and protection of property rights: rather than operating out of a store front, a trader sells
his goods on the black market, invisible to the state and its agents. Despite its popularity,
however, this assumption is strong: If the division of production between the “formal” and
“informal” sectors merely reflects tax evasion within a single sphere of activity rather than
the diversion of production to a different form of productive activity, then it is implausible
to think that such state actions as contract enforcement have no impact on the profitability
of “informal” economic activity. For example, for a given proportion of total revenues hid-
den, a restaurant which cooks its books will have more to hide if the state cracks down on
bribe-seeking fire inspectors, as will an oil firm engaging in transfer pricing schemes if the
state provides assistance in establishing foreign markets.
We begin, however, by assuming that the informal sector is truly informal, i.e. we assume
k = b
using the notation above, with b exogenous. Assume as before that b < e
F B
. Further,
to establish a benchmark, assume that the state can commit to a nondistortionary lump-sum
tax conditional on state support e.
Examining Proposition 1, we observe that for the firm to want to fully report its revenues,
it must be given at least as much as when it engages in optimal revenue hiding, i.e. the state
must commit to leaving the firm with b
¡H
N C
− g
¡H
N C
, α
¢¢. Consideracommitmentby
the ruler to extract no more than T (e), where T (e) satisfies:
T (e) = max
£0,e−b¡H
N C
− g
¡H
N C
, α
¢¢¤
(3.5)
19
Convention