Thresholds, Informality, and Partitions of Compliance

Charles H. Dyson School of Applied Economics and Management, Working Paper 2014-11

Abstract: This paper explores the impact and design of tax thresholds, and the light this casts on notions of ‘informality.’ It shows how thresholds generate partitions of the population of potential taxpayers by different forms of compliance and non-compliance. The richness of these partitions means one should resist thinking of ‘the informal sector’ as an undifferentiated mass, but instead recognize that there are quite distinct varieties of informality with potentially very different policy implications. We characterize the forces shaping such taxpayer partitions, and, within that setting, the optimal threshold and the partitions it induces. The analysis is extended to the (realistic) case in which taxpayers face multiple tax (or other) obligations, showing how a threshold on one obligation affects partitioning and optimal threshold choice with respect to the other.