In light of the existence of an informal sector in most developing countries, economists are beginning to reconsider the integrated tax reform consisting of a reduction in tari®s with an increase in VAT that has been advocated by the IMF in recent years. This paper explores the welfare change of such a reform in an economy in which the size of the informal sector is endogenously determined. Assuming that products are nontraded, the levy of VAT distorts the aggregate output; allowing the size of the informal sector to be determined endogenously worsens the situation. This leads to a conclusion which tends to favor an integrated tax reform toward tari®s under some plausible conditions. This result may help to explain the slow adoption of VAT in many developing countries.
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