Public finance pressures are a central concern in developing countries. With large informal economies, the tax base is narrow and the resulting revenue on average only about half the fraction of GDP seen in developed countries. In response to the resulting tax distortions favoring the informal sector, countries commonly impose a variety of restrictions favoring the formal sector and hindering the entry of new firms that likely join the informal sector. While these policies help protect the country's tax base, they also unfortunately can hinder economic growth, by discouraging entrepreneurial activity.The experiences in China show this trade off dramatically. When restrictions on firm entry were eliminated, economic growth rates jumped but tax revenue fell by two-thirds, since the growth largely took place in sectors that were hard to tax.How should a country then handle these revenue costs of growth-promoting policies? The choices are few: cut expenditures, borrow in the hopes of higher revenue in the future, come up with new sources of revenue such as user fees, or undertake only partial reforms that yield some growth but also help preserve the existing tax base. The paper argues that the latter approach is likely to be the most successful, in spite of the lower resulting growth rate.
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