Tax Policy and the Underground Economy

Abstract

Once the underground economy is taken into account, there is a whole new layer of complexity to tax policy. In effect, it means that individuals can sometimes choose to "opt out" of the tax system. Taxes that may seem to be optimal without the underground economy may no longer be optimal once it is taken into consideration. The underground economy in this context should also be considered to include informal activities such as barter and household production that avoid taxation. Taxes that lead people to opt out of the formal economy usually cause lower productivity due to reduced specialization and diseconomies of small scale. Careful empirical analysis of elasticities of response are the key to good tax policy that takes into account the reality of tax evasion. There is no simple universal answer to what is the best tax policy. The answer will vary for different countries, depending on their pre-existing tax policies and institutions.

Keywords: underground economy, informal economy, tax evasion, productivity

JEL Classification: H21, H26