It is widely recognized that one major effect of taxation is to stimulate activities in the so-called underground (or shadow) economy. Indeed, the extent of underground activities even in the Western countries is by no means negligible: Schneider and Enste (2000) report that the size of the shadow economy as percent of gross domestic product (GDP) in the Organisation for Economic Co-operation and Development (OECD) countries in 1996 ranged from 7.5% in Switzerland to 28.5% in Greece. This existence of underground activity is a significant source for concern. The possibility of evading taxes makes taxation less efficient; by undermining the tax base this possibility may jeopardize long-run scope for financing adequate public services. Furthermore, it implies that official measures of, for example, income and unemployment, which form the basis for policy, will necessarily be biased.
The purpose of this article is to suggest a simple micro-founded framework for studying the relationship between tax policy and underground economic activities. A defining characteristic of the latter is that they are illegal. (1) The traditional approach, starting with the seminal contribution of Allingham and Sandmo (1972), characterizes tax evasion as an activity for which there is a risk of detection. (2) This approach, however, does not particularly highlight that underground economic activity involves trade. We argue that although underground economic activities and regular activities are similar and can coexist, one effect of the illegal status of the former is to differentiate the amount of information that is available in the two market segments. Whereas information about trading opportunities in regular markets can be assumed to be perfect, because underground activity is (by definition) furtive, information about trading opportunities in this segment will be less than perfect.
Traditionally, search theory has been used to capture the notion of imperfect information in markets. This has a natural interpretation in the current context: Though trading in the regular market can be regarded as frictionless, an agent wishing to trade in the underground sector must devote some time and effort to locating "trustworthy" trading partners with whom he or she can trade illegally at no risk. Hence we model underground trade as the outcome of a standard bilateral search process where buyers and sellers devote some time to locating each other (and, implicitly, verifying each others' 'trustworthiness'). (3) This process--individually rational when facing taxes--is a socially wasteful activity because it subtracts effort from physical production.
The model identifies a natural link between participation in the underground economy and individual characteristics. This is important for analysis of micro-level data. Our model suggests that individuals with lower earnings capacity are more active in underground economic activities; hence, the model predicts a negative correlation between individual participation in the underground economy and, for example, hourly wage and education. From the evidence that is available, this seems consistent with the data. (4) The current model can be used as a framework for future empirical work using micro-data because it can fairly easily be extended to include other features, such as unemployment and variation across industries in the technology available for underground production, to make further predictions about individual involvement in underground activities.
The systematic relation between earnings capacity and participation in the underground economy is also relevant for policy design. Consider the implementation of a redistributive tax; although the tax aims at improving the welfare of the individuals with low earnings capacity, the same individuals can benefit from trading in a relatively large underground economy if the tax is only mildly enforced. …