We document cross-country differences in informal activity, government policies and institutions using a data set covering 118 countries. Five key facts emerge: better institutions are associated with lower inflation, higher income tax rates and less informal activity and higher levels of informal activity are associated with lower income tax rates and higher inflation. We develop a general equilibrium model where households optimally choose the extent of informal activity and a benevolent government optimally chooses policies, both taking as given the institutions of the economy.