Tax reforms and the underground economy: a simulation-based analysis

Of course there are other factors playing an important role, such as the possibility of tax avoidance, which affects the extent of tax evasion and, therefore, the size of the underground economy. See, e.g., Neck et al. (2012).

Along this line of research, see Feltenstein and Shamloo (2013).

A laudable exception is given by the recent contribution of Pappa et al. (2015) who study the effects of fiscal consolidation accounting for the presence of tax evasion and corruption. In their analysis, conducted for Greece, Italy, Portugal and Spain, they unambiguously show that the recent consolidation plans introduced in these economies tend to increase tax evasion.

In doing so we enrich the analysis of Busato et al. (2012) who focus on the effects of tax reductions on labor and income, with public spending being determined endogenously so as to preserve the balance of the public budget constraint at all times.

In this respect, through the use of a macroeconomic model embodying an underground sector, this paper contributes to the vast literature studying the effects of tax distortions and measuring the impact of tax reforms involving tax shifts or changes in public spending met by adjustments in taxes (see e.g. Baxter and King 1993, Mendoza and Tesar 1998, Leeper and Yang 2008).

See the OECD Tax Database available online at https://​data.​oecd.​org/​tax/​tax-wedge.​htm. The tax wedge is measured as the ratio between the amount of taxes paid by a single worker at 100% of average earnings without children and the corresponding total labor cost borne by the employer.

This value arises when considering only the market economy, that is excluding the non-market services provided by Public Administrations. When the latter are included, the estimate of the underground economy reduces to 17.5% of GDP. See ISTAT (2010).

This discrepancy of estimates can be partly explained by the fact that different definitions of the shadow economy entail different measurements. For instance, Buehn and Schneider (2016) claim that explicit shadow activities—that is, shadow activities from ‘black’ hours worked—only account for about one third of the shadow economy. See also Zizza (2002) for further details.

The model abstracts from international mobility of productive factors. Yet illegal immigration and the size of the informal sector in the destination country are strongly intertwined, as shown by Dell’Aringa and Neri (1987) for the Italian economy. For a comprehensive analysis on Southern Europe, see Baldwin-Edwards and Arango (1999). For a nice theoretical model dealing with this unexplored aspect and the implied economic policy implications, see Camacho et al. (2017).

On the contrary the final good sector can only operate formally. Since production of the final good sector utilizes domestic and foreign intermediate inputs a value added tax scheme could be introduced into the model, so allowing for tax evasion also in this sector. Notably, being based on a credit-and-refund scheme, the VAT is strongly vulnerable to evasion, fraud and tax avoidance. For instance, over the period 2009–2013, Italy reported an average VAT gap of 33%. See European Commission (2015a). For an analysis of revenue-neutral tax shifts accounting for the existence of a VAT credit-and-refund scheme, see Paz (2015).

As is common practice in new open economy macroeconomics, we assume that the elasticity of substitution between varieties in the tradable sector is the same for the domestic and the imported bundle.

Perfect competition can be rejected for almost all sectors in all countries and Italy is not an exception. See Christopoulou and Vermeulen (2012).

The existence of price stickiness is fully supported by empirical evidence. See, e.g, Alvarez et al. (2006) and Dhyne et al. (2006). In general, a marked heterogeneity in the frequency of price adjustment is found across sectors. Further, prices seem to change less frequently in Europe than in the United States.

For instance, Gallaway and Bernasek (2002) and Marcelli et al. (1999) show that, at least in urban settings, low skilled workers are more likely to work in the irregular sector compared to those workers who attained a higher level of education. Amaral and Quintin (2006) link the presence of low-skill workers in the underground sector to the fact that informal managers have access to less outside finance than their formal counterpart, and they substitute part of physical capital with low-skill workers. Further, Paz (2014) points out that small firms are more likely to hire informal workers. Since capital intensity tends to increase with firm size, this stylized fact is consistent with the assumption we make that in the informal sector firms are less capital intensive.

On the notion of ‘moonlighting production’, see e.g. Bajada (1999) and Cowell (1990). This scheme allows us to capture the fact that firms operate simultaneously in the official and in the unofficial sectors. Several causes have been listed in the literature to explain the coexistence of formal and informal production within the same firm in contrast to a ‘ghost’ type production scheme, where firms opt to operate only in the informal sector. For instance, participation in the official market facilitates access to credit and public sector services and grants property right protection. Official production may also represent a valuable shield against fiscal audits for firms engaging in underground production. Moreover, openness to trade implies that export products should meet the requirements of the destination country, which looks in principle less likely for ‘ghost’, unregistered, firms. Our choice is also supported by the empirical evidence showing the predominance of this scheme of informality for Italian firms (see Mantegazza et al. 2014).

This property, together with homogeneity and the fact that both \(Y_{i,t}^{m}\) and \(Y_{i,t}^{u}\) can be both used in the final good production function with no additional costs, suggests that this model with underground economy could be more appropriately defined a two-technology model rather than a two-sector model.

For evidence of habit formation in consumption of Italian households, see Rossi (2005).

Despite the absence of adjustment costs on shifting labor supply or demand from one market to another, each labor market has its own specific characteristics that this extra term tries to represent.

On these behavioral aspects of households regarding participation in the shadow economy and ‘tax morality’, see e.g. Gordon (1989) and Dhami and Al-Nowaihi (2007).

The price at time t of a risk-free asset that pays one unit of currency in period \(t+1\) has to be equal to the inverse of the risk-free nominal (gross) interest rate \(R_{t}\), that is \(Q_{t}=R_{t}^{-1}\).

In other words, there is a premium on foreign bond holdings which is a function of the aggregate net foreign asset position of the domestic households. The existence of this debt elastic risk premium is necessary to induce stationarity of the equilibrium dynamics. For details, see Schmitt-Grohé and Uribe (2003).

This assumption implies that all the observed changes in the terms of trade are to be ascribed to changes in the price level \(P_{t},\) since \(P_{t}^{*}\) is also kept constant. See Eq. (31). This is due to the fact that we assume perfect pass-through, therefore any change in the price of domestic varieties is fully reflected in the price of exportations.

This assumption allows us to switch off any possible feedback channels coming from monetary policy.

These estimates have been obtained on the sample period 1982–2006.

Both use U.S. data. The estimate provided by Boldrin et al. (2001) is consistent with asset returns observed over the period 1892–1987, whereas Christiano et al. (2005) use information from 1965 to 1995.

Deterministic simulations are carried out when studying the effects of structural and/or policy interventions involving permanent changes in some structural parameters and/or tax rates.

Recently many EU Member States have been attempting to strike the balance between economic recovery and fiscal soundness by reducing the tax burden on labor and by narrowing the tax base of corporate income taxation, while increasing consumption taxes. Lower tax wedges on labor, in fact, ought to lead to a significant rise in labor utilization and, thereby, to a higher level of economic activity. Similarly, alleviating the tax burden on business may stimulate investment. However, given the risk for public finance, lower labor and business taxes need to be compensated by increases in other sources of revenue, such as consumption taxes, or by public spending cuts. For further details, see European Commission (2015b).

Moreover, in the last years, personal income tax has also been reduced for those starting a new business and to the benefits of those embarking on home renovation works. Other sectors involved regard art, sport, and tourism.

See the note available from Italian Ministry of Economics and Finance website at http://​www.​mef.​gov.​it/​inevidenza/​article_​0190.​html and the information made available from the spending review working group at http://​revisionedellasp​esa.​gov.​it/​.

We have also conducted a more standard analysis in which we vary the marginal tax rates by 1 p.p. in isolation. This analysis is useful to uncover the forces at work in each combined policy scenario. See Appendix 2.

This could be interpreted as a reduction in the sum of the tax on labor income and workers’ SSC, reflecting the fact that these two wedges isomorphically affect households decisions.

As shown in Appendix 3, similar results emerge after a fiscal policy envisaging a reduction of the business tax base, rather than a cut of the tax rate.

Similar qualitative results are obtained in response to a reduction of SSC bearing on firms financed by a cut in government spending. See Appendix 3.

It should be noted that the model is calibrated and solved on a quarterly basis. We do not show the full transition dynamics, rather we report the effects of tax reforms over a 20-quarter horizon.

See Appendix 1 for details.

It can been shown that in closed economy and, therefore, of external competition, the tax reforms induce firms to expand their production by more by decreasing the markup immediately. This effect tends to be stronger, the smaller the dimension of the underground sector, so exacerbating the short-run differences in the reaction of output under different sizes of the informal sector. These results are available from the authors upon request.

In Appendix 4 we investigate the role played by nominal and real rigidities in determining the speed of adjustment toward the new steady state.

Given the parametrization of the model, the term \(1-ps\tau _{t}^{y}\) is always larger than zero. This rules out the possibility that \(H_{i,t}^{u}=0\).