The role of tax evasion in the rapid growth of the informal sector in developing countries

Under-taxation is a major feature of economies in developing countries and one that has been little ignored in the subsequent literature on the informal sector. Tax evasion is an endemic and more predictable problem in developing countries striving to balance their budgets. Its effects have been extensively studied in the empirical literature. In this article, we examine the role of tax evasion on the size of the informal sector. Using a sample of 99 developing countries, we specify and estimate a panel data model using the ordinary least squares, fixed effects and generalized least squares methods. Our analysis of tax evasion implies significant improvement for the informal sector. Controlled by two complementary measures of the informal sector (the ‘multiple indicators, multiple causes’ indicator and share of informal firms), our results remain statistically significant, robust and stable overall. We suggest a policy of using carrots, for example, by digitizing tax procedures, and sticks, such as tax adjustments, to promote the development of the informal sector.