Reducing Informality

AuthorRavi Kanbur and Michael Keen
PositionT.H. Lee Professor of World Affairs at Cornell University and is Deputy Director of the IMF’s Fiscal Affairs Department.

“Taxing the informal economy” leads the African Development Bank’s tax priorities (Mubiru, 2010). Auriol and Warlters (2005) cite “large informal sectors that are difficult to tax” as a major issue for these economies. The same theme replays when it comes to some advanced economies. The IMF (2013) said that “low revenue efficiency in Greece” is partly the result of the “large . . . informal economy.”

It is no surprise then that reducing informality is often seen as a central objective of tax reform. But precise definitions of informality, as set out for instance by the International Labour Organization (2013), are based on labor and enterprise regulation rather than on tax considerations. So thinking in terms of reducing informality may not be a useful guide to making tax policy.

Paying or not

What informality means is rarely spelled out in tax discussions, but when economists build models informality usually seems to mean nonremittance of the full amount of tax due—that is, failure to pay. Yet there are many reasons why a firm or individual might pay no tax. They could simply be below the threshold (of size or income) at which they are legally obligated to pay taxes—in some cases because they reduced their activity to get under that limit. Or they could be evading—dishonestly failing to pay. For policymaking, why a firm or individual pays no taxes can matter as much as or more than the fact that they pay nothing. The question is how tax systems should be structured when their design may affect not only how much tax is paid, but the different ways in which it is not paid.

It is important, moreover, to recognize that individuals and firms commonly have several different obligations with which they may or may not comply—not only to different taxes (for example, value-added tax, VAT, and personal income tax), but also across different aspects of their activity. They are likely to face various labor laws, for instance, as well as tax rules. This raises a set of policy challenges that have been almost entirely ignored. How do measures that affect compliance with one obligation affect compliance with others? Does it make sense to harmonize the criteria defining these various obligations, so that either all apply or none do?

To see why all this matters, and illustrate how different types of agents might respond in very different ways to changes in tax design, take one key element of any tax system: the threshold above which tax is legally due. Most taxesâand indeed...

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