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Tax evasion, the underground economy and financial development

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  • Blackburn, Keith
  • Bose, Niloy
  • Capasso, Salvatore

Abstract

We study the relationship between the underground economy and financial development in a model of tax evasion and bank intermediation. Agents with heterogeneous skills seek loans in order to undertake risky investment projects. Asymmetric information between borrowers and lenders implies a menu of loan contracts that induce self-selection in a separating equilibrium. Faced with these contracts, agents choose how much of their income to declare by trading off their incentives to offer collateral against their disincentives to comply with tax obligations. The key implication of the analysis is that the marginal net benefit of income disclosure increases with the level of financial development. Thus, in accordance with empirical observation, we establish the result that the lower is the stage of such development, the higher is the incidence of tax evasion and the greater is the size of the underground economy.

Suggested Citation

  • Blackburn, Keith & Bose, Niloy & Capasso, Salvatore, 2012. "Tax evasion, the underground economy and financial development," Journal of Economic Behavior & Organization, Elsevier, vol. 83(2), pages 243-253.
    • Handle: RePEc:eee:jeborg:v:83:y:2012:i:2:p:243-253
    DOI: 10.1016/j.jebo.2012.05.019
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    More about this item

    Keywords

    Tax evasion; Shadow economy; Financial development;
    All these keywords.

    JEL classification:

    • E26 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Informal Economy; Underground Economy
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • H26 - Public Economics - - Taxation, Subsidies, and Revenue - - - Tax Evasion and Avoidance
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
    • O17 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements

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