3.7 The Share of Informality

INFORMALITY: NUMBER AND OUTPUT

Table 3.7 shows the share of informality after VAT adoption. The replacement of the cascading sales tax with the VAT causes the share of formal firms to increase slightly, from 5.5 percent to 5.7 percent, while the share of formal output rises from 87 percent to 89 percent. In addition, the share of workers in the formal sector also rises, from 11.3 percent to 13.3 percent, suggesting that a substantial reallocation of labor has occurred from the informal sector to the formal sector; the share of workers employed in the formal sector increases by 17 percent, while the share of workers in the informal sector decreases by 2 percent.9 If the VAT rate rises to the level in the informality-neutral scenario, the share of formal firms in the economy remains similar, at 5.6 percent, which accounts for 89 percent of total output. If the VAT rate climbs farther, to the level in the revenue-neutral scenario, the share of formal firms is 5.5 percent, and the share of formal output is 89 percent.

However, the share of informality neglects the absolute change number and output. Table 3.8 shows that about 0.6 percent of informal firms become formal after VAT adoption, which corresponds to a 2 percent increase in the number of formal firms if the tax rate remains the same. Yet, VAT adoption has a significant impact on formal sector output. Formal sector output rises by 12 percent, while informal sector output shrinks slightly, by 2.8 percent. In the informality-neutral scenario, the number of formal firms remains unchanged, but the number of informal firms increases by 0.2 percent. The output of the formal and informal sectors rises by 10 percent and −2 percent, respectively. In the revenue-neutral scenario, the output of formal and informal firms increases 10 percent and 1 percent, respectively. The results suggest that VAT adoption does not have a large effect on the total number of formal firms, but it does have an important effect on the incentive of productive firms to expand production.

TABLE 3.7 The Share of Informality percent

Tax

Number share Revenue share Labor share Formal Informal Formal Informal Formal Informal

ST, 7.5 vAT, 7.5 5.54 94.46 87.34 12.66 11.34 88.66

5.68 94.32 89.21 10.79 13.30 86.70

vAT, 17.5 5.10 94.90 86.98 13.02 11.61 88.39 vAT, informality neutral 5.55 94.45 88.91 11.09 12.97 87.03 vAT, revenue neutral 5.52 94.48 88.72 11.28 12.88 87.12

Source: Original compilation for this publication. Note: ST = cascading sales tax. vAT = value added tax. The informality-neutral rate is 9.5 percent; the number of formal firms is thus the same as in the benchmark scenario of a cascading sales tax at 7.5 percent. The revenueneutral rate is 10.1 percent; the total value added tax revenue is thus the same as with the total cascading sales tax revenue.