Taxation, wage controls and the informal sector

In this paper, we study the effects of taxation and wage controls in a developing economy with an informal sector. For that purpose, we build a model with firm heterogeneity, in which a formal and an informal sector endogenously emerge in some productive branches of the economy. Based on the assumption that the marginal cost of tax and regulation evasion increases with the size of the firm, our model offers an explanation for the observed discontinuity in the distribution of firms size (the 'missing middle'). Three forms of dualism-scale, wage and evasion-consistent with market segmentation are obtained. The model accounts for the presence of waiting unemployment that seems particularly pervasive in urban regions. A computable general equilibrium (CGE), model for Cameroon is built incorporating these features. Various reforms of the tax and regulation system are simulated and their effects on the extent of the informal sector are analyzed. (C) 1997 Elsevier Science S.A.