## An Analysis of the Underground Economy and its Macroeconomic Consequences

_IMF Working Papers, January 1, 2003_

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## Bibliographic details
- Authors: Era Dabla-Norris, Andrew Feltenstein
- Published: January 1, 2003
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451844061.001

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### Model and approach
- Develops a dynamic computable general equilibrium model in which optimizing agents evade taxes by operating in the underground economy.
- Evasion feature: firms that evade taxes face credit rationing from banks as the cost of operating underground.
- Model simulates economy-wide interactions between tax policy, underground activity, credit allocation, investment, and external balances.

### Core findings
- In the absence of budgetary flexibility to adjust expenditures, raising tax rates too high drives firms into the underground economy, thereby reducing the tax base.
- Aggregate investment in the economy is lowered because of credit rationing affecting firms that operate underground.
- Taxes that are too low eliminate the underground economy, but result in unsustainable budget and trade deficits.
- The optimal rate of taxation, from a macroeconomic point of view, may lead to some underground activity.

### Policy implications and trade-offs
- There is a non-monotonic relationship between tax rates and observed tax revenue: excessively high tax rates can reduce the effective tax base by incentivizing tax evasion.
- Budgetary flexibility to adjust expenditures can mitigate distortions from high tax rates; without such flexibility, higher tax rates risk enlarging the underground economy.
- Policymakers face a trade-off between reducing underground activity and maintaining sustainable fiscal and external positions; setting tax rates too low may remove evasion but create unsustainable deficits.
- Credit market frictions amplify the macroeconomic costs of underground activity by restricting firm investment through credit rationing.

### Publication and metadata
- Authors: Era Dabla-Norris, Andrew Feltenstein
- Publication date: January 1, 2003
- Series: Working Paper No. 2003/023
- Issue: 023
- Volume: 2003
- Pages: 26
- DOI: https://doi.org/10.5089/9781451844061.001
- Stock No: WPIEA0232003
- ISBN: 9781451844061
- ISSN: 1018-5941
- Subject: Banking; Budget planning and preparation; Economic sectors; Government debt management; Informal economy; Labor; Public financial management (PFM); Revenue administration; Tax evasion
- Keywords: Budget planning and preparation; capital tax; credit rationing; firm capital; firm's capital; Government debt management; implied ownership; Informal economy; macro economy; savings rate; Tax evasion; tax rate; Underground economy; WP

*Source: IMF Working Paper "An Analysis of the Underground Economy and its Macroeconomic Consequences" by Era Dabla-Norris and Andrew Feltenstein (Working Paper No. 2003/023).*

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/30/an-analysis-of-the-underground-economy-and-its-macroeconomic-consequences-16274_