ciated with the macroeconomic context in which spending decisions have taken place. Building upon di¤erent macroeconomic theoretical frameworks, recent empirical ...ndings have shown that spending multipliers tend to be larger under ...xed exchange-rate regimes (Ilzetzki, Mendoza, and Vegh, 2013), under low debt (Ilzetzki, Mendoza, and Vegh, 2013; Huidrom, Kose, and Ohnsorge, 2016), and in recessions (Auerbach and Gorodnichenko, 2012a,b; Riera-Crichton, Vegh, and Vuletin, 2015). Rather than focusing on the aforementioned macroeconomic-based non-linear e¤ects, our paper focuses on the non-linear e¤ects of tax changes on output generated by distortionary and disincentive-based arguments.<sup>5</sup> Based on di¤erent types of macroeconomic models (which in turn rely on di¤erent mechanisms), the output e¤ect of tax changes is expected to be small at low initial levels of taxation but exponentially larger when initial tax levels are high. Therefore, the distortions and disincentives imposed by taxation on economic activity are directly, and non-linearly, related to the level of tax rates. By the same token, for a given level of initial tax rates, larger tax rate changes have larger tax multipliers. These theoretical results are present, for example, in Jaimovich and Rebelo (2017) (hereafter JR) who show that such a non-linear mechanism may operate through heterogeneity in entrepreneurial ability and its disincentives to innovate and invest. We also propose an alternative explanation for such a non-linear e¤ect, based on the role played by informality. For this purpose, we use a simple reduced-formed solution type of model, where both the formal and informal sectors have identical production functions. The existence of VAT (which is imposed only on the “formal”good, and not on the “informal”one) generates, in and of itself, an initial distortion in which workers are incentivized to work in the informal sector more than under the absence of such a tax. Therefore, the marginal productivity of formal workers is, in equilibrium, larger than that of informal ones. Under this situation, an increase in the VAT rate simply increases the initial distortion, raising the share of informality, and reducing total output. Moreover, larger increases in the share of informality and more profound falls in output are observed when the tax increase is implemented in a context of higher initial VAT rates. Naturally, while we exempli...ed the mechanism using an increase in the VAT rate, the same results hold for a reduction in the VAT rate.<sup>6;7</sup> In line with theoretical distortionary and disincentive-based arguments, we ...nd, using our novel worldwide narrative, that the e¤ect of tax changes on output is indeed highly non-linear. Our empirical

> 5 As we will discuss later in Sections 5.6 and 6, macroeconomic-based non-linear e¤ects are not behind the non-linear e¤ects associated with distortionary and disincentive-based type of arguments.

> 6 See Appendix 2 for details on the model. If the production functions of the formal and informal sectors allowed larger productivity in the formal sector than in the informal one (as it is frequently assumed based on ...rm level data evidence) and/or if there existed a segmentation in the labor market where formal workers were paid more than informal ones (as empirical evidence strongly suggests), the proposed mechanism as well as the output and informality implications would be further ampli...ed.

> 7 While di¤erent in the nature of the object under analysis (output versus tax burden), JR and our simple model based on the role played by the informal sector, also relate to a well-established public ...nance literature (e.g., Harberger, 1964a,b; Browning, 1975; Feldstein, 1995) which argues that the excess burden of taxation, or deadweight loss, associated with taxation is small at low tax rates, increases with higher tax rates, until, eventually, “a tax [is] imposed at so high rate that it eliminates the taxed activity.”(Hines, 2007, p. 1).

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