An Analysis of the Underground Economy and its Macroeconomic Consequences

Era Dabla-Norris and Andrew Feltenstein ()

No 2003/023, IMF Working Papers from International Monetary Fund

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.

Keywords: WP; tax rate; credit rationing; Underground economy; capital tax; savings rate; firm's capital; firm capital; implied ownership; macro economy; Informal economy; Government debt management; Tax evasion; Budget planning and preparation (search for similar items in EconPapers)
Pages: 26
Date: 2003-01-01
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Citations: View citations in EconPapers (13)

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