Tax reforms and the underground economy: a simulation-based analysis

Abstract

This paper studies the effects of several tax reforms in an economy where taxes are partially evaded by means of undeclared work. To this purpose, we consider a two-sector dynamic general equilibrium model calibrated to Italy which explicitly accounts for underground production. We construct various tax reform scenarios, such as ex ante budget-neutral tax shifts from direct to indirect taxes, and tax cuts on labor and business financed by decreases of government spending. Our results indicate that neglecting the existence of the underground sector may lead to severely miscalculating the macroeconomic effects of tax reforms. Further, the dimension of the underground sector is permanently and considerably reduced by changes in the tax mix that diminish the labor tax wedge. Reductions of the business tax prove to be highly expansionary in the presence of a sizable informal sector.Keywords Dynamic general equilibrium model · Underground economy · Tax reforms · Italy JEL Classification E62 · O41 · O52 Electronic supplementary material The online version of this article (

Noncompliant behaviors in general equilibrium: A survey

“…The underlying mechanism is a reallocation of resources to the formal sector. This mechanism also appears in Annichiarico and Cesaroni (2018), who examine in a two-sector DGE model calibrated to Italy the effects of several tax reform scenarios in an economy with an underground component. Unlike Ferrara et al (2022), they assume that the real stock of public debt is kept constant at its initial baseline level.…”

“…Nevertheless, there are some exceptions to the standard modeling choices regarding informal labor detection. In Granda‐Carvajal (2012) and Annichiarico and Cesaroni (2018), monitoring activity is applied to household tax evasion as well. In particular, households and firms face the same probability of being detected and pay the same penalty if detected.…”

“…Importantly, the allocation of agents’ time between reported and nonreported activities—rather than simply between labor and leisure, as in standard models—raises business cycle issues that traditional schemes often neglect. Therefore, ignoring aspects related to theoretical models not only implies disregarding an important channel for macroeconomic fluctuations (Conesa et al., 2002; Busato & Chiarini, 2004) but might also suggest misleading policy recipes (Annichiarico & Cesaroni, 2018). Alm (2019) emphasizes that only considering NCBs allows us to understand the real effects of taxation.…”

Determinants of the Shadow Economy in the Czech Regions: A Region-Level Study

“…These methods include the structural equation model (SEM) and the dynamic stochastic general equilibrium (DSGE) model. The former examines statistical links between observed and unobserved variables (see, for example, Frey and Weck-Hanneman (1984), Buehn (2011), Wiseman (2013), whereas the latter is based on the rational behavior of agents (see, for example, Orsi et al (2014), Argentiero and Bollino (2015), Pappa et al (2015), or Annicchiarico and Cesaroni (2016)). …”

Relation between tax wedge and employment rate: The case of OECD countries

“…Tax wedge can be decreased by lowering taxes on labour and covering the revenue loss with higher indirect taxes and recurrent taxes on personal immovable property (André and Hwang, 2018). Namely, a lower tax wedge on labour leads to a relevant growth in labour performance (Annicchiarico et al 2017).…”