RICERCA ITALIANA     

Macroeconomic and Policy Implications of Underground Economy and Tax Evasion

Università degli Studi di Napoli "Parthenope"

Abstract

The project research aims to investigate several fiscal policy aspects under a sizeable underground economy and tax evasion. In particular, we plan the following:
1) A dynamic general equilibrium structure in order to analyse a) the inter-relationships between underground sector-tax evasion and fiscal policy, in the long run and in the short run; b) sunspot effects that an underground production along with regular production, may generate under certain circumstances.
2) An analysis of optimal taxation policies under tax evasion using concepts and theorems belonging to the dynamic game theory (markovian perfect equilibria)
3) Partial dynamic equilibrium models for studying the effects of fiscal amnesties upon the firms’ behaviours which are able to operate in both the sectors (regular and underground)
4) Microeconomic models useful to estimate some dimension of the underground production, taking into account the relationship between regular firms and illegal economy. <<<

Principal Investigator

Bruno Chiarini Università degli Studi di NAPOLI "Parthenope"

Research Objectives

The research aims to investigate the relationship between fiscal policy, underground economy and tax evasion. We plan to study four aspects of this relationship: positive (Research unit 1); theoretical (Research unit 2); normative (Research unit 3) and empirical (Research unit 4).
We aim to study the macroeconomic and microeconomic implications and the dynamics effects of the fiscal policy under tax evasion. Precisely, we investigate on: the effects of tax policies under underground economy and the effects of fiscal amnesties (Research unit 1); the possibility that the economy may generate aggregate externalities in presence of an underground sector (Research unit 2); the time consistent and optimal tax policy under tax evasion (Research unit 3); the real motivations that lead firms to operate in the underground and illegal sectors (Research unit 4).

Studying these aspects is crucial for understanding the industrialized economies (and, in particular, the Italian economy) which show a sizeable share of resources employed in the underground economy and, therefore, a relevant tax evasion. Thus, the proposed research aims also to fill the gap in the scientific literature, providing some theoretical and methodological works and some policy suggestion. This work should be useful to better outline the phenomenon and the relative policy analysis.
The methodological frameworks which the plan project should calling for are the following:
1) Construction and simulation of dynamic general equilibrium models. This scheme is required to analyse the following aspects:
a) The study of the equilibrium and short-run analyses of the relationship between underground economy, tax evasion and fiscal policy. In particular, the simultaneous causality between tax evasion and fiscal policy may be investigated both theoretically and quantitatively: on one side, the direct causality between (the burden of) taxation and the shadow economy and income tax base; from another side, the real effect (and the tax base effect) of a tax policy when a relevant part of the resources operates under the ground and is determined by the resources allocation between sectors (market and underground) (Research unit 1)
b) The analysis of the relationship between distortionary taxation, tax evasion and indeterminacy of the equilibrium. Under certain circumstances, the underground sector may generate sunspots and very peculiar equilibria and dynamic effects (Research unit 2).

2) Construction and simulation of dynamic partial equilibrium models (optimal investment) for analysing the effects of fiscal amnesties on firms behaviour in presence of an underground sector. (Research unit 1);
3) Construction and simulation of a theoretical model for analysing optimal (and consistent) taxation under tax evasion in a dynamic game context.
4) Construction and estimation of microeconomic models for analysing the relationship between illegal, underground and formal firms and evaluate the policy measures. <<<

Timescale

24 months

National and international background

The estimation of the real size of the underground economy and the relative tax evasion is a difficult task, (Chiarini and Marzano 2004), nonetheless several interesting considerations apply in economies characterized by a sizeable underground sector, both for policy makers and for researchers (Feige 1989; Frey and Pommerehne 1984; Schneider 1994; Tanzi 1999; Thomas 1992, 1999; Giles 1999, Schneider and Enste 2000; Busetta and Giovannini 1998). As stressed by Schneider and Enste (2000,2002), and by several authors within the recent Economic Journal symposium (EJ vol. 109, 1999, see Thomas, Bhattacharyya, Tanzi, Giles), the underground economy is a sizeable and increasing phenomenon both in terms of output produced and labour input employed in all the OECD economies.


Among the most important studies on the underground economy there is the literature on the reaction of firms and households who are pushed to cope with the informal sector by complex tax systems and taxation and social security burden. Many others, aim to show the implication of the underground behaviour for the dynamic of the budget deficits and taxation. A further subject investigated by the literature on the black economy is the unreliability of the official statistics on production, employment and unemployment (Tanzi 1999; Thomas 1999; Chiarini and Marzano 2004). Some others research have dealt with the analysis of the labour market (Boeri and Garibaldi 2001, 2005; Bianco, 2002; Lucifora, 2003; Marzano, 2004), as well as with the role of regulation (Loayza 1996; Jhonson, Kaufmann and Zoido-Lobaton 1998; Friedmann, Jhonson, Kaufmann and Zoido-Lobaton 1999; Bovi 2002). Others authors have investigated the impact of an irregular sector for the economic growth (Carillo and Pugno 2002; Carillo and Papagni 2002, Dessy and Pallage 2003; Di Domizio 2003).


With regard to the research project, the scientific background of the research units'objectives, is as follows:


1)Fiscal Policy (Research unit 1)
Surprisingly, a bulk of the existing literature about EMU economic structure, as well as the empirical and theoretical literature about European labour market and fiscal policy, do not consider properly the presence of the irregular sector. Differences in economic performance among euro-area Members States are related to several sources. Cyclical divergences are also investigated within adjustment schemes in which dynamics due to price and wage rigidities are crucial factors. The importance of economic adjustment in cyclical divergences depends, in this traditional literature, on the extent to which countries are susceptible to idiosyncratic shocks and on the characteristics of the adjustment process, whereas the shadow economy and its dynamic implication for economic policy is completely neglected (to this end, see for instance, the articles in the European Commission Economic Papers and Economic Policy).
Although the existing wide range of analysis, we think that there is a lack in the literature on the effects and the implications of a large and increasing size of the underground economy on dynamic attitudes of agents and on economic policy performances. With the exception of a recent paper of Busato and Chiarini (2004), where the optimal resources re-allocation mechanism between formal and informal sector is investigated in a general equilibrium scheme, literature in this field is quite inexistent, and there are a few models able to explain the dynamic attitude of firms and households toward the irregular sector of the economy. Even more rare are the analyses on the relationship between underground economy, tax evasion and fiscal policy, although policy implications for extensions of canonical general equilibrium models with taxation and home production are studied and discussed (see for instance Cooley 1995, MacGrattan 1994; 2006; King and Rebelo 1999; Rebelo 2005).
However, the Research unit 1 project aims to give a contribution in a new and very promising area, to better explain the real effects of taxation in the short and long run.

2)Fiscal Amnnesties (research unit 1)
A large part of the literature has focused the attention on the economics of fiscal amnesties (Alm and Beck, 1990; Franzoni, 1996), considering the decision to evade as a lottery (Alligham and Sandmo, 1972, Yitzhaki, 1974; Cowell, 1990). There is no general agreement on the efficiency of tax amnesties, since some authors find that permanent tax amnesty may actually increase, rather than decrease, the efficiency and equity of the tax system (Andreoni, 1991) while some others stress that different typologies of amnesties may have different final effects (Franzoni,1996; Macho-Stadler et. al. 1999; Marchese e Privileggi, 1997). However, so far no author has explicity considered the technology available to tax evaders, since revenues are ususally set as exogenous. Following Busato et al (2005), we argue that firms which do not comply with fiscal rules may adopt different technologies and, consequently, they may react differently to fiscal amnesties.


3) Sunspot effects under undeground economy (Research unit 2)
Traditional one-sector models characterized by aggregate externalities of production show a relevant limit: these models present local indeterminacy of the equilibrium only if labor demand curve describe a growing relation between labor and wage. This relation do not find support in micro and macro stylized facts.
Recent literature has suggested different solutions to this problem. Some examples are the introduction of mechanisms as the factor hoarding (Wen, 1998), the distinction between capital-good producing sectors and consumption-good producing sectors (Benhabib and Farmer, 1996), the introduction of another production sector (Guo and Lansing, 2004; Perli, 1998).
We are not aware of other studies concerning the analysis of these dynamic effects (local indeterminacy of the equilibrium)on behaviours and business-cycle fluctuations under undeground economy.


4)Optimal fiscal policy and time inconsistency (Research unit 3)
The macroeconomic literature on the "equilibrium approach to fiscal policy" studies effects of fiscal policy disturbances within neoclassical growth models: Aschauer (1988), Barro (1989), and Baxter and King (1993) are seminal contributions sharing an emphasis on the supply-side response of labor and capital to shifts in government demand and tax rates. Recent related contributions are: Braun (1994), McGrattan (1994), Mountford and Uhlig (2005), and Burnside Eichenbaum and Fisher (2003). Another strand of the literature studies optimal fiscal policy in a dynamic and time-consistent framework: Klein and Rios-Rull (2003), Klein, Krusell, and Rios-Rull (2004), Klein, Quadrini, and Rios-Rull (2005), Ortigueira (2006), are some recent examples. This literature focuses on the quantitative difference between fiscal regimes under different assumptions on the ability of governments to implement credible and time consistent policies.
None of these contributions, however, evaluates the macroeconomic effect of fiscal policy explicitly incorporating tax evasion and underground activities. McGrattan, Rogerson and Wright (1994) study fiscal policy effects in a dynamic general equilibrium model for the U.S. economy augment with an household production sector. The model reveals the significant influence of household production in its affection on official variables. It generates different predictions for the effects of tax changes than similar models without household production. Notice, however, that an underground sector significantly differs from an household production sector. More recently, Busato, Chiarini and Rey (2005) study the equilibrium effects of fiscal policy disturbances within a dynamic general equilibrium model where tax evasion and underground activities are explicitly incorporated. This contribution, however, does not focus on optimal fiscal policies. Other examples of papers that analyze the dynamic implications of tax evasion in simplified frameworks (in partial or general equilibrium) are Renström (1998), Boadway and Keen (1998), and Niepelt (2004).

5)Microfoundation of estimation (Research unit 4)
The international organizations has decided to include the non-observed economy (NOE, i.e. the illegal economy, the underground economy and the informal economy) in national accounts data. The official statistics institutes have been asked not only to estimate the value added of the NEO but also in fact to complete the national accounts frameworks for demand, the distribution of value added and employment by supplying a disaggregation consistent with that of the official economy.
The NOE consists of small and micro firms, mainly labor-intensive, operating in protected sectors and having few dealings with the public administrations.
The economists who have studied this sector have dwelt on the decision of the entrepreneur and/or worker to operate, placing legal and regulatory compliance among the options (see, among others, Cowell 1990 for a theoretical survey and Busato and Chiarini 2004 for some empirical simulations). That is to say, the institutional framework is not a constant, but a variable among the determinants of the expected profit function to be maximized, the probability of incurring and the amount of the sanction being given.
The methods used for estimating the NOE have focused on a few aggregated variables, most commonly, money demand and electricity consumption (see for a survey Schneider and Enste 2000 and 2002; Thomas 1999 among others). These methods may perhaps be useful for countries lacking a longstanding tradition of national accounts, and for international comparison but now are inadequate to meet the requirements of the UN and EUROSTAT handbook and also the official statistical institute are in difficulty because now the issue is on the quality of statistics and there is a lack of adequate methodology and of experience.
The fieldwork and econometric analyses performed by individual researchers continue to have relevance, but attention is shifting to the methodology and to the implications of explicit estimation of non-observed data for econometric modeling and economic policy.
The studies on the behavior of economic agents who, either voluntarily or out of necessity, evade tax obligations and do not comply with the rules remain open. As is right and proper, the issues of efficiency and equity raised by the coexistence of these two parts of the economic system are being pondered. <<<