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An Analysis of the Underground Economy and Its Macroeconomic Consequences

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Author Info
Era Dabla-Norris
Andrew Feltenstein

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Abstract

This paper develops a dynamic computable general equilibrium model in which optimizing agents evade taxes by operating in the underground economy. The cost to firms of evading taxes is that they find themselves subject to credit rationing from banks. Our model simulations show that in the absence of budgetary flexibility to adjust expenditures, raising tax rates too high drives firms into the underground economy, thereby reducing the tax base. Aggregate investment in the economy is lowered because of credit rationing. Taxes that are too low eliminate the underground economy, but result in unsustainable budget and trade deficits. Thus, the optimal rate of taxation, from a macroeconomic point of view, may lead to some underground activity.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 03/23.

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Length: 26 pages
Date of creation: 28 Feb 2003
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Handle: RePEc:imf:imfwpa:03/23

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Keywords: Banking ; Consumption ; Credit ; Economic models ;

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Blejer, Mario I. & Feldman, Ernesto V. & Feltenstein, Andrew, 2002. "Exogenous shocks, contagion, and bank soundness: a macroeconomic framework," Journal of International Money and Finance, Elsevier, vol. 21(1), pages 33-52, February. [Downloadable!] (restricted)
  2. Simon Johnson & Daniel Kaufman & Andrei Shleifer, 1997. "The Unofficial Economy in Transition," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 28(1997-2), pages 159-240. [Downloadable!]
  3. Sarte, Pierre-Daniel G., 2000. "Informality and rent-seeking bureaucracies in a model of long-run growth," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 173-197, August. [Downloadable!] (restricted)
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  4. Burgess, Robin & Stern, Nicholas, 1993. "Taxation and Development," Journal of Economic Literature, American Economic Association, vol. 31(2), pages 762-830, June. [Downloadable!] (restricted)
  5. Ball, Sheryl & Feltenstein, Andrew, 2001. "Bank failures and fiscal austerity: policy prescriptions for a developing country," Journal of Public Economics, Elsevier, vol. 82(2), pages 247-270, November. [Downloadable!] (restricted)
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  6. Mehnaz Ahmed & Qazi Masood Ahmed, 1995. "Estimation of the Black Economy of Pakistan through the Monetary Approach," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 34(4), pages 791-807. [Downloadable!]
  7. Loayza, Norman V., 1996. "The economics of the informal sector: a simple model and some empirical evidence from Latin America," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 45(1), pages 129-162, December. [Downloadable!] (restricted)
  8. Kiyotaki, Nobuhiro & Moore, John, 1997. "Credit Cycles," Journal of Political Economy, University of Chicago Press, vol. 105(2), pages 211-48, April.
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  9. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. M. Ali Kemal, 2007. "A Fresh Assessment of the Underground Economy and Tax Evasion in Pakistan: Causes, Consequences, and Linkages with the Formal Economy," PIDE-Working Papers 2007:13, Pakistan Institute of Development Economics. [Downloadable!]
    Other versions:
  2. Vesa Kanniainen & Jenni Pääkkönen, 2004. "Anonymous Money, Moral Sentiments and Welfare," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
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