Optimal taxation with heterogeneous firms and informal sector

• Published in: Journal of macroeconomics 2013-03, Vol.35, p.39-61
• Main Authors: Cerda, Rodrigo A., Saravia, Diego
• Format: Article
• Language: English
• Subjects: Capital taxation; Fiscal policy; Heterogeneous firms; Income taxes; Informal economy; Informal sector; Optimal taxation; Productivity; Studies; Tax incentives; Tax increases; Tax rates; Taxation; Welfare
• ISSN: 0164-0704; 1873-152X
• DOI: 10.1016/j.jmacro.2012.08.002

► Optimal taxes in a context where firms decide to produce in a formal or an informal sector. ► The optimal capital income tax is negative. ► Corporate tax rate is positive and the sign of labor income tax is ambiguous. ► We show numerically that following a Ramsey policy has significant effects on welfare. We study steady state optimal taxation in a context where firms differ in productivity and they decide whether to produce in a formal sector where the government raises taxes or an informal sector where it cannot do so. The government taxes capital income, firms’ profits and labor income. In this context, taxation might distort the firms’ decisions to participate in the formal sector (extensive margin) as well as their factor allocations once they decide to produce (intensive margin). We find that the government has incentives to subsidize costs to induce firms into the formal sector, making them taxable and completing the tax system. The optimal capital income tax is negative while the corporate tax rate is positive and the sign of labor income tax is ambiguous. We show numerically that following a Ramsey policy rather than actually observed taxes have significant effects on welfare.