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The Determinants of Informal Sector and Their Effects on the Economy: the Case of Korea(Working Paper No.395)

Economic Research Institute (82-2-759-5430) 2009.09.23 1190
In this study, we adopt a general equilibrium model with occupational choice and
incomplete contract enforcement to evaluate the effects of policies for reducing
the size of the informal economy. More concretely, we try to quantify the effects
of tax, entry cost, and contract enforcement on output, income distribution, and
tax revenue. The model is specifically calibrated to the Korean economy. Under
the assumption of endogenously determined interest rate, the effects of policies on
total output are restrictive. However, the demand effect shows that entry cost and
contract enforcement have signifcant potential influences on output. Lowering
the tax rate increases the income inequality though the size of the informal sector
shrinks. Despite the broadened tax base, there is no Laffer curve effect when the
tax rate is lowered.

1 Introduction

2 Model
2.1 Preferences
2.2 Endowments
2.3 Production technology
2.4 The capital market
2.5 Entrepreneurs' Problem
2.6 Occupational Choice
2.7 Consumers' problem
2.8 Competitive Equilibrium

3 Calibration and Baseline Economy

4 Policy Experiments
4.1 Comparison with the Past
4.2 Experiments with Policy Variables
4.2.1 Effects on Output
4.2.2 Effects on Income Distribution
4.2.3 Effects on Tax Revenue

5 Policy Implications and Further Research Suggestions