Tax Evasion Financial Dualism and Economic Growth

Abstract

This paper examines the optimal policy of tax enforcement in an endogenous growth model with the presence of financial dualism. Individuals can accumulate capital by depositing savings into the formal and informal financial sectors, and capital incomes derived via informal (formal) financial institutions are evadable (non-evadable). By following the argument of new structuralists, we find that it may be optimal for countries with a less developed formal financial sector to choose a policy of tax enforcement that results in more severe tax evasion and a larger informal financial sector. Conversely, countries with a more developed formal financial sector should impose a policy of tax enforcement that leads to more tax compliance and a small size of the informal financial sector. This result is consistent with recent empirical studies. Moreover, our calibration shows that countries with a less developed financial sector and more severe tax evasion can perform equally well in terms of economic growth with those countries whose financial sector is more developed and tax evasion is less severe. This may provide a theoretical explanation for the growth experience of Asian tigers in the 1980s and 1990s