Environmental regulation in the presence of unrecorded economy

Abstract

Unrecorded economic activities have an important weight, especially in developing countries where environmental regulations are gradually pursued. Both theoretical and empirical studies on the subject which do not take into account the existence of unrecorded economy may not provide a complete insight on the effects of both fiscal and environmental enforcement policies. After a brief review of the relevant literature, this paper develops an economic model to analyze the potential impacts of environmental regulatory policies on the size of unrecorded economy. Two dierent cases are considered: first, firms' emissions and productions are audited with exogenous probabilities which may be different from each other; second, a unique probability-to-audit function is determined to audit both emissions and productions of firms whether in recorded or unrecorded economy. The form of this function is specied using the cointegration technique. The results in this paper essentially show that environmental regulations may increase the size of unrecorded economy. The paper also attempts to give a precise limit value for the environmental tax rate exceeding which may induce a rise in the extent of unrecorded activities.