Political Turnover, Taxes, and the Shadow Economy

Abstract: Several cross-section empirical studies argue that a higher tax burden or different indicators of statutory tax rates are associated with a smaller informal economy. I show that the turnover of governments provides the key to understanding this relation. To this end, I present evidence that once political turnover is controlled for, the data shows no association between the tax burden and the size of the informal economy. This result is empirically robust in a panel data consisting of 80 countries and 5 years. To account for this observation, I develop a dynamic political economy model with two political parties alternating in office. In equilibrium, if the incumbent party faces a higher probability of staying in office, it sets a higher tax rate to invest more in productive public capital, while spending less for current office rent. I argue that public capital is mainly utilized by the formal sector and this implies that countries in which incumbent parties are more likely to stay in power, have a higher tax burden but a smaller informal sector. Finally, I compare the model against the data and present evidence that my theory is consistent with empirical observations.