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A Theory of the Informal Sector

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February 2002 A Theory of the Informal Sector Yoshiaki Azuma Doshisha University Herschel I. Grossman Brown University Abstract In many countries, especially poor countries, a heavy burden of taxes, bribes, and bu- reaucratic hassles drives many producers into the informal sector. Is this situation explicable only as a consequence of either the ignorance or the ineptitude of the state authorities? On the contrary this paper shows that we can attribute the existence of a large informal sector to the fact that, because productive endowments contain important unobservable components, the state cannot adjust the amounts that it extracts from producers in the formal sector ac- cording to each producer s endowment. Given this fact we Þnd that, if either the distribution of endowments is sufficiently inegalitarian or the production of private substitutes for public services is sufficiently easy, then the state would extract a large enough amount from produc- ers in the formal sector that poorly endowed producers would choose to work in the informal sector. This result obtains both for a proprietary state, which maximizes its own net rev- enue, and for a hypothetical benevolent state, which would maximize the total net income of producers. But, we also Þnd that a proprietary state would create an informal sector for a larger set of combinations of parameter values than would a hypothetical benevolent state. JEL classiÞcation numbers: H0, K4, O2 Keywords: Informal Sector, Proprietary State, Public Services, Taxes, Bribes Many authors, Hernando De Soto (1989) being a prominent example, have pointed out that in many countries, especially poor countries, a heavy burden of taxes, bribes, and bu- reaucratic hassles drives many producers into an informal sector.1 Producers in the informal sector avoid much of this burden, but they must produce with less assistance from public services than is available to producers in the formal sector. These public services include the protection

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