We document cross-country differences in informal activity, government policies and institutions using a data set covering 118 countries. Five key facts emerge: better institutions are associated with lower inflation, higher income tax rates and less informal activity and higher levels of informal activity are associated with lower income tax rates and higher inflation. We develop a general equilibrium model where households optimally choose the extent of informal activity and a benevolent government optimally chooses policies, both taking as given the institutions of the economy. The model is able to account for most of the cross-country differences in policies and informal activity as well as other key facts that emerge from the data. The performance of the model is significantly reduced for various subsets of countries, where some its key assumptions are likely to be violated.
First Draft : September 2009
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