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Ms. Era Dabla-Norris and Ms. Gabriela Inchauste

This paper relies on rich firm-level data on transition economies to examine the role of informality as an important channel through which regulatory and other policy constraints affect firm growth. We find that firms reduce their formal operations with greater tax and regulatory burdens, but increase them with better enforcement quality. In terms of firm growth, we find a differential impact of regulatory burden and enforcement quality on formal and informal firm growth. In particular, we find that growth in formal firms is negatively affected by both tax and financing constraints, whereas these constraints are insignificant for growth in informal firms. Moreover, formal firm growth improves with better enforcement, while informal firm growth is constrained by organized crime, pointing to informal firms’ inability to take full advantage of the legal and judicial systems. Finally, we find that an interaction term between a countrywide measure of the rule of law and formality is positive, suggesting that better rule of law improves formal firm growth. IMF Staff Papers (2008) 55, 50–82. doi:10.1057/palgrave.imfsp.9450030; published online 22 January 2008

XAVIER SALA-I-MARTIN*

This paper analyzes the role of social safety nets in the form of redistributional transfers and wage subsidies. It argues that public welfare programs can be viewed as devices to prevent crime or disruption because they tend to increase the opportunity cost of engaging in crime or disruptive activities. It is shown that, in the presence of a leisure choice, wage subsidies may be better than pure transfers. Using a simple growth model, the optimal size of the public welfare program is found, and it is argued that public welfare should be financed with income (not lump-sum) taxes, despite the fact that income taxes are distortionary. The intuition for this result is that income ta.xes act as a user fee on congested public goods and transfers can be thought of as productive public goods subject to congestion. [JEL H53, H55, H56, 040,015]