The Mmeasurement of Underground Economy: A Dynamic-Simulation Based Approach

This paper presents a theoretical contribution to model and dynamically analyze underground economy. We build a DSGE model with two sectors and one homogeneous good produced either by the sunlight and the underground firm. The sunlight firm is subject to distortionary taxation, whereas the underground firm evades taxation. The economy is subject to stochastic uncorrelated technology shocks on total factor productivity on private sectors and public labor. The demand side of the economy is populated by an infinite number of households with preferences defined over legal good consumption, public expenditure and labor services on a period-by-period basis. The government collects taxation from the sunlight sector and fights tax evasion through audit activity undertaken by public officers. When detected, underground firms are subject to regular taxation and additional fine payments. We simulate the model under the productivity shocks for Italy, over the sample 1974:01-2011:02. We find that in Italy underground economy share of GDP is on average about 23%. The dynamic behavior of the model shows that: (i) an efficient audit activity has a negative impact on public accounts thus generating a tradeoff between the reduction of underground economy and the worsening of public finance; (ii) sunlight production has a greater relative volatility with respect to undeground production; iii) all variables of the underground sector appear to be negatively correlated with the corresponding ones of regular economy. This implies that underground activity is a sort of buffer for the economy, whenever the business cycle is in downturn phases.