The Underground Economy and Tax Base Erosion

Yu-Kun Wang

doi:10.5539/ass.v9n10p1

Abstract

The tax evasion behaviors of above-ground and underground economic activities differ. Above-ground economy tax evasion refers to people engaging in government sanctioned production and consumer activities and circumventing the payment of taxes mandated by law. The underground economy refers to people engaging in economic activities that are not sanctioned by the government, which is also known as the “grey economy.” The main objective of engaging in underground economic activity is to avoid taxation by tax agencies. To explore the relationship between taxpayers’ underground economic income reporting and tax compliance rates, this study established a utility function that included both the above-ground and underground economies, and divided public goods based on their above-ground and underground economic weight. This study analyzed taxpayers’ underground economic income by adopting the probability of penalization and identifying the optimal participation rate. This study also found that taxpayers’ corresponding risk aversion attitudes after becoming wealthy, or experiencing increased income, was a key factor of whether increases in the tax rate generated increases in the ratio of the underground economy labor force.

Highlights

In literature related to underground economic activity (Note 1) and tax base erosion, Cowell (1990) and Cremer and Gahvari (1994) asserted that illegal concealment and legal avoidance are difficult to define in practice. McLaren (1998) indicated that because government personnel and investigation funding are limited, audits cannot be conducted on all taxpayers
The underground economy refers to people engaging in economic activities that are not sanctioned by the government, which is known as the “grey economy.”
To investigate how concealed costs affect representative taxpayers’ underground income level, this study further investigated how representative taxpayers’ unreported income and concealed costs affected the results of Eqs. (4) to (8)

Summary

Introduction

In literature related to underground economic activity (Note 1) and tax base erosion, Cowell (1990) and Cremer and Gahvari (1994) asserted that illegal concealment and legal avoidance are difficult to define in practice. McLaren (1998) indicated that because government personnel and investigation funding are limited, audits cannot be conducted on all taxpayers. McLaren (1998) indicated that because government personnel and investigation funding are limited, audits cannot be conducted on all taxpayers He contended that this causes the after-tax above-ground sale price of goods to exceed the price of goods sold on the black market, regardless of discovery of tax evasion behaviors. The remainder of this paper is organized as follows: After the introduction provided, Section 2 describes the basic model, sequentially explores the relationship between representative taxpayers’ underground economic income reporting coefficient and tax compliance rate, and calculates the optimal participation rate θ* of the representative taxpayers’ underground economy income.

Establishing the Underground Economy Model

Concealed Costs and Underground Economic Income

Adding the Effects that Public Goods Have on Underground Economic Income

Analysis of the Underground Income and Utility of Representative Taxpayers

Conclusions