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Is the Income Tax Responsible for Large Informal Economies in Developing Countries?

The informal economy is a major hurdle in the economic growth of developing countries, causing a loss of revenue, inequities, and misallocation of resources. An income tax is generally recommended as a major revenue instrument in informal economies because other taxes are considered regressive and consequently become a catalyst for the informal economy (Alm et al., 2003, p. 6). But studies show that the income tax has failed to secure most of its objectives in developing countries (Tanzi, 1991, p. 205) because most businesses in such countries are small in size and so cannot afford the compliance costs. In many instances, such businesses do not comply with their income tax obligations by operating in the informal sector (Schneider and Hemetner, 2007, p. 5). Instead they hide all or certain parts of their business transactions from the income tax authorities, with a low risk of being caught owing to weak and corrupt tax administrations (International Finance Commission [IFC], 2007, pp. vi, 3).