Fiscal policy options for reducing informality in an economy with fiscal rules

Abstract

We use a dynamic general equilibrium model to examine the effect of various fiscal policies in an economy with a large informal sector. More specifically, we simulate (i) a reduction of the tax rate on personal income and social security contributions and (ii) an increase in the efforts of the tax administration to uncover shadow activities in a model, calibrated to the Bulgarian economy. While both policies encourage total economic activity and discourage shadow practices, they worsen the inequalities in the economy. Due to the application of fiscal rules in the model, the tax cut leads to a permanent increase in public debt and lower public investment, while the strengthened control over tax collection has a negative impact on employment, but, nonetheless, does not deepen inequalities as much as the tax cut.