valuable research assistance at different stages. All errors and omissions are our own. Financial support from Universidad de Antioquia through the Centro de Investigaciones y Consultorías of the Facultad de Ciencias Económicas (project CODI No. 2017-18035) and from the program “Inclusión productiva y social: programas y políticas para la promoción de una economía formal,” code 60185, which conforms to Alianza EFI—Economía Formal Inclusiva, under the contingent recovery grant No. FP44842-220-2018, is gratefully acknowledged.
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Granda-Carvajal, C., García-Callejas, D. Informality, tax policy and the business cycle: exploring the links. Int Tax Public Finance 30, 114–166 (2023). https://doi.org/10.1007/s10797-021-09717-7
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DOI: https://doi.org/10.1007/s10797-021-09717-7