Steady State Laffer Curve with the Underground Economy

Abstract:     
This paper studies equilibrium effects of fiscal policy within a dynamic general equilibrium model where tax evasion and underground activities are explicitly incorporated. In particular, we show that a dynamic general equilibrium with tax evasion may give a rational justification for a variant of the Laffer curve for a plausible parameterization. In this respect, the paper also identifies the different parameterization of the model formulation with tax evasion under which a Laffer curve exist. From a revenue maximizing perspective, the key policy messages are that bringing tax payers to compliance would be better than announcing to punish them if convicted, and that an economy without problems of compliance is much more sensitive to myopic behavior.

Keywords: two-sector DGEM models, fiscal policy, tax evasion, underground activities

JEL Classifications: E32, E13, H2, E26

Working Paper Series