Narrowing time windows to study effects of tax policies on GDP and the underground economy: Italy 1982 to 2006

Studies of the effect of tax changes on GDP and the underground economy, UGE, give ambiguous results when correlation techniques are applied to long, observed time series. Here, we apply a novel technique that identifies time windows in linearly detrended tax rate time series where tax changes are leading variables to GDP and to UGE and thereby candidate causes. With the raw series for GDP and UGE in Italy, 1982 to 2006 linear regression showed that increasing taxes increased GDP whereas the effects on UGE were ambiguous. With restricted time windows, the net effect of increased personal and corporate tax rates was decreased GDP, and increased UGE. In 10 out of these time windows major tax shocks coincide with the leading relation. Tax shocks set up 3 to 6 years long cycles in tax rates that precede corresponding cycles in UGE and GDP with 1 to 4 quarters. We also added insights into 3 conjectures related to taxation and UGE; the existence of multiple equilibriums in UGE, delayed response to tax evasion control and the Yitzhaki tax evasion puzzle. For the two last conjectures, a delayed economic response to tax policies that is greater than ¼ of the common cycle length seems to be important.