In many transition countries, a considerable part of economic activity takes place in the informal
sector. On the other hand, tax evasion constitutes a major problem and causes improvements
to all levels of the informal sector in which the volume of the informal sector in transition
countries is much higher than in developed countries. Previous works have examined separately
both the determinants of the size of the informal sector and the determinants of tax evasion
for transition countries. But, this paper complements these significant works by examining cross
sectional analysis based on firm-level data for South Caucasian countries. In addition, our paper
has a new contribution to previous works by providing some empirical evidence for informality
and tax evasion with the quality of business environment. Building on a simple analytical framework,
we test the channels affecting the degree of informality in South Caucasian countries and
vice versa, the channels affecting the degree of tax evasion. We use instrumental variable OLS
and find that the extent of informality is determined by tax evasion, as well as the extent of
tax evasion is determined by the informality for these countries. In addition, we find that the
business environment has implications for both informal economy and tax evasion. These results
suggest generally ameliorating the business environment in South Caucasian countries, while
strengthening an access to land and financial sources, adequate provision of public capital such as
telecommunication, transport and electricity infrastructure will reduce informality, reigning the
corruption, tax administration and labor regulation will reduce tax evasion and ultimately lead
to increasing government revenue collections.