Coming out of the shadows? Estimating the impact of bureaucracy simplification and tax cut on formality in Brazilian microenterprises ☆ Joana C.M. Monteiro, Juliano J. Assunção ⁎ Department of Economics, Pontifícia Universidade Católica do Rio de Janeiro (PUC-Rio), Rua Marquês de São Vicente, 225-Gávea Rio de Janeiro, RJ, 22453-900, Brazil abstract article info Article history: Received 20 September 2007 Revised 8 September 2011 Accepted 16 October 2011 JEL classification: D73 E26 K34 Keywords: Informal economy Tax legislation Bureaucracy This paper evaluates the impact of a program of bureaucracy simplification and tax reduction on formality among Brazilian microenterprises — the SIMPLES program. We document an increase of 13 percentage points in formal licensing among retail firms created after the program when compared to firms in ineligible sectors. The impact on retailers is robust to a series of tests. We find no impact on construction, transportation, ser- vices and manufacturing sectors. © 2011 Elsevier B.V. All rights reserved. 1. Introduction In most countries, a substantial portion of the GDP is produced by the so-called shadow or underground economy. In Latin America, for example, the size of the informal sector relative to official GDP ranges from 25% to 50%. For OECD countries, underground activities account, on average, for 16% of GDP (Enste and Schneider (2000)). A large body of literature addresses the measurement of the shad- ow economy. Many contributions are published in a special issue of the Economic Journal (109:456, June 1999) and a survey of the differ- ent methodologies and main estimates can be found in Enste and Schneider (2000). However, less attention has been devoted to the causes and consequences of informality. Empirical evidence about key determinants is still very scattered due, predominantly, to the ab- sence of data. As mentioned by Enste and Schneider (2000), “gather- ing information about underground economic activity is difficult, because no one engaged in such activity wants to be identified”. This paper evaluates the effects of new bureaucracy simplification and tax reduction legislation for micro and small firms in Brazil — the so-called SIMPLES system. The analysis of SIMPLES program offers a great opportunity to contribute to the literature on determinants of infor- mality because the program promotes a sizeable reduction in tax burden and reduces the red tape involved in tax payments, and therefore bypass- ing cumbersome procedures that increase the costs of being formal. Our evidence is based on a special cross-sectional survey of micro and small firms conducted in 1997, less than one year after the imple- mentation of the program. This database along with the implementa- tion of this new taxation in Brazil provides an opportunity for investigating the informal economy at the firm level. The identification strategy is based on a few key aspects of the empir- ical environment. First, the new tax system is restricted to a subset of sectors. We explore this characteristic using a difference-in-difference ap- proach, comparing the legal status of firms in sectors affected and not af- fected by the reform, created before and after the program. By restricting the analysis to a single country, our empirical strategy is less subject to other changes in the legal environment than other studies based on cross-country comparisons. Second, we do have data on unofficial firms – more than 75% of the firms in our sample are unlicensed – and we investigate the variation in the official registration of firms. We show that the SIMPLES program affects the formalization of economic sectors differently. There is an increase of 13 percentage points in the licensing of retail firms, while the licensing of the other eligible sectors (construction, manufacturing, transportation and service) remains unaffected by the new legislation. Since only 27% of the retailers which started-up before the program are licensed, this result represents a measurable reduction in unlicensed firms in Journal of Development Economics 99 (2012) 105–115 ☆ We would like to thank Áureo de Paula, Sérgio Firpo, Gustavo Gonzaga, Naércio Menezes Filho and Rodrigo Soares for useful comments and suggestions on this paper. Financial support from CNPq and FINEP is gratefully acknowledged. Any remain- ing errors are our own. ⁎ Corresponding author. Tel.: + 55 21 35271078; fax :+55 21 35271084. E-mail addresses: joanacmm@gmail.com (J.C.M. Monteiro), juliano@econ.puc-rio.br (J.J. Assunção). 0304-3878/$ – see front matter © 2011 Elsevier B.V. All rights reserved. doi:10.1016/j.jdeveco.2011.10.002 Contents lists available at SciVerse ScienceDirect Journal of Development Economics journal homepage: www.elsevier.com/locate/devec