Sovereign Default, Taxation, and the Underground Economy

Almuth Scholl () and Liang Tong ()
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Almuth Scholl: Department of Economics, University of Konstanz
Liang Tong: Department of Economics, University of Konstanz

No 2020-02, Working Paper Series of the Department of Economics, University of Konstanz from Department of Economics, University of Konstanz

Abstract: This paper studies the dynamic interaction between sovereign default risk, taxation, and the underground economy. For a large sample of countries, we find that the size of the underground economy is positively correlated with sovereign debt and interest spreads. We rationalize these empirical regularities within a quantitative model of sovereign default that explicitly accounts for underground activities. We highlight a vicious circle: Higher sovereign risk premia tighten the endogenous borrowing constraint and force the government to raise taxes. Tax hikes, however, induce the private sector to invest less and to evade taxes by producing in the underground sector. Eventually, falling tax revenues force the government to either implement further tax hikes or to default. Our quantitative findings suggest that the underground economy fosters sovereign default risk and deepens debt crises.

Keywords: sovereign debt; default; fiscal policy; underground economy; tax evasion (search for similar items in EconPapers)
JEL-codes: E62 F34 H26 (search for similar items in EconPapers)
Date: 2020-08-03
New Economics Papers: this item is included in nep-dge, nep-iue, nep-mac and nep-pub
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Citations: View citations in EconPapers (3)

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