Productivity, Taxation and Evasion: A Quantitative Exploration of the Determinants of the Informal Economy

Abstract

This paper evaluates the relative importance of labor productivity vs. income taxes and social security contributions for tax compliance in an economy with a large degree of informality. To this end, we build a bargaining model in which matched employer-employee pairs of heterogeneous productive capacities make decisions on output sharing and the degree of tax evasion. The quantitative model takes as inputs the income tax structure and the estimated aggregate productivity series. The estimation strategy recovers the bargaining parameters and the cost function of tax evasion in the model by matching the empirical series for the size of the informal sector (2000-2014). The results from the performed computational experiments point out that the most important factor is labor productivity, followed by the corporate tax. Income tax progressivity in Bulgaria is found not to be quantitatively relevant for tax evasion.