Taxation base in developing countries

Informal sectors are larger in developing countries than in rich countries. This is a result of higher fixed costs of entry into the formal economy in developing countries. We show that raising barriers to entry is consistent with a deliberate government policy for raising tax revenue. By generating market power, and hence rents, for the permitted entrants, market entry fees foster the emergence of large taxpayers. The rents can be readily confiscated by the government through entry fees and taxes on profits at a low administrative cost. The relevance of the theory is assessed with a sample of 64 countries. Empirical analysis supports the results of the paper. (c) 2004 Elsevier B.V. All rights reserved.