Tax revenue as a proportion of GDP is typically much lower in developing countries than in rich countries. The difference in tax revenues between the poorest and the richest nations of the world is entirely explained by the weakness of direct taxation in developing countries. For instance direct taxation represents 7% of GDP in Sub-Saharan Africa and 22% in industrial countries. In comparison, indirect taxation in developing countries is roughly 10% of GDP, which is the same level as in industrialized countries. The paper aims to analyze why the direct taxation base is so low in developing countries.

Informal sectors are larger in developing countries than in rich countries. This is a result of higher fixed costs of entry into the formal economy in developing countries. We show that raising barriers to entry is consistent with a deliberate government policy for raising tax revenue. By generating market power, and hence rents, for the permitted entrants, market entry fees foster the emergence of large taxpayers. The rents can be readily confiscated by the government through entry fees and taxes on profits at a low administrative cost. The relevance of the theory is assessed with a sample of 64 countries. Empirical analysis supports the results of the paper.

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