Explaining the size of informal sector: The role of trust, corruption and bureaucratic quality

Abstract

Previously, studies on informal sector were under the monopoly of economists. The determinants of informality were set by economic criteria such as cost of registering a business, tax rates and GNP per capita. Lately, it has been discovered that in most of the developed world, the tax rates are significantly higher than in the developing world, but the informal sector size is considerably lower. This fact points out to the unexplored aspects of informality such as bureaucratic quality and corruption. What matters most is the quality of rules and procedures and the strictness of enforcement and punishment for the violators. On top of this, we have to add the psychological aspects of informality such as low confidence in state institutions. Just as in the case of psychological aspect of inflation inertia, informality can be a by-product of low levels of belief in the necessity of paying one's taxes. In this work, a regression equation was created to test the impact of certain variables on the size of informality. Corruption and bureaucratic quality were included to measure the effect of an impartial bureaucracy on informality while confidence in state institutions variable was used to see if there is any psychological determinant of informal sector. Variables such as GNP per capita Cost to Register a Business, Overall Tax Burden and Employment Laws Index were the control variables which economists mostly mention as the underlying reason for informality. The results of the regression equation showed that the combined variable of corruption and bureaucratic quality is the single most important determinant of informality, while confidence does not have much influence on the size of informal sector. Another important finding of the quantitative analysis was the confirmation of the fact that high taxes do not mean large informal sector. Keywords: confidence, corruption, bureaucratic quality, informal sector, bureaucracy, regression