The effect of fiscal policy on the size of the informal sector in Nigeria

Abstract

This paper adapts a dynamic real business cycle model to examine the effect of fiscal policy on the relative size of the informal sector in Nigeria. The motivation for this paper is to provide an economic intuition on how fiscal policy has contributed to the growth of the informal sector. The results of the model show the presence of an inverted U-shaped relationship between the tax rate and the size of the informal sector. It also predicts that for a given tax rate below a threshold of 30%, public capital stock contributes to an increase in the size of the informal sector and vice versa. The theoretical predictions of the model are supported empirically using data from Nigeria between 1980 and 2000. The model finally shows that there is a proportional relationship between the agent’s welfare and the size of the informal sector.