Laffer curves in emerging market economies: The role of informality

How much tax revenue can be raised in developing countries with a large informal sector? In this paper, we introduce informality into a two-sector neoclassical growth model and characterize the Laffer curves under labor, consumption, and capital income taxation. The model is calibrated for five Latin American countries: Brazil, Chile, Colombia, Mexico, and Peru, and we quantify how informality affects the fiscal space under each tax rate. We show that the peak of the Laffer curves crucially depends on the elasticity of substitution between formal and informal goods. For commonly used values of this elasticity, the tax revenue implications of informality are found to be severe. Using labor taxes, Colombia, Mexico, and Peru can only increase tax revenues within the range 2%-4%. While Chile can maximally increase tax revenues by 11% with higher labor taxes, Brazil can increase tax revenues by 6% by cutting labor taxes. The budgetary gains under capital income taxation are found to be even smaller, where the fiscal space does not exceed 4% in any country. Using consumption taxes, Mexico and Chile can maximally increase tax revenues by 8% and 3%, respectively. For the remaining countries, the fiscal space is found to be less than 1%. Finally, the iso-revenue analysis suggests that in order to maximize total tax receipts in Latin America, governments should in general raise labor and consumption taxes and cut capital income taxes.