The informality trap

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Our latest journal note by Thomas Kenyon and Emerson Kapaz looks at the adverse consequence of informality on private sector development. Using data from Brazil, the authors show the extent of tax evasion and confirm that informal firms are less productive than others. But what can we do about it? Emphasize the carrot...

Policymakers need to convince firms that it is in their interests to go formal. Not only are informal firms shut out from markets for finance and technology; they also are more at risk from predation by public officials and less likely to participate in other formal institutions such as the courts… Policymakers also need to reduce the burden of regulation. They should remember that tax compliance is not the only reason that firms remain informal. Registration and other procedural costs also matter, as do excessively rigid labor laws.

…but keep hold of the stick:

Tackling informality also requires governments to pay more attention to enforcement. This means stiffer penalties for noncompliance. In industrial countries fines for tax evasion are usually two or three times the taxes owed; in Brazil they are much lower. Detecting and punishing evaders also requires more resources. Brazil still spends only a small fraction of what most industrial countries spend on tax collection.

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