Determinants of the Informal Sector and their Effects on the Economy: The Case of Korea

Abstract

In this study we adopt a general equilibrium model with occupational choice and incomplete contract enforcement in order to evaluate the effects of policies to reduce the size of the informal economy. More concretely, we try to quantify the effects of tax, entry cost, and contract enforcement on output, income distribution, and tax revenue. The model is specifically calibrated to the Korean economy. Under the assumption of an endogenously determined interest rate, the effects of policies on total output are restrictive. However, the demand effect shows that entry cost and contract enforcement have significant potential influences on output. Lowering the tax rate increases income inequality in spite of the shrinkage in size of the informal sector. There is no Laffer curve effect when the tax rate is lowered, despite the broadened tax base. Lowering the entry cost turns out to be a viable policy option for reducing the size of the informal sector, as it reduces inequality and increases tax revenue effectively.