Tax enforcement, technology, and the informal sector

•We document a surprising negative correlation between taxes and informal sector size.•We build a two-sector model to account for this surprising correlation.•Further empirical analysis supports the channels identified by our model.

Theoretical models of the informal sector mostly assume-or end up with-a positive correlation between a measure of taxes and the size of the informal sector. However, some recent empirical studies associate higher taxes with a smaller informal sector size. In this paper, we build a theoretical framework-an extension to a two-sector growth model-which allows us to unravel the negative correlation between informal sector size and taxes. We find that (a) a higher degree of tax enforcement, (b) a higher productivity of formal sector households, and (c) a lower physical capital depreciation rate make for a negative relation between these variables. Our results suggest that enforcement and technological factors are likely candidates to account for this relationship.