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The underground economy and its macroeconomic consequences

  • Era Dabla-Norris
  • Andrew Feltenstein

This study develops a dynamic 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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Article provided by Taylor & Francis Journals in its journal Journal of Economic Policy Reform.

Volume (Year): 8 (2005)
Issue (Month): 2 ()
Pages: 153-174

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Handle: RePEc:taf:jpolrf:v:8:y:2005:i:2:p:153-174
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  1. Pierre-Daniel G. Sarte, 1999. "Informality and rent-seeking bureaucracies in a model of long-run growth," Working Paper 99-07, Federal Reserve Bank of Richmond.
  2. Dessy, Sylvain & Pallage, Stephane, 2003. "Taxes, inequality and the size of the informal sector," Journal of Development Economics, Elsevier, vol. 70(1), pages 225-233, February.
  3. Stephane Straub, 2004. "Informal Sector: The Credit Market Channel," ESE Discussion Papers 101, Edinburgh School of Economics, University of Edinburgh.
  4. John Moore & Nobuhiro Kiyotaki, . "Credit Cycles," Discussion Papers 1995-5, Edinburgh School of Economics, University of Edinburgh.
  5. Burgess, Robin & Stern, Nicholas, 1993. "Taxation and Development," Journal of Economic Literature, American Economic Association, vol. 31(2), pages 762-830, June.
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