Optimal Penalties on Informal Firms

Abstract: I study a much discussed and highly policy relevant question: what, if anything, should the government do about informal production? In a simple capital accumulation model of informal firm growth and potential formalization, I show analytically that optimal penalties depend on the productivity level: the least productive firms should be left alone, the more productive ones should always face positive penalties, which increase in the productivity level. This holds for two different government objectives, i.e. maximizing formal sector tax revenue, and speeding up formalization, respectively, where the latter objective results in higher average penalties. This theoretical result provides a direct policy advice in an area where some countries may have followed such a policy, without a rigorous foundation, whereas other countries have simply let all informal firms be, independent of productivity or size. The result is in line with an emerging consensus about distinct types of informal entrepreneurs.

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