Tag Archives: formal sector



Follow this link for full essay: INFORMALITY AND DISTRIBUTIVE POLITICS(final)

Rory Creedon London School of Economics (MPA ID)


An individual’s preferences regarding taxation may be derived from a number of sources such as the distance between his income and the average income[1] or notions of social justice. A further particularly salient source is that presented by Alesina and Rodrik [2]. Individuals, they argue, are endowed with labour, capital, or most likely a mixture of the two, whilst governments make productive investments financed by a tax on capital. The basic result of their model is that an individual who derives all of his income from capital will prefer the tax rate that maximizes the economy’s growth rate, whereas anyone who earns even part of his income by selling his labour will prefer a lower tax rate and a correspondingly lower growth rate.[3] To this insight I would like to add another: that the presence of a large informal economy will affect the preferences for taxation of both capitalists and wage earners.

The directional influence that a large informal economy will have on preferences for taxation is not discernable a priori. This is because the true nature of the key mechanism by which the informal economy affects preferences for taxation, namely the interaction between the informal and formal economy, is disputed. This essay analyses two major lines of thought on how the informal economy interacts with the formal economy. Dualists argue that the informal economy is a separate marginal sector not linked to the formal sector in any significant way. Structuralists on the other hand maintain that both the informal and formal economy are part of the same capitalist spectrum.[4] This essay does not assert the primacy of either of these views. Rather, within the stylized model presented by Alesina and Rodrik with the additional assumption of a large informal economy, I seek to emphasize that preferences over taxation will vary according to whether the true nature of the informal sector is closest to the dualist or structuralist tradition, thus reaffirming the importance of the debate. Arguments and examples are drawn largely from the literature surrounding the informal economy of Latin America as the extent of the informal economy in that region is such that it is impossible to ignore in terms of policy making and preferences over policy[5]. Additionally a particularly rich vein of scholarship has emerged in relation to the Latin American informal economy.

[1] A.H. Meltzer & S.F. Richard, A Rational Theory of the Size of Government The Journal of Political Economy, Vol. 89, No. 5, (Oct., 1981)  pp.916

[2] A. Alesina & D. Rodrik, Distributive Politics and Economic Growth The Quarterly Journal of Economics, Vol. 109, No. 2, (May 1994) pp. 465-90.

[3] Ibid. pg. 466

[4] M. Carr & M.A. Chen, Globalization and the Informal Economy: How Global Trade and Investment Impact on the Working Poor, ILO Employment Sector Working Paper on the Informal Economy, No. 1, Geneva, ILO pg. 5

[5] J.R. Franks Macroeconomic Policy and the Informal Sector in C. Rakowski (ed.) Contrapunto: The Informal Sector Debate in Latin America, New York: State University of New York Press (1994)