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INFORMAL ECONOMY IN A DYNAMIC POLITICAL FRAMEWORK

Published online by Cambridge University Press:  09 October 2013

Ceyhun Elgin
Ceyhun Elgin*
Affiliation:
Bogazici University
*
Address correspondence to: Ceyhun Elgin, Department of Economics, Bogazici University, Natuk Birkan Hall, Bebek 34342, Istanbul, Turkey; e-mail: ceyhun.elgin@boun.edu.tr.
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Abstract

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I develop a dynamic political economy model with an informal sector and two political parties alternating in office. In equilibrium, if the incumbent political party faces a higher probability of staying in office, it sets a higher tax rate on the formal economy to invest more in productive public capital, while spending less for current office rent. Moreover, I argue that public capital is mainly utilized by the formal sector, and this implies that countries in which incumbent parties are more likely to stay in power have a higher tax burden but a smaller informal sector. I also present some empirical evidence that supports the main results of the model.

Keywords

Tax EvasionInformal SectorPolitical TurnoverMarkov Perfect Equilibrium

Information

Type
Articles
Information
Macroeconomic Dynamics , Volume 19 , Issue 3 , April 2015, pp. 578 - 617
Copyright
Copyright © Cambridge University Press 2013 

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