Public goods, trust, and tax policy: shaping economic formalization

Asto, Richard and Ortiz Sosa, Marco Antonio and Ruelas-Huanca, Walter (2025): Public goods, trust, and tax policy: shaping economic formalization.

Abstract

This paper develops a general equilibrium framework that integrates heterogeneous firms with both idiosyncratic productivity and subjective beliefs about public goods provision—specifically, confidence in institutional quality—alongside endogenous informality. We examine the impact of tax policy on the formalization process and highlight the crucial role of firms' trust in public institutions. Our findings reveal that when firms perceive the government as credible, an increase in both tax rates and tax revenues enhances public goods provision, fostering greater formalization. However, in environments with weak institutional trust, formalization policies may yield suboptimal economic outcomes—potentially even worsening conditions compared to scenarios with higher trust levels. This underscores how institutional confidence influences the productivity of formal firms and facilitates their transition into the formal sector. In the long run, effective tax policy can improve overall welfare, but its success is contingent on government credibility. Our research contributes to the literature on informality by providing novel insights for policymakers seeking to enhance formalization and economic welfare, particularly in settings where skepticism about government commitment and institutional capacity prevails.

• Item Type: MPRA Paper
• Language: English
• Keywords: Informality, Optimal Tax Policy, Entrepreneurship, Tax Evasion
• Subjects: E - Macroeconomics and Monetary Economics > E2 - Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy > E26 - Informal Economy ; Underground Economy; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal Policy; H - Public Economics > H2 - Taxation, Subsidies, and Revenue > H26 - Tax Evasion and Avoidance

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