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Welfare gains from the adoption of proportional taxation in a general-equilibrium model with a grey economy: the case of Bulgaria’s 2008 flat tax reform


This paper provides a quantitative evaluation of the welfare effect of the introduction of proportional taxation in Bulgaria in 2008, an effect that operates through the grey economy channel. Using a general-equilibrium model, augmented with informal sector, a computational experiment is performed to evaluate the welfare gain from the adoption of proportional taxation. The lower effective tax burden in the new tax regime produces a relocation of people into the official sector, stimulates investment, and increases output and consumption. Finally, under the flat tax regime, the size of the informal sector is smaller, and quantitatively consistent with OECD (Is informal normal? Towards more and better jobs in developing countries. OECD, Paris, 2009) and European Commission (Tax reforms in EU member states, Official Publications of the European Communities, Luxembourg, p 2012, 2012) figures.

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  1. 1.

    Even though a flat corporate tax rate of 10 % (and a 5 % divident/capital gains tax) was introduced in 2007, the flat tax rate of 10 % on household’s income was introduced in 2008.

  2. 2.

    Still, it is important to have the same tax rate applied to labor and capital income—otherwise small business owners would declare their income to be the one that is levied with the lower tax.

  3. 3.

    In Bulgaria, the share of personal income tax revenue out of total government revenue is approximately 10 %.

  4. 4.

    Given the lack of data on wages in the unofficial sector, it will be assumed that the most workers could earn there is the minimum wage. If that were not the case, those workers would have been better-off working in the official sector.

  5. 5.

    As Conesa et al. (2001) point out, “those are neither illegal goods or services, nor home produced ones; the importance of this unregistered production is that it is non-tradables.”

  6. 6.

    The description of the progressive tax system in Bulgaria in this section follows the structure used in Vasilev (2015).

  7. 7.

    Since the introduction of the currency board arrangement in 1997, the lev is fixed to the Euro at the rate of 1 Euro =  BGN 1.95583.

  8. 8.

    The second component, personal income tax revenue from business activities (14 %), is decreasing over the period, which reflects the financial crisis, but then rebounds in 2011.

  9. 9.

    An alternative way to confirm the hypothesis that the increase in tax revenue is driven by improvements in tax compliance is to look at the implicit tax rate documented by the European Commission (2012): the rate before the introduction of the flat tax rate was 38.1 versus 24.4 % for the years after.

  10. 10.

    As in Azacis and Gillman (2010), the model is a closed-economy one, which is a useful simplification. In a closed economy the return on capital is determined endogenously, and this assumption that cannot be relaxed so easily. However, under the assumption of a closed economy, the welfare gains from the introduction of a flat tax rate might be different from reality, as Bulgaria is a small open economy.

  11. 11.

    The “wage rate” in the unofficial sector could also be interpreted as the opportunity cost of working in the unofficial sector.

  12. 12.

    For simplicity, we shall assume that in this economy there are no financial assets and the public sector cannot issue debt.

  13. 13.

    Notice that when \(\phi =0, \tau _{t}=\eta\), i.e., the tax rate is constant (“flat tax”), while \(\phi >0\) produces a tax rate that rises with total income (“progressive tax”).

  14. 14.

    The low participation rate is consistent with the experience of Soviet and post-Soviet Baltic states, as documented in Smith (2014).

  15. 15.

    In this way we can solve for the steady-state recursively, instead of solving for all variables jointly. Another advantage is that we can obtain the big ratios directly.

  16. 16.

    For computational simplicity, steady-state output has been normalized to unity.

  17. 17.

    More specifically, the average effective tax rate is approximated by the average amount of tax actually paid, divided by total income. Since the model is an infinitely-lived agents one, and the level of social contributions has not changed substantially, (except for the 3 % points cut in social security contributions in the last quarter of 2007, which was quickly reversed shortly after) the model will abstract away from those “taxes”.

  18. 18.

    For the three tax brackets, \(\phi =0.43,0.57,0.70\), respectively. Robustness checks are performed in later sections of the paper to evaluate how welfare effect of the tax reform depends on the degree of progressivity of the previous regime.

  19. 19.

    Enste (2002) calculate the average share of the grey economy in Bulgaria over the 1994–1995 period to be 0.327, while Nenovsky and Hristov (2000) compute that share to be 0.268 over the 1997–1999 period. Ahumada et al. (2009) obtain a conservative range of 0.122–0.175 for the share of the unofficial sector for the period 1998–2007.

  20. 20.

    This long-term approach was preferred in order to abstract away from the effect of the financial crisis. After all, the tax reform in Bulgaria was introduced in the same year the financial crisis unravelled, so computation of the transition path was ruled out.

  21. 21.

    On the other hand, Funke and Strulik (2006) find much smaller welfare gains using also an exogenous growth model to study the effect of the Estonian 2000 income tax act.


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Correspondence to Aleksandar Vasilev.

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Vasilev, A. Welfare gains from the adoption of proportional taxation in a general-equilibrium model with a grey economy: the case of Bulgaria’s 2008 flat tax reform. Econ Change Restruct 48, 169–185 (2015).

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  • Taxation
  • Exogenous growth
  • Informal sector
  • Labor reallocation
  • Welfare gains

JEL Classification

  • H22
  • J46
  • D51
  • D91
  • O41