Fiscal policy and underground economies: there may be no easy answers

AuthorEra Dabla-Norris
PositionIMF Institute
Pages212-213

Page 212

There is a widespread belief that underground economies arise from high statutory tax rates and excessive, but poorly enforced, government regulation.

Whatever their causes, underground economies can impede macroeconomic performance and undermine economic growth. A recent IMF Working Paper, "An Analysis of the Underground Economy and Its Macroeconomic Consequences," by Era Dabla-Norris and Andrew Feltenstein, explores the interaction between fiscal policy, underground economies, and economic performance.

Underground economies-that part of the economy operating outside the reach of official registration and taxation-can have a substantial and costly impact on the performance of many developing and transition countries. Sizable underground economies, for example, can siphon off considerable revenue, adversely affect public finances, and significantly diminish the quality of public administration. Lost government tax revenues can also translate into larger budget deficits that, in turn, can lead to higher public borrowing requirements and crowd out private investment.

In addition, the illegal nature of underground activity often deters private investment and constrains growth. The efforts that firms make to avoid detection can generate distortions and result in misallocated resources.Moreover, firms operating underground are typically unable to use market-supporting institutions, such as the judicial system, and may, as a result, underinvest. Clearly, one important cost imposed by the inability to enforce legal contracts is limited access to formal credit markets.

Causes and costs

What are the consequences of the underground economy for public finances and aggregate economic performance?

In particular, what encourages businesses to enter the underground economy, and what role can appropriate tax rates and interest rates play in encouraging firms to exit the underground economy and join the formal economy?

Using a simple general equilibrium model, this study explores the link between tax rates, access to credit, and the size of the underground economy. It assumes that firms will enter and exit the underground economy when it is most advantageous to do so and models the benefits derived from operating in the underground economy in terms of a firm's desire to evade corporate taxes. In many developing countries, taxes on formal firms constitute a major source of government...

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