The heterogeneous effects of labor informality on VAT revenues: Evidence on a developed country

Di Caro P., Sacchi A., 2020 – Journal of Macroeconomics

Do labor informality and its changes have consequences on the collection of VAT revenues?

The value-added tax (VAT) is widely spread in many advanced and developing countries primarily because it allows rising public revenues by preserving production efficiency and promoting compliance through self-enforcing mechanisms. International organizations often suggest switching tax revenues from distortionary income and trade taxes to commodity taxation for sustaining long-run economic growth without discouraging saving, investment and labor supply. However, its revenue performance can be undermined in the presence of informality.

In a recently published paper in the Journal of MacroeconomicsThe heterogeneous effects of labor informality on VAT revenues: Evidence on a developed country, Paolo Di Caro and Agnese Sacchi aim at investigating the consequences of labor informality on VAT revenues in Italy.

Italy is a good candidate for this analysis for different reasons. It is a developed country where the size of the shadow economy, 211 billion euro (about 12% of the Italian GDP), and the VAT gap, 34 billion euro (about one-third of the VAT revenues), both referring to the year 2017, are the highest among the advanced economies. In Italy, the regional distribution of VAT revenues and informality is highly heterogeneous following the very different economic conditions and industrial structures across regions. In this country, the regional shadow economy labor markets are different in size, characteristics, and economic implications. In the North, informal occupations are mostly made up of secondary jobs and moonlighting activities, while in the South informal workers, which are concentrated in agriculture, building and private services, are the by-product of weak labor markets, low productivity, and high unemployment levels. The maps in Fig. 1 illustrate the distribution of total VAT (a) and labor informality (b) across Italy. High (low) VAT revenues (labor informality) are registered in the Central and Northern regions; the opposite is true in the Southern regions.


Fig. 2 gives a preliminary view of the connections among labor informality, labor productivity, and unemployment: high levels of informality are registered in the regions having low productivity and high unemployment.


Starting from these premises, the authors gather novel regional administrative data on VAT revenues and on labor informality, regional distribution of economic value added, and productivity and document the existence of heterogeneous effects of labor informality on VAT collection in Italy. By applying different panel models, and exploiting the richness of information which distinguishes business-to-business (B2B) and business-to-consumer (B2C) information, and B2C VAT revenues only, they find that labor informality produces negative effects on total VAT collection, including VAT on production and consumption, and positive effects on VAT revenues from consumption only.

They also find that the consequences of labor informality on VAT collection depend on the size of informality, by approximating an-inverted U-relation. In particular, we document that, for relatively low (high) levels of informality, which in Italy means being located in the center-North (South) of the country, the effects of labor informality on the growth of total VAT revenues are positive (negative). The situation partially changes when looking at the effects of labor informality on B2C VAT collection, where we find low heterogeneity depending on the size of informality. These heterogeneous effects are explained with the presence of regional differences in labor market conditions. Specifically, the negative effects of labor informality on VAT collection are mostly concentrated in regions characterized by weak labor market conditions, such as low productivity, high unemployment and low activity rates.

Finally, they document that labor informality has heterogeneous effects on VAT collection when considering specific productive sectors, and the cyclical consequences of the Great Recession. In particular, we find counter-cyclical (pro-cyclical) effects for high (low) levels of labor informality, when analyzing the consequences of informal jobs on total VAT collection. A possible explanation for this result is that the Great Recession produced an asymmetric effect on shadow economy labor markets across areas, by reducing (augmenting) informality where informal jobs are complement to (substitute for) formal ones.

In conclusion, the set of evidence that the authors present suggests more than one possible answer to the initial question, at least for the case of a developed country such as Italy, since they find mixed results: negative effects of labor informality on total VAT revenues but positive effects when considering VAT revenues deriving from sales to consumption only. This evidence mostly confirms the theoretical predictions of macro, general equilibrium models and some recent evidence pointing out the mixed effects of the informal economy on welfare. Moreover, they show that the relation between labor informality and VAT collection is heterogeneous and depends on the size of informality, by approximating an inverted U-curve.

Some policy implications can be derived, possibly of interest for other countries characterized by internal variability in the extent of labor informality. First of all, this study might raise the necessity of incorporating aggregate, general equilibrium considerations, which imply looking at the production and demand side of the economy empirically, when analyzing the effects of informality on tax revenues. More specifically, considerations on the informal economy are crucial when assessing the VAT performance and, in particular, the VAT collection following VAT reforms. Indeed, a rise of tax rates can produce lower additional revenues than expected, when labor informality increases and reduces the VAT self-enforcing mechanism. Lastly, policies aimed at reducing labor informality need to necessarily take into account the possible, asymmetric consequences of a reduction of informal jobs on VAT collection, across regions and sectors. In this contest, the Italian government has just approved a new law on this issue. The legalisation of a large number of (mainly low-skilled) natives and immigrant workers in certain sectors (e.g., agriculture, domestic work, family assistance) would increase public revenues as newly legalised workers will sustain VAT self-enforcing mechanisms and VAT collection. However, the choice of limiting the regularization of those workers employed only in some sectors is not justified by economic reasons and reduces the possible positive effects in terms of public revenues.

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