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Approximately 16.7% of output in high-income OECD countries is produced informally. There exists a positive (negative) relation between tax rates (governance quality) and informality across high-income OECD countries. While existing models of the informal economy mostly focus on developing countries, this paper studies the mechanisms behind the informal economy in high-income countries. The author builds a model economy where agents can become workers or entrepreneurs. Entrepreneurs decide how much of their production to declare as formal and to report for tax purposes and how much to keep informal and hidden. Informal economic activity carries a risk of getting caught, taxed, and fined.
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