The Welfare Cost of the Underground Economy

Abstract

This paper estimates the welfare cost of taxes that create an incentive for resources to flow to the underground, or untaxed, sector in the United States. Using a general equilibrium model of the American economy, the welfare cost is found to be large and growing in absolute and relative terms over time. In 1980 the welfare cost may be as much as $220 billion, or over 9 percent of output; even conservative estimates place the loss at nearly $100 billion. It also is found that small reductions in tax rates substantially reduce the welfare cost.

Is there a displacement deadweight loss from tax evasion? Estimates using firm surveys from the Czech Republic

“…Our final step was to apply Palda's model to our data on the joint distribution of efficiency and tax honesty in order to calculate DDL. We found that a DDL comparable to the measures of deadweight loss calculated by Alm (1985).…”

“…With these ideas in mind Loayaza (1996) modeled the underground economy and found that it could reduce economic growth if this economy reduced the availability of public services to all. Alm (1985) saw the main cost of the tax evasion as being the fact that the absence of tax in the underground economy drives a wedge between the marginal product of labour in the underground economy and the marginal product of the same labour in the taxed economy. This wedge means that society's overall product would be higher if labour moved back to the taxed economy.…”

“…3) Is displacement deadweight a phenomenon of comparable importance to, say, Alm's (1985) deadweight loss from evasion? Alm found deadweight losses of 9% for the US.…”

Efficient black markets?

“…Given the potential for welfare improvements, these results are not fully consistent with the large welfare losses from a black market identified by Alm (1985), who assumes a labor-intensive back market (see Footnote 3), or with Slemrod and Bakija's argument, described in our introduction. Alm and Rosen also identify circumstances under which a black market may be increase welfare, but their description of welfare-improving black markets seems more closely related to our welfare-worsening black markets at low quality levels.…”

“…3 Using U.S. data from 1980, Alm (1985) estimated the efficiency losses from the diversion of resources into the underground economy to lie between 100 billion and 220 billion dollars per year, where the latter figure represented nine percent of GDP. Both Alm's calculations and Kesselman's (1989) qualitative results about the extent and incidence of tax evasion are based on general equilibrium models in which tax evasion is associated with the production of particular goods.…”