We demonstrate how the presence of an untaxed informal sector can sharply lower the cost of environmental and energy tax policy. The mechanism involves substitution between formal and informal labor supply: energy or environmental taxes can improve the efficiency of the tax system by drawing activity into the formal sector.
Our result applies to broad classes of corrective taxes and we first present it in a simple analytical framework. We then investigate its magnitude in a simulation model using the case of an energy tax in the U.S., where the informal sector is relatively small. Even so, we find the cost of energy taxes is negative for abatement up to 6% and substantially reduced for large policies. Developing countries provide an important extension: they have much larger informal sectors but at the same time include the potential for substitution into informal fuels. We model these countervailing features and show that the welfare enhancing effect typically dominates, making the efficiency improvements even greater than in the U.S. case.