The state’s cannibalistic relationship with the informal economy will never consider an option other than taxation.

We find a reduction in the tax rate or an increase in enforcement (1) increases the level of output and decreases the size of the informal sector in the steady state and (2) increases the rate of convergence to the steady state. While small changes in the tax rate cause measurable changes in both the level of and convergence to the steady state, modest changes in the enforcement variable (i.e., increases in the probability of detection without substantial penalties) have negligible effects on the size of the informal sector. In order for enforcement to have a measurable effect, the government must impose penalties rather than just increase policing. This suggests that governments interested in reducing the size of the informal sector should reduce the tax rate and/or increase the tax penalty of informal agents who are caught. If the economy wants to maintain tax revenues as a percent of GDP (for public good provisions), the model suggests lowering the tax rate and increasing enforcement simultaneously. Therefore, when the World Bank sends mobile tax units to countries for tax collection, this increase in enforcement has minimal effects on the standard of living. Alternatively, if their objective is to increase the country's standard of living, the World Bank should encourage governments to lower tax rates along with increasing tax collection efforts. To quantify the distortion introduced to an economy by their informal sector, we calculate the difference in the present discounted value of the capital stock between an economy with no taxation or informal sector and (a) our model and (b) an economy with a tax on formal output but no informal sector. We found the majority of the welfare loss comes from a tax rate on formal output rather than the distortions introduced by the informal sector: the informal sector only contributes 2 percent to the total welfare loss of the economy. This finding provides support for those who believe the informal sector should remain a functioning part of the economy. Of course, we should keep in mind that tax policies can alter the size of this sector and, therefore, the standard of living. We now turn to Section 2 where we describe some stylized facts associated with informal employment. The theoretical economy is presented in Section 3. In Section 4 we discuss the selection of parameter values. The model simulations are presented in Section 5, and we demonstrate how the model matches time-series and cross-sectional data. We conduct policy experiments in Section 6. We examine transitional dynamics and quantify the effect of tax policies in an economy with an informal sector. Concluding remarks are found in Section 7.