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. JEL Classification Numbers: D43, H25, H26, H32, H60 * We are extremely grateful to the participants at the Cornell/ISPE Conference on Public Finance and Development (September 2001) for the comments, critics and suggestions they made on a preliminary version of the paper. The friendly atmosphere and the stimulating discussions of the conference were of great help to us. We are indebted to Hiranya Mukhopadhyay and Benjamin F. Jones for their discussion of the paper. We are extremely grateful to Alban Thomas and Stéphane Straub for comments and advice. Finally we would like to thank two anonymous referees and the two associated editors of this issue for their thorough comments. All remaining errors are ours.

JEL classification: D43 H25 H26 H32 H60 Keywords:Marginal cost of public fund Tax reform Developing countries Africa In this paper we propose estimates of the marginal cost of public funds (MCF) in 38 African countries. We develop a simple general equilibrium model that can handle taxes on five major tax classes, and can be calibrated with little more than national accounts data. A key feature of our model is the explicit recognition of the informal economy. Our base case estimate of the average MCF from marginal increases in all five tax instruments is 1.2. Focusing on the lowest cost tax instruments in each country, commonly the VAT but not always, the average MCF is 1.1. Finally extending the tax base to include sections of the informal economy by removing some tax exemptions offers the potential for a low MCF source of public funds, and a lowering of MCFs on other tax instruments.

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