Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/149183
Authors: 
Tumen, Semih
Year of Publication: 
2016
Series/Report no.: 
IZA Discussion Papers 10324
Abstract: 
I develop a dynamic model of forward-looking entrepreneurs, who decide whether to operate in the formal economy or informal economy and choose how much to invest in their businesses, taking government policy as given. The government has access to two policy tools: taxes on formal business activity and enforcement (or policing) discouraging informality. The main focus of the paper is on transitional dynamics under different initial wealth levels. Whether an initially small business will be trapped in the informal economy and remain small forever or grow quickly and become a large formal business depends on tax and enforcement policies. High tax rates accompanied by loose enforcement – which is mostly the case in less-developed countries (LDCs) – induce tax avoidance, discourage investment in formal businesses, and drive the entrepreneurial activity toward the informal sector even though the initial wealth level is high. Lowering taxes on formal activity joined with strict enforcement can help reducing the magnitude of poverty traps in LDCs.
Subjects: 
investment
government policy
informal economy
entrepreneurship
wealth constraints
JEL: 
E21
E26
L26
O17
Document Type: 
Working Paper

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