Economic Informality and Inequality: a Decomposition Approach and an Application to Campania Region

Work-in-Progress

Antonio Abatemarco, Roberto Dell’Anno, Zouhair Ennaoumi

Department of Economics and Statistics, University of Salerno and CELPE

Introduction

Economic informality and tax evasion are pervasive, intertwined features of contemporary economies. Informality encompasses income-earning activities outside the reach of labour regulation, social insurance, and tax administration (from unregistered self-employment and off-the-books jobs to small businesses that do not keep standard accounts) while tax evasion refers to intentional non-compliance with legally owed taxes. Although the two often co-occur in practice, they are conceptually distinct and can move measured inequality in opposite directions. For some households, informal earnings act as a last-resort buffer that keeps them from the bottom of the distribution. For others, especially higher-income or self-employed units, evasion weakens the progressivity of the tax-benefit system, allowing them to retain a larger share of income. Any credible assessment must therefore speak to both income flows and the institutional environment that shapes compliance, while also confronting limited observability and under-reporting in surveys. A further complication is reranking: when adding informal incomes changes individuals’ relative positions along the income ladder, a purely vertical assessment of redistribution can be misleading. This study addresses these issues by isolating, in a transparent way, how much of the observed change in inequality comes from informal earnings themselves, how much from the taxes that are not paid on those earnings, and how much from reranking effects.

Methodology

The paper proposes a simple, non-parametric decomposition grounded in Lorenz and concentration curves and the Reynolds–Smolensky (RS) index. The approach compares (i) the distribution of formal, post-tax incomes with (ii) the distribution observed once informal income is added, and with (iii) a counterfactual distribution in which all income (formal and informal) is fully reported and taxed under the prevailing personal income tax. Three quantities are identified. First, an “informality-only” component captures the distributional effect of informal earnings if they had been taxed (i.e., abstracting from evasion). Second, an “evasion-only” component captures the effect of not paying taxes on informal income, holding fixed the counterfactual ranking implied by full reporting. Third, a reranking residual quantifies how much the relative ordering of individuals changes when informal income is brought into the picture. Intuitively, the same euro has a larger rank impact in the dense lower tail, where informal earnings can move a person from zero or near-zero formal income into meaningful positive income—than at the top, where wide gaps mean the same absolute change rarely flips ranks. The key novelty is to treat reranking not as an afterthought but as an explicit object of measurement: the overall RS effect is exactly the sum of the informality-only term, the evasion-only term, and the reranking residual. A corollary is particularly informative: if adding (taxed) informal earnings preserved the original ordering by formal income, then the overall redistributive effect would simply be the sum of the informality-only and evasion-only components and reranking would vanish. By testing where the identity does and does not hold tightly, the framework reveals which mechanism—income inflows at the bottom, tax erosion at the top, or reshuffling of ranks—actually drives the observed change in inequality.

Data

The method is illustrated with microdata from the Survey on Tax Evasion and Informal Economy (STEvIE 7.0) for Campania (Italy), covering 2019–2025. The cleaned sample includes 504 respondents with weights for age, gender, and education. Average net formal income is roughly €19,100 for employees and €20,000 for the self-employed, while average informal income is about €1,650 for employees and €5,360 for the self‑employed. The sample composition skews toward working-age adults, with men slightly overrepresented, and educational attainment concentrated in upper secondary and tertiary levels. The dataset is not nationally representative—its value lies in unusually detailed questions on both formal and informal earnings, which allow construction of pre‑informal income, the informal component, and the implied tax treatment consistent with the Italian system. These features make it well suited for a decomposition whose purpose is illustrative and diagnostic rather than for producing national estimates.

Conclusions and policy implications

The decomposition shows that adding informal income yields a modest reduction in measured inequality overall, with an RS value around 0.027. However, nearly all of that improvement is accounted for by reranking (about 0.030). When abstracting from reranking and looking only at vertical redistribution, the informality-only component is positive but small (roughly 0.010), while the evasion-only component is negative (around −0.012), so their sum is slightly negative. Put differently: informal earnings do reach lower‑ranked households and act as a safety net, but the erosion of progressivity due to unpaid taxes offsets, and in purely vertical terms slightly outweighs, those gains. From a welfare perspective this asymmetry matters. Reranking violates horizontal equity: individuals starting from similar positions end up in different places once informal income is included, in ways unrelated to need or effort. It can also blunt incentives in the formal labour market if people expect positional changes to come from shifting into informality rather than from formal earnings growth. Policy should therefore aim to preserve the insurance role of informal earnings for the most vulnerable while reducing the inequities generated by evasion and reranking. Three directions stand out. First, broaden access to formal opportunities and social protection at the bottom—through simplified regimes for micro‑activities, portable social insurance, and administrative support—to keep the safety‑net function while drawing activity into the contributory base. Second, focus enforcement where it is most redistributively salient: on high‑income evasion at the intensive margin (systematic under‑reporting), pairing credible audit probability with fair procedures that strengthen tax morale. Third, reduce scope for reranking by smoothing transitions into formality (e.g., phase‑in designs that avoid sharp cliffs) and by improving data integration so that policy targets vertical redistribution rather than unintended reshuffling. Fourth, further policy consideration concerns the implications of informality for the redistributive role of public spending. The presence of informality induces a reranking of individuals within the income distribution, thereby undermining the effectiveness of redistribution when it is based on distorted indicators such as declared income. As a result, public spending may inadvertently reinforce, rather than reduce, existing inequalities. To mitigate this risk, redistributive transfers should be designed with reference to more robust indicators of actual need (such as multidimensional measures of non-monetary deprivation) rather than exclusively relying on reported low income levels. Taken together, these steps would shrink the role of evasion, retain the insurance value of marginal informal earnings for low‑income households, and deliver a more legitimate, progressive, and horizontally fair tax‑benefit system.