Fiscal policy and the structure of production in a two-sector developing economy

This paper develops a two-sector model of a developing economy and examines the role of the informal sector in limiting the government's ability to increase tax revenues. A key feature is the introduction of auditing of the informal sector and degree of tax enforcement in that sector. We emphasize the interdependence between tax policy and enforcement in achieving a developing economy's fiscal objectives and show that by judicious policy choices the presence of the informal sector need not hinder its ability to raise tax revenues. We supplement the formal analysis with numerical simulations highlighting the contrasting intertemporal tradeoffs implied by higher tax rates and tax-enforcement levels.