Fiscal Policy in the presence of Informal Labour and Goods Markets.

This doctoral thesis consists of three chapters on the impacts of fiscal policy in the presence of informal labour and goods markets.

In developing countries, the presence of large informal sector as well as weak financial and economic institutions makes the conduct of the economy partially different from developed world. The structure of the goods and labour markets are different in both formal and informal sectors of the economy. For a better understanding of the response of an economy to external and internal shocks, it is important to have knowledge about the responses of the formal and informal sectors to these shocks. The first chapter "Macroeconomic effects of fiscal policy shocks in the presence of informal sector", develops a New-Keynesian dynamic stochastic general equilibrium model to analyse the impacts of five fiscal policy shocks in economies with large informal sector. The model shows that government expenditure and government consumption impact multipliers are larger than one in the presence of informal economy. The government expenditures shocks are more stimulating at increasing the level of formal sector output in the first few quarters, whereas decreases in capital and labour income taxes are more effective in the longer horizon. The analysis shows that, the increases in government expenditures and decrease in consumption tax, which are financed by increasing the labour and capital income taxes, increase the size of the informal economy. The size of the informal economy decreases on impact of a decrease in labour income tax, whereas a cut in capital income tax decreases the size of informal economy after ten quarters. This chapter also finds that an increase in labour mobility amplifies the impacts of fiscal policy shocks on both formal and informal segments of the economy. The government expenditures present value multipliers for aggregate and formal sector output increase when labour is highly mobile across both sectors. Additionally, the negative impacts of cuts in capital and labour income taxes are more pronounced on the output of informal sector, when there is a high degree of labour mobility.

The second chapter "Optimal capital taxation in the presence of informal labour and goods markets", contributes to the literature of optimal fiscal policy by incorporating the informal labour and goods markets in a neoclassical growth model. The objective of this study is to find the optimal tax rate on capital income in the long run. The model assumes that the set of the tax instruments is not complete. This chapter analyses the Ramsey problem in the context, where taxes cannot be collected from the consumption of informal goods and working in the informal labour market. According to Chamley (1986), the optimal tax rate on capital income is zero in a neoclassical growth model. There are several studies which show that the capital income tax rate is not zero if the modelling framework is modified in certain ways. In the lines of these papers we find that the optimal tax rate on capital income is different from zero in the presence of informal labour and good markets.

The third chapter "Fiscal multipliers and the choice of exchange rate in an open economy with informal sector", gives the impact and present value multipliers under fixed and flexible exchange rate regimes in a small open economy New-Keynesian DSGE model. This study shows that the fiscal policy is more effective at increasing the level of formal sector output in economies where the exchange rate is fixed. The informal sector responds strongly to flexible exchange rate regime. The difference between the size of impact multipliers under the both exchange rates is smaller than implied by the traditional Mundell-Fleming model. The results also reveal that, in an economy with segmented labour markets, the impact of fiscal policy becomes stronger and fiscal policy multipliers increase under the fixed exchange rate, when friction in the labour market decreases. An increase in the labour mobility does not have any significant impact on fiscal policy multipliers under flexible exchange rate regime. This implies that an increase in the labour mobility across the sectors widens the gap between the government expenditure multipliers associated with fixed and flexible exchange rates. We also analyse the effectiveness of the fiscal stimulus under different debt financing strategies. The fiscal multipliers are higher when debt is financed through an increase in the consumption tax under both exchange rate regimes, while capital tax financing scheme is found to be less effective. The difference of impact multipliers between the most and least effective schemes is larger under fixed exchange rate. We also report that the fiscal policy impact multipliers decrease with the increase in the size of informal economy under both exchange rate regimes but this effect is more pronounced when the exchange rate is fixed.