RIEB Discussion Paper Series No.2024-18

Title

Optimal Income Taxation and Formalization of the Informal Economy

Abstract

The United Nations' "2030 Agenda for Sustainable Development" highlights the importance of formalizing the informal economy, which could potentially increase tax revenues in developing countries. This paper investigates the impact of formalization on optimal tax schedules, emphasizing the need for redistributive incentives alongside formalization. Extending the Mirrlees model to incorporate government intervention against the informal economy, we propose an optimal tax formula. Quantitative analysis shows that aligning the tax schedule with formalization increases tax revenue and income transfers while maintaining social welfare. The result can be interpreted as an implicit cost of welfare-neutral formalization in terms of tax revenues and income transfers. Conversely, leaving the tax schedule unchanged undermines these benefits. This research provides insights into the design of optimal tax policies that incorporate formalization.

Keywords

Informal economy; Formalization; Income tax; Redistribution

JEL Classification

E26, H21, H26, J46, O17

Inquiries

Hirofumi TAKIKAWA*
Faculty of Economics and Business Administration, Goethe University Frankfurt
Junior Research Fellow, RIEB, Kobe University

*This Discussion Paper won the Kanematsu Prize (FY 2023).