Abstract
This paper demonstrates theoretically that a profit tax does not affect the distribution of the firm’s operations between the official and the underground economy. Or, if the firm was initially operating only officially, direct taxation of its business would not be a reason to go underground. Indirect taxation in the form of a sales tax does influence an already existing mix of official and underground activities, favoring the latter. And, it does constitute a reason to “go underground†for an otherwise fully official business. This is a thesis robust to market structure changes and to introducing tax evasion in the usual sense, provided the underground demand is inelastic. The tax authority can still collect the planned tax revenue through a combination of a cash-flow tax with indirect taxation, under only consumersurplus loss by the underground customer.
Highlights
The literature on the underground economy is vast
This decline might be countered under optimal indirect taxation, because it presupposes equalization of the after-tax Lerner indexes, tax rates increasing subsequently with inelasticity as very well Wang (2011) notes, and increasing inelasticity is one factor conferring increasing market power
Measuring the output of both sectors from the origin of the axes in the outputprice space, the demand curve is the line connecting the official equilibrium at official price-output, with the underground one at underground price and total, i.e. formal and informal output. These are in sum the considerations surrounding the notion of perfect competition which is appropriate to the study of the topic investigated below as follows: The Basic Argument: Suppose for a moment that a fraction m of a perfectly competitive firm’s product is already channeled into the underground economy in order to avoid excessive regulations and institutional constraints but not for tax evasion purposes
Summary
The literature on the underground economy is vast (see e.g. Aureo & Scheinkman, 2008; Charmes, 2012). Even if underground economy was inexistent, it would have to be invented to shift indirect taxation on official sales to the underground customer, to cover with it official business tax payments, and escape the indirect tax on the output that is disposed underground This has serious welfare implications not so much for the firm as for the consumer. Koehne & Kuhn, 2015) Another reason could be a network effect, encouraging underground workers to keep purchasing underground commodities The section elaborates upon the idea of underground forward indirect-tax shift exhaustively, taking as a benchmark case that of perfect competition in either type of economy.
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