Entrepreneurship in the Shadows: Wealth Constraints and Government Policy

Entrepreneurship in the Shadows: Wealth Constraints and Government Policy

Title:

Entrepreneurship in the Shadows: Wealth Constraints and Government Policy

Number:

16/23

Author(s):

Semih Tümen

Language:

English

Date:

November 2016

Abstract:

I develop a dynamic model of forward-looking entrepreneurs, who decide whether to operate in the formal economy or informal economy and choose how much to invest in their businesses, taking government policy as given. The government has access to two policy tools: taxes on formal business activity and enforcement (or policing) discouraging informality. The main focus of the paper is on transitional dynamics under different initial wealth levels. Whether an initially small business will be trapped in the informal economy and remain small forever or grow quickly and become a large formal business depends on tax and enforcement policies. High tax rates accompanied by loose enforcement—which is mostly the case in less-developed countries (LDCs)—induce tax avoidance, discourage investment in formal businesses, and drive the entrepreneurial activity toward the informal sector even though the initial wealth level is high. Lowering taxes on formal activity joined with strict enforcement can help reducing the magnitude of poverty traps in LDCs—such as the MENA region, Latin America, and developing Asia.

Keywords:

Entrepreneurship, Informal economy, Government policy, Investment, Wealth constraints

JEL Codes:

E21; E26; L26; O17

Entrepreneurship in the Shadows: Wealth Constraints and Government Policy
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