To tax or not to tax? When does it matter for informality?

•Empirical studies find both positive and negative effects of tax on informality.•Theoretical models predict only positive tax-informality relationships.•This paper highlights a theoretical construct where both relationships arise.•A tax-enforcement threshold exists beyond which taxes reduce informality.•Threshold depends on level of financial development.•Productive government expenditures do not matter for the threshold.

Theoretical models generally always predict or assume that higher taxes lead to larger informal sectors. Empirically, however, there is considerable debate on the effect of taxes on informality. In this paper I show that whether a positive, negative or non-relation arises between tax rates and informality depends on the degree of tax enforcement and the level of credit market development in an economy. Higher enforcement implies a higher probability of detection and punishment while more credit implies better formal sector access to finance. Both are incentives to become formal. In a two-sector dynamic general equilibrium model with borrowing constraints, I show that informality rises with the tax rate up to a threshold level of tax enforcement beyond which it falls as tax increases. This enforcement threshold depends negatively on the level of credit in the economy.