Currency, Marginal Tax Rates, and the Underground Economy

Abstract

This paper has attempted to isolate that portion of the underground economy which is both measurable and controllable. The standard variables postulated by Cagan, income and interest rates, are still important, although the value of the income elasticity of currency demand may be larger than expected. Marginal tax rates have a positive and significant influence on currency holdings, which supports Tanzi's work and contradicts the findings of the Internal Revenue Service. While not all the increase in currency holdings in the last 20 years can be explained by using tax rates, somewhere between $11 and $12 billion worth of currency can be attributed to that source. While unemployment compensation ought to affect the size of the underground economy, no statistical verification can be found through the specification contained here. Finally, it is noted that the trend toward less currency holding, which one would expect from the recent banking innovations, would have occurred had not other forces offset it. One of the forces which has probably led to an increase in currency holdings is increased drug-related activity. However, that portion of the underground economy which exists because of crime has been largely ignored here because little of it can be controlled by economic policy. What is explored here is a measurement of how much underground activity we could dissuade by lowering taxes, and further, how those lower taxes would influence tax collections. The effects appear to be large enough to warrant concern about the impact of tax rates on incentives.