Optimal Redistribution with a Shadow Economy

Abstract

We extend the theory of the optimal redistributive taxation by Mirrlees (1971) to economies with an informal labor market. The existence of the shadow economy can be welfare improving either by enhancing the efficiency of labor allocation or by strengthening possible redistribution. Conditional on the distribution of formal income and marginal social welfare weights, the shadow economy weakly reduces the optimal marginal tax rates. We apply the theory to Colombia. The Colombian tax schedule is inefficient, as it does not account for agents' incentives to work informally. Conditional on the optimal policy, the existence of the shadow economy in Colombia is roughly welfare neutral. (joint with Luis E. Rojas, Universitat Autonoma Barcelona)