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We would like to thank Mohammad Arzaghi, Alina Carare, Edward Gardner, Mohsin Khan, Saleh Nsouli, Sudipta Sarangi, Anwar Shah, Hajime Takizawa, Shahid Yusuf, and Shang-Jin Wei for many helpful suggestions.
As in Braun and Loayza (1993), the underground economy is defined as “a set of economic units which do not comply with one or more government imposed taxes and regulations, but whose product is considered legal.”
Johnson et al. (1998) find that a high corporate tax burden combined with ineffective and discretionary application of the tax system and other regulations influences the size of the underground economy.
Burgess and Stern (1993) note that in developing countries, corporate income taxes represent 17.8 percent of total tax revenues as opposed to 7.6 percent in industrialized countries.
In reality, the underground firm may not be able to borrow from official banks but may still be able to invest by borrowing from secondary lenders who charge higher than market interest rates and are willing to incur high risks. Huq and Sultan (1991) note that in Bangladesh, while borrowing rates from commercial banks were around 12 percent, firms dependent on noninstitutional sources to meet their financing needs paid rates between 48 to 100 percent.
Sarte (2000) develops a model which examines the link between the size of the informal economy and corrupt bureaucracies. He shows that in the presence of a corrupt bureaucracy, it may be efficient to locate economic activity in the informal economy if the costs of informality are low. However, he ignores credit rationing by banks.
We could have any number of capital types without affecting the structure of the model.
We assume that the labor market is not segmented and there is no wage differential between workers in the underground and the formal economy.
We assume that all foreign borrowing for investment is carried out by the government, so that, implicitly, the government is borrowing for the private investor but the debt incurred is publicly guaranteed.
In reality, we can regard the tax rate on capital as the generalized tax rate, including taxation, regulation, and corruption (bribes).
Clearly this is an ad hoc assumption. We wish to capture the notion that the decision whether or not to pay taxes is based on the relationship between the return to investment and the tax rate on capital.
Here α could be a function of the enforcement technology. In our model, however, we assume that there is no enforcement technology or means to enforce tax compliance.
Clearly these percentages are arbitrary and should serve only for illustrative purposes. We could have any initial pattern of distribution of bank assets across the different sectors.
We have not explicitly incorporated bankruptcies and defaults in this model, for the sake of simplicity. However bankruptcies and corresponding bank contractions can be introduced as in Ball and Feltenstein (2001) and Blejer, Feldman, and Feltenstein (2002).
Since the only information the consumer has about the future is the real interest rate, adoptive expectations is, in this case, equivalent to rational expectations.
As before, 1 denotes period i and 2 denotes period i+1.
In practice, we take 1993 as the base year. By this we mean that initial allocations of factors and financial assets are given by stocks at the end of 1992. We have data for fiscal and other policy parameters for the next 8 years, that is, through 2000.