Integrated tax reform in economies with an endogenous informal sector

In light of the existence of an informal sector in most developing countries, economists are beginning to reconsider the integrated tax reform consisting of a reduction in tariffs with an increase in VAT that has been advocated by the IMF in recent years. This paper explores the welfare change of such a reform in an economy in which the size of the informal sector is endogenously determined. Assuming that products are nontraded, the levy of VAT distorts the aggregate output; allowing the size of the informal sector to be determined endogenously worsens the situation. This leads to a conclusion which tends to favor an integrated tax reform toward tariffs under some plausible conditions. This result may help to explain the slow adoption of VAT in many developing countries.