Price Neutral Tax Reform with an Informal Economy

A strand of recent literature shows that a reform of import tariff (export tax) and consumption tax (production tax) that keeps consumer (producer) price unchanged enhances welfare and increases revenue under plausible conditions. It has been argued that the results provide an ex post justification for the widely implemented reform policies in developing countries that reduce trade taxes and increase consumption tax like VAT for revenue. We demonstrate that the results derived so far critically depend on the unrealistic assumption that there is no informal sector in the economy, implying that each and every commodity in the economy can be taxed through VAT and production tax. Our results show that, when the feasibility restrictions on the tax instruments imposed by the presence of a large informal and shadow economy is taken into account, such consumer or producer price-neutral reform reduces both welfare and revenue under plausible conditions.