Previously circulated under the title “Informal Sector, Government Policy and Institutions”
The mix of inflation and income taxation that governments adopt vary considerably across countries. We take a Ramsey optimal-policy approach to explain these differences, focusing on the institutions of the country, modeled as the difficulty of tax evasion, as the key variation across countries. In our model 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 matches qualitatively the observed relationships between institutions and inflation, taxes and tax evasion. In a cross-country quantitative exercise with 125 countries, the model delivers a good fit: the correlation of data and model-generated values for inflation and taxes are 0.42 and 0.78, respectively.
First Draft : September 2009
Most Recent Working Paper [July 2018]
Econ Browser (James Hamilton’s Blog) [May 16, 2010]
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