effect on MCF estimates in Canada.<sup>4</sup> In addition to the economic effect of informal sectors, including informal sectors avoids a calibration problem. CGE models have sometimes applied ‘effective’ tax rates, calculated as tax revenues divided by sector size. This results in low modelled tax rates. Effective tax rates provide an average between taxpayers who pay tax at something like the legal rate, subject to some under-reporting, and informal producers or consumers who pay no tax. Effective tax rates underestimate the marginal tax rate incurred by those who actually pay tax. Models using effective tax rates are thus likely to underestimate MCFs.<sup>5</sup> Our paper makes several contributions to the literature on MCFs. The first is the development of a simple general equilibrium model that can handle taxes on the five major tax classes, takes account of the existence of informal sectors, can be calibrated with little more than national accounts data, and can be easily reproduced by other researchers for other countries. After a brief review of the existing literature in section 2, we present the model in section 3. It is inspired by the minimal data requirements of the ‘1-2-3 model’ of Devarajan, Go, Lewis, Robinson, & Sinko (1997). The basic 1-2-3 model has one country with two producing sectors and three goods: a domestic good, exports and imports. This model is extended to include production of an informal good, and four factors of production: formal capital, informal capital, formal labor and informal labor. Our definition of an informal good or factor is simply one on which no tax is paid.

Section 4 contains the paper’s second important contribution: application of the model to produce estimates of MCFs for taxes in 38 African countries, vastly increasing the number of developing countries for which MCF estimates exist. Sensitivity testing of the model reveals which elasticities are the most important in determining MCF magnitudes, and suggests that our base case estimates are reasonably robust for purposes of tax reform.

The paper’s third innovation, presented in section 5 is an investigation of the

> 4Fortin & Lacroix (1994) suggest the informal sector accounts for around 0.02-0.05 of their MCF estimates of 1.39-1.53 for labor taxation in Canada. They note that although small, the impact of the informal sector increases rapidly with the level of the marginal tax rate. The importance of the informal sector when analyzing taxation in developing countries is also emphasized in other settings in recent papers by García Peñalosa & Turnovsky (2005) and Emran & Stiglitz (2005).

5It seems that the models used by Devarajan, Suthiwart-Narueput & Thierfelder (2001) apply ‘effective’ tax rates. For example their Cameroon model applies tax rates of 0.7% for food and forestry, 2.5% for intermediate goods, 3.4% for construction, 6% for services, 7.4% for food and consumption, and 19.1% for cash crops. We do not have access to the legal tax rates in force at the time the Cameroon model was created, but the current VAT rate (which has replaced the previous system of sales taxes) is 18%, suggesting that effective tax rates were indeed used in their model. The relatively high effective tax rate for cash crops may be explained by noting that cash crops are largely exported. Exports tend not to escape taxation, so the effective tax rate approximates a revenue-weighted average of legal tax rates.

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