Subjective welfare and (in)formal sector in a transition country

Ada Ferrer-i-Carbonell
ICREA & IAE(CSIC). Spain

and

Klarita Gërxhani
Faculty of Social and Behavioural Sciences, Amsterdam Institute for Advanced Labour Studies, Faculty of Economics and Business, and Tinbergen Institute University of Amsterdam, The Netherlands

May 2008

Acknowledgments: We would like to thank Bruno Frey, Erik Plug, Arthur Schram, Jeroen van den Bergh, Bernard van Praag for useful comments and support.

Subjective welfare and (in)formal sector in a transition country

Abstract This paper examines the relationship between working in the formal or informal sector and subjective welfare in a country in transition. It does so by allowing for individual heterogeneity in attitudes towards taxes. The results indicate that, for most individuals, working in the informal sector has negative effects on their subjective welfare. For some individuals, however, this effect is positive. The differentiating characteristic of the latter group is their low private tax morale, i.e, they disagree that not paying taxes today has personal financial repercussions in the future.

Keywords: financial satisfaction; informal sector; tax morale; transition. JEL-Classification: J0; I3; O5; H26; O17.

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Moreover. It is characterized by limited-entry and high wages.1. Fields (1990) reports that individuals working in the upper-tier informal sector have voluntarily moved there from the formal sector and are happy about their choice. This transformation has been accompanied by the appearance of an informal sector of substantial size. These findings are based on distinguishing between two sub-sectors within the informal sector. Despite these disadvantages. and Bourguignon. Early contributions to the literature argue that average individual earnings in the informal sector are lower than in the formal sector (Merrick.g. and is preferred by workers to formal sector employment. for these individuals. Marcouiller et al. 1982. Aside from the financial advantage of not paying taxes (e. This paper focuses on the latter. 1997). working in the informal sector is often preferred to being unemployed (De Grazia. Kugler et al. 1979). however. the informal sector sometimes provides more flexibility and opportunities for individual initiative and creativity than the formal sector (De Grazia. 1990). which are characterized by rapid economic and institutional change. One is called the ‘upper-tier informal sector’. 1982. Introduction An important episode in the previous century was the rise and fall of communist economies in Central and Eastern Europe and the Baltic states. From an economic perspective.. 1997. The end of these economies led to the emergence of so-called transition countries. Individuals who participate in the easy- 3 . have no labor contract and. 1975.. the informal sector is important in terms of both the re-allocation of resources it causes and its impact on individuals’ welfare. 1979. Gërxhani. Workers consider the latter to be undesirable relative to formal sector employment. 1990). working in the informal sector has other disadvantages: workers often experience worse working conditions. which consists of employment that is characterized by free-entry and low wages. Based on this distinction. 1982). In other words.. Hansson. as a consequence are excluded from various social benefits. face higher job insecurity. Kesner-Skreb. 1990. Various studies have suggested that the earnings distributions in the formal and informal sectors have substantial overlap (Fields. Thomas (1990) presents evidence that this mainly holds for less developed countries. the disadvantages of working in the informal sector are outweighed by the advantages. Renooy. so that the differences may be smaller than is commonly thought (Charmes. 2004b) and sometimes even considered to be a better option than working in the formal sector. The other is called the ‘easy-entry informal sector’.

the existing literature remains unclear about the consequences for individual welfare. a systematic analysis of individuals’ subjective welfare attributed to working in the (in)formal sector and its causes is still missing. This is due to a limited number of jobs available in the formal sector combined with trivial and short-termed financial support by the Albanian welfare system. The empirical analysis uses a dataset for Albania. (un)certainty about the future and (lack of) social security.g. In the empirical application. After the collapse of communism. 2005). we conclude that though the existing literature touches upon welfare differences between the two sectors. An important distinction between working in the formal and informal sector is whether or not individuals pay taxes. 2006). 4 .1 Moreover.entry informal sector are unsatisfied with working in the informal sector and are typically looking for jobs in the formal sector. Individuals may. a country in transition. there is more to welfare than just income. This note recognizes this gap and offers a first (econometric) analysis of the effect of working in the (in)formal sector on individual self-reported financial situation. Despite these attempts to characterize the pros and cons of working in the informal sector. ‘survival’ plays an important role in the decision to participate in the informal sector. e.. this lack of choice is a fundamental difference between the informal sector in developed countries and that in transition countries. the individual involvement in the informal sector in this country is not voluntary.4% in 1999/2000 (Schneider. this note takes the analysis one step further by recognizing that individuals are not homogenous economic agents with identical perceptions of their own welfare. This refers to individual attitudes towards taxes. it identifies two groups of individuals. i.2 Finally. social and institutional factors created suitable conditions for the informal sector to be prevalent in Albania (Gërxhani and Schram. distinguished by the extent of their ‘tax morale’. 2 The fact that formal and informal sectors are often found to be complementary in transition countries is another indication of the survival aspect of the informal sector in these countries. subjective welfare is used. a broader concept of economic welfare. A broader discussion can be found in Schneider and Enste (2000). As shown by Gërxhani (2004b).e. This is captured by individuals' own evaluation of their financial situation. In transition countries. which has not been taken into account in previous studies. a combination of economic. however. Although income is often used to compare individuals across sectors.. In this note. differ on how they perceive the financial 1 The average size of the shadow economy in Albania was estimated to be 33. From this overview.

to address a wide range of scientifically and politically relevant questions. Section 3 presents and discusses the results. (1999). the following question is used to capture the information on individuals’ subjective welfare: “How satisfied are you with the financial situation of your household?”. and health satisfaction. the analysis provides a more accurate explanation for heterogeneity in subjective welfare. 2. More recently. DiTella et al. Wilson (1967) and Bradburn (1969). From now on. Ferrer-i-Carbonell and van Praag (2002). among others. Easterlin (2001). Section 4 concludes. 5 . Section 2 introduces the empirical approach. where 0 stands for totally dissatisfied and 10 for totally satisfied.consequences of (not) paying taxes. This means that the lower the respondents are in the 3 Studies include Clark and Oswald (1994). The empirical approach 2. Ferrer-i-Carbonell (2005). The financial satisfaction question is thus used here as a measure of subjective welfare. Pradhan and Ravallion (2000). An overview of this literature is presented in Kahneman et al. welfare (financial satisfaction). Ravallion and Lokshin (2002). many economists have made use of subjective questions on. Special attention is given to the importance of the sector one works in. This involves a description of the question used to capture subjective welfare. (2001). such as job. or financial situation. health. The most relevant characteristic of the subjective measures is their focus on individual perceptions. other than income. this information will be referred to as individual financial satisfaction (FS). Subjective measures Psychologists have measured individual well-being by means of subjective questions since the late 1960s. van Praag and Frijters (1999). This means that two individuals who have the same income can experience different financial satisfaction levels. In this paper. housing. van Praag et al. (2004). starting with Cantril (1965). Frijters et al. The remainder of this note is structured as follows. and a characterization of the data. Individuals are asked to evaluate their satisfaction on a 0 to 10 scale. (2003). Frey and Stutzer (2002). an explanation of the econometric model. By allowing for this difference. Kapteyn (1994).1. Ng (1997).3 Subjective questions ask individuals about their life satisfaction in general or with respect to various domains of life in particular. Ferrer-i-Carbonell and Frijters (2004). The analysis presented here sheds light on which circumstances. FS reflects individuals’ perceptions of their economic situation. Oswald (1997). well-being. determine FS.

. Equation (1) shows that the financial satisfaction is explained by whether an individual works in the informal Ravallion and Lokshin (2002) use another subjective welfare question. The individual financial satisfaction is here described by the following empirical model: FS * = α + β Ln( y ) + γ I + δ X + ε FS= k ⇔ µ k ≤ FS* < µ k+1 (1) where FS* is the underlying non-observed variable. FS is a positive monotonic transformation of the concept economists are interested in. and the Minimum Spending Question (see. Garner and Short. First. 4 6 . it is assumed that different individuals understand and respond to the financial question in similar ways. In other words. e. 2). The model The discussion about what is the best econometric technique to estimate the answers to satisfaction questions has not yet been resolved (Ferrer-i-Carbonell and Frijters. Second. FS is the observed variable. 2004. It is beyond the scope of this paper to discuss these two assumptions. but only the range in which it lies (FS). 2004. Here.scale. Thus. the Minimum Income Question. it is not possible to observe the exact level of financial satisfaction (FS*). van Praag and Ferrer-i-Carbonell.. 1971. not a cardinal one. the answers to the financial satisfaction question are interpersonally comparable. individuals are able and willing to evaluate their own financial satisfaction in a questionnaire.. A detailed discussion is provided in Ferrer-i-Carbonell and Frijters (2004) and Senik (2004). welfare. an individual answering ‘8’ is more satisfied than one answering ‘4’. that is.4 The econometric analysis of financial satisfaction (FS) -−and of any subjective measure− requires two main assumptions. but not necessarily twice as much. Other subjective measures of poverty are based on the Income Evaluation Question. Second. First. 2004. and van Praag et al. 2003. k is one of the 11 categories (0 to 10). Van Praag and Ferrer-i-Carbonell (2004) make use of the same question when studying the extent of poverty in Russia. van Praag.g. and µ are the estimated intercept terms. Chp. the variable gives an ordinal ranking. This choice is based on two assumptions we impose on the variable FS. Gustafsson et al. Kapteyn et al.2. an Ordered Probit is chosen. 1997). called the Economic Welfare Question. the lower their subjective economic well-being is. 2.. For example. 1988. to explain the large differences between objective and subjective poverty in Russia.

6 In Albania.. is normally distributed with mean 0 and variance 1. 2003. This includes experience with tax authorities. a private and a public one. In the data set. and insecurity of property rights (Alm et. For these individuals. the constitutional environment. This specification is chosen to reflect a diminishing marginal utility of income. For details. Several studies argue that tax morale. 2003). 2002. The ‘private’ tax morale reflects individual attitudes towards taxes that have direct personal benefits. The error term ε. as a particular kind of individual intrinsic motivations. an individual is entitled to benefits only if (s)he has contributed to the scheme (see Beqja. demonstrate a high ‘private’ morale towards taxes. working in the informal sector and thus not paying taxes may negatively affect their current financial satisfaction. 6 This hypothesis is closely related to a research question put forward by Feige (1990). 2. payment of social and health insurance premiums is mandatory and is directly subtracted from income together with other taxes. Our data set captures two aspects of tax morale. interaction with other taxpayers. 2002). Introducing tax morale Tax morale can be defined as “individuals’ willingness to pay taxes or. Schneider and Enste. In addition. 5 7 . as usual in Ordered Probit. this aspect is measured by the information on whether individuals (dis)agree (on a 5-point scale) with the following statement: “Not paying social and health insurance today would cause serious financial problems for me in the future (e. 1989.. in other words. by the household (monthly) net income (y). The household income is taken in logarithmic form. 1992.3. which represents the part of FS* that cannot be explained. Torgler. see Maddala (1983).. Feld and Frey. al.sector (I). no pension benefits)”. the moral obligation to pay taxes or the belief in contributing to the society by paying taxes” (Cummings et al.5 The underlying meaning behind this question is that individuals who agree that not paying social and health insurance today has personal financial repercussions in the future. and by a set of socio-economic and demographic variables (X). and 0 if (s)he works in the formal sector. Frey. our case study.g. I is a dummy variable that takes a value 1 if the individual works in the informal sector. He questions whether the benefits of working in the informal sector (by avoiding institutional constraints) outweigh the costs of exclusion from economic benefits and legal rights. does not only depend on one’s upbringing but also on the specific institutional context. 2004: 5).

Financial satisfaction is now explained by: FS = α + β Ln( y ) + γ I + ϕ ( I * HPrTm) + φ HPrTm + π ( I * HPbTm) + κ HPbTm + δ X + ε (2) Experimental evidence shows that one reason why people contribute to taxes is because they finance public goods (e. respectively. The frequency distribution of private tax morale based on the original scale is: 82% strongly agree with the statement. described by Andreoni (1990: 473) as the utility gain “from the act of giving”. For public tax morale. ‘mildly disagree’ (4). the effect of working in the (in)formal sector on an individual’s financial satisfaction may depend on the individual’s tax morale. 1% mildly disagree. Therefore. 9%.The public aspect of tax morale is reflected in the individual (un)willingness to contribute to public goods7. for whom the impact of working in the (in)formal sector on financial satisfaction may differ. This corresponds to the verbal categories ‘strongly agree’ and ‘mildly agree’.. (2) altruistic individuals who contribute to public goods will experience a utility gain due to contributing to the welfare of others. They are called HPrTm and HPbTm. 3% and 3%. and social/health insurance.8 Financial satisfaction is now regressed including two interaction terms between working in the informal sector and the two dummy variables. 1987). about 90% of respondents are classified as having a high private tax morale and 85% as having a high public tax morale. more parks. 8 Individuals are classified as having a high tax morale if they choose 1 or 2 on the 5-point scale. 17%. Thus. This is captured by whether individuals (dis)agree (on a 5point scale) with: “People should pay taxes because if they do. the two dummy variables are included separately in the analysis so as to differentiate between the effect of tax morale through working in the informal sector. This is operationalized using two dummy variables indicating whether individuals have a high ‘private’ or ‘public’ tax morale. or ‘strongly disagree’ (5). this distribution is 68%. better roads... The last is known as the ‘warm-glow’ effect. Individuals who agree that people should pay taxes because of the public benefits involved.. they will benefit from them (e. and 2% strongly disagree. Obviously. reveal a high ‘public’ tax morale.g. The respondents are classified as having a low tax morale if they answer ‘neither agree or disagree’ (3). These dummy variables take value 1 if an individual reveals a high tax morale and 0 otherwise. Additionally. The empirical analysis distinguishes between various types of individuals (defined by their private and public tax morale). Alm et al. respectively. 7 8 . 11% mildly agree. 1992 and Becker et al.g. there is a direct relationship between the sector one works in and the (non)payment of taxes. 4% are neutral. and the direct effect of tax morale on financial satisfaction. Contributing to public goods can positively affect individual financial satisfaction in three ways: (1) individuals enjoy a larger provision of public goods. and more schools)”. and (3) the economic burden of having to pay taxes may be compensated by the pleasure of contributing to the group’s welfare.

One would expect that individuals without any alternative sources of income would have a higher probability to For a theoretical model in which occupational choice depends on risk attitudes.9 In this case. whether an individual has a low or high tax morale does not have any influence on her or his decision to work in the (in)formal sector. The endogeneity of the sector choice An empirical concern is that the sector choice may be endogenous. individuals would choose the sector where they obtain a higher financial satisfaction.. For the latter. We have two variables to test for this in our data set. 1994. In other words. for example. and Schroyen. namely: the number of household members who have a paid job (or a dummy variable indicating that there is more than one household member working). The former ones benefit financially from not paying taxes today and do not perceive any future consequences of it. If these three coefficients are identical. one would expect individuals with a low private tax morale to choose to work in the informal sector and those with a high private tax morale in the formal sector. We ran a Probit regression to explain the individual probability of working in the informal sector by individual private tax morale. 2. (γ +ϕ). Watson. While this research refers to developed countries. In other words. 9 9 . see Pestieau and Possen (1991). the opposite is true. Most of the recent research until now models tax evasion and occupational decisions as an individual choice (see. the literature about less developed countries argues that working in the informal sector is not a matter of choice in a transition country like Albania (see Section 1). 1985. or (γ +ϕ+π) depending on the individuals’ tax morale. one may argue that although individuals do not freely self-select into one sector.4. In this paper we empirically test this hypothesis.The effect that working in the informal sector has on the financial satisfaction is described by γ. individuals self-select themselves into one sector or another. they may be forced to enter the informal sector if they do not have any incomeearnings’ options elsewhere. and the number of family members living abroad who financially support the individual. This indicates that individuals do not self-select themselves into one of the two sectors. 1997). In addition. all the groups are affected in the same way. The results show that the private tax morale has a very small and insignificant effect on the probability of working in the informal sector. If there were a free choice of sector. Jung et al.

This may lead to an inconsistent estimate of the effect of informal sector on financial satisfaction if education would co-determinate both. many of these variables proved not to have any effect on the sector selection. time variation (de Holanda and Filho. the region of origin. 1991). are more often not chosen for a job in the formal sector. but can be excluded from the wage equation. Thus. In addition. as people with higher education have a statistically significant lower probability to be working in the informal sector. gender. working in the informal sector and the level of financial satisfaction. among others. This would be the case if lower educated individuals would not only have a higher probability to work in the informal sector but would also have a set of unobservable characteristics (such as reduced social network and capacity to deal with adversities) that correlate negatively with financial satisfaction. it is difficult to believe that education does not affect financial satisfaction in other ways than through the probability of working in the formal sector. number of children and other household structure variables (Gindling. Looking at our sample we cannot exclude this option. other authors have instrumentalized the sector choice by. we could alternatively apply a fixed effects model. Magnac. One would correct for this possible source of endogeneity by using instrument variables. In our data set. Next to education. 1998).be in the informal sector. A second source of sample selection bias may be driven by the demand side. 2006). 2005). One could also exploit geographic variation (see Beuran and Kalugina. 1998). Given the crosssectional nature of our data set and its restriction to individuals located in only one region. Dustman and Van Soest. Moreover. if individual with certain characteristics. For example. age. A probit analysis of the probability of working in the informal sector however shows that the effect of both variables is statistically insignificant. or information on parent’s occupation or education (e.. Therefore. but is only useful if appropriate instrumental variables are available which play a role in the selection mechanism. which may lead to bias results (Dustmann and Van Soes.” (p. we do not posses such instruments. such as low education and skills.10 Some studies use human capital characteristics to estimate both the selection mechanism and the main equation. gender and being married suffer from the same weaknesses as education. 1419). They do that by using different specifications of the education variables. age. the best we can do is to look at the effect of working in the informal sector on financial satisfaction while controlling for those 10 If we were to have panel data. 10 .g. and as Dustmann and Van Soest (1998) conclude regarding selection between private and public sector: “…correcting for nonrandom selection is important. 1991.

These variables will be included in the financial satisfaction equation. 11 . 24. Next to having lower education. The data contain information about individual self-reported financial satisfaction on a 0 to 10 scale.1% of Tirana households in 2000. it appears that the average age of the respondents. From the comparison. percentage of children in the household. covering the five –more or less equally sized– regions of urban Tirana. see Gërxhani (2006). However. The data The analysis is based on data collected in a field survey conducted by one of the authors in 2000. The response rate of 89. in the urban area of Tirana. 2006) and can be provided upon request. The method applied is the ‘selfadministered questionnaire’. Our data set also provides information on the sector in which individuals work. which represented about 1. The survey sample consisted of 1.500 households living in Tirana. chapter 3). The sample average equals 3. and to the Russian financial satisfaction in the RUSSET data set (1999). the capital of Albania. For a more detailed description of the data collection method. The sampling was random and based on a geographical framework. Individuals with more 11 The complete questionnaire can be found in Gërxhani (2002.observable characteristics that differ between individuals in the formal and in formal sector. it is concluded that the data collected in 2000 are to a large extent representative of Tirana households. This is used to distinguish between individuals working in the formal and informal sectors.5. and having emigrating to Tirana from rural areas also increase the probability of being in the informal sector.340 valid questionnaires returned.11 Gërxhani (2006) discusses the representativeness of the data collected by comparing its results to the most recent survey with comparable data by the Albanian Institute of Statistics (INSTAT). the low score of Financial Satisfaction in Albania compares very well to the level of subjective welfare reported in the Albanian LSMS data set of the World Bank (2003). In the sample.37. and gender division of adult members in the household are very similar in the two surveys. 2004.3% gave 1.6% of the respondents work in the informal sector. older. which combines personal contacts with written questionnaires. that is. which is very low compared to the two most well known data sets utilizing this question. 2. average size of the household. financial satisfaction scores in the United Kingdom and Germany (see van Praag and Ferrer-i-Carbonell. The main income earner of the household was asked to respond to all the questions. being a woman. Hence.

although the last coefficient is non-significant.3). On the one hand. the data contain information on individuals’ socio-economic and demographic characteristics (e. First. 2002).than one job (this is 13% of the sample) are classified as working in the formal sector if at least one of their jobs is in this sector. however. Gërxhani (2004a) uses these and other questions as a measure of tax morale.. Finally. 12 . The regression analysis (below) corrects. Equation (1)). although “male” non-significantly so. and education). the number of family members living abroad who support the family financially).1. which takes value 1 if an individual has more than one job and 0 otherwise.. Second. and other information relevant for a transition country like Albania (e. On the other hand. “married”. 3. and Ravallion and Lokshin. These are to a large extent consistent with the existing literature on countries in transition (see van Praag and Ferrer-i-Carbonell. household monthly net income. gender. Finally. Two of these attitudinal questions are used to study the importance of tax morale in explaining the relationship between working in the (in)formal sector and subjective welfare (cf. “higher education”. having lived in a rural area before transition also affects financial satisfaction positively (this may capture a comparison 12 This is because by having at least one job in the formal sector. the individual financial satisfaction related to working in the informal sector is evaluated in terms of income. Financial satisfaction and the (in)formal sector Table 1 presents the estimation results for equation (1) in columns 2 and 3. Albania has its own particularities. the analysis proceeds by distinguishing between various groups of individuals based on their tax morale (cf. by the household monthly net income. nevertheless. In a study of tax evasion. which relate to its transitory phase of development.12 In addition. section 2. financial satisfaction is explained by whether or not an individual works in the informal sector. the data provide information on individual attitudes to various statements related to paying taxes. and by a large set of socio-economic and demographic variables (cf. the coefficients for “having children” and “family size” show a negative sign.g. 3. They involve the following: having (and being financially supported by) family members living abroad has a positive coefficient. taxes. for having more than one job by including a dummy variable (“moonlighting”).g. and “net family income” have a positive coefficient. Results The presentation of the results is split in three parts. age. 2004. the explanatory variables “male”. Equation (2)). they have the right to social benefits.

individuals working in the formal sector are the reference group.330 -0.300 0. The total coefficient for these individuals is –0. These two coefficients are both statistically significant at about 6% and 2%.560 -0. In the regression analysis.232 3.157 -1.111 -0. For those individuals with a low private tax morale.330 0.501 -3. This group represents a minority (10% of the sample).500 Model 2 (Equation (2)) Coeff. working in the informal sector correlates negatively with financial satisfaction. Ordered Probit Model 1 (Equation (1)) Coeff.370 -0.518 3. z 0.2.661).114 1.590 Male Ln(Age) Individual is married Individual has children Ln(Family size) Individual has higher education Migration from North or South to Tirana 13 The coefficients of all variables included in both models are almost identical.550 -0. the coefficient between being in the informal sector and financial satisfaction is positive (0.120 -0. 13 .630 0. Financial satisfaction and tax morale The fourth and fifth columns of table 1 present the estimation results for equation (2). the empirical analysis shows that the coefficient for working in the informal sector is negative but not statistically significant. the effect of working in the informal sector on financial satisfaction will become statistically strong.113 -0. Thus.245 3.640 0.160 -0. ceteris paribus. 3.526 3.040 -0. Table 1: Financial Satisfaction Albania.499 -3. the effect of the dummy variable indicating a high private tax morale is insignificant and very small.048 -0. Below we show that this non-significant coefficient is a weighted average across two groups of individuals for whom working in the informal sector has a different impact on their financial satisfaction.effect with the past).110 -0.13 The analysis shows that for individuals with a high private tax morale (about 90% of the cases). the financial satisfaction from working in the formal sector is lower than that of working in the informal sector in case of a low private tax morale.129 1.132 (=0.160 -1. Finally.550 -0. These results imply that Model 1 was unable to distinguish between two types of individuals whose effect of working in the informal sector on their financial satisfaction is very strong and distinct. z 0. Finally. respectively. By correcting for individuals’ tax morale. and having more than one job also has a positive coefficient (although only significant at 10%).528).528-0.

623 8. This means that the effect of working in the informal sector on financial satisfaction does not seem to depend on the individual public tax morale.661 -0.Migration from rural to Tirana Working in the Informal sector (I) Informal * High ‘private’ tax morale (I*HPrTm) High ‘private’ tax morale (HPrTm) Informal * High ‘public’ tax morale (I* HPbTm) High ‘public’ tax morale (HPbTm) Moonlighting: having more than one job Ln(Number of family members working) Ln(Number of (family) emigrants) Ln(Net family income) Intercept term 1 (µ1) Intercept term 2 (µ2) Intercept term 3 (µ3) Intercept term 4 (µ4) Intercept term 5 (µ5) Intercept term 6 (µ6) Intercept term 7 (µ7) Intercept term 8 (µ8) Intercept term 9 (µ9) Intercept term 10 (µ10) Number of observations Log.210 12. The dummy variable reflecting individual high public tax morale is positively correlated with financial satisfaction.180 1.890 -2.528 -0.219 -0. the lower (higher) the financial satisfaction.068 1.366 0. regardless of whether they work in the formal or informal sector. and thus not paying taxes.003 6.609 908 -1856 1.670 1.289 8.364 5.362 0.218 7.500 6.597 4. the results show that the effect of working in the (in)formal sector on subjective welfare (after controlling for income and other variables).200 12. In summary.368 7.446 6. can be completely attributed to the individual private tax morale.185 0. although only significant at the 10% level.640 1.597 4.494 5.780 8.032 0. For individuals working in the formal sector.260 2. Evaluating the importance of working in the informal sector 14 . Likelihood 0. The higher (lower) the private tax morale when working in the informal sector.187 0.170 0.230 0.810 0.992 7.116 0.850 The interaction term between working in the informal sector and a high public tax morale is not significant and very small.363 4. These results imply that the effect of public tax morale on financial satisfaction is positive for all individuals.910 0.864 6.170 2.909 5.125 8.940 -0.305 6.043 5. For individuals working in the informal sector.035 0.420 -0. 3.3.125 0. the positive coefficient may result from a free riding effect.820 1.440 908 -1862 1.640 1.194 0.846 7. the economic burden of paying taxes may (as argued above) be compensated by the ‘warm glow’ effect of contributing to a public good.

These results show the relevance for financial satisfaction of moving from the formal to the informal sector. The (compensating) income necessary to bring this individual back to the initial level of satisfaction is a 19. for most individuals. it has remained an open question what the effect of working in the formal or informal sector is on an 15 . 2004. 4. they disagree that not paying taxes today has personal financial repercussions in the future.1% of his or her income.2% income increase.e. From equation (2) we can derive the income necessary to compensate an individual with a high tax morale for the loss of satisfaction due to working in the informal sector: ∆ ln y = γ +ϕ −1 β ⇒ ∆y = exp( γ +ϕ ) −1 β The income necessary to compensate an individual with a low tax morale for the loss of satisfaction due to working in the informal sector equals: ∆ ln y = γ −1 β ⇒ ∆y = exp( ) − 1 γ β The equivalent loss is the reciprocal of the compensating income. and Ferreri-Carbonell and van Praag. Even when other aspects like ease of entry and social exclusion are theoretically recognized. 2000). some individuals who work in the informal sector are financially even more satisfied than their counterparts in the formal sector. Comparative studies of individuals working in the formal and informal sectors have mainly focused on the income differential between the two sectors. The differentiating characteristic of these individuals is that they demonstrate a low private tax morale. i. Distinguishing between two types of individuals based on their attitudes towards taxes. Combining the estimated coefficients with these relationships indicates that an individual with a high private tax morale moving from the formal to the informal sector would experience a satisfaction loss equivalent to 16. Conclusions This paper studies the relationship between working in the formal or informal sector and subjective welfare in a country in transition. Remarkably. the results show that. working in the informal sector has negative effects on their subjective welfare.The importance of the correlation between financial satisfaction and working in the informal sector (for individuals with high private tax morale) can be evaluated in terms of income by calculating the compensating income and the income equivalent of working in the formal sector (for similar approaches see Blanchflower and Oswald.

16 .individual's welfare. This paper contributes to the literature by providing an empirical answer to this question.

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