The Underground Economy and Tax Base Erosion

Yu-Kun Wang


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.

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