Tax Toleration and Tax Evasion: Why Firms Enter the Unofficial Economy

Abstract

In this paper we propose a model of how institutional benefits, taxation and government regulations affect the propensity of private firms to enter the unofficial economy. A central implication of the model is that profit-maximizing firms frequently will operate simultaneously in both the official and unofficial sectors. And contrary to a common view that high tax rates are intrinsically a major cause of large shadow economies, our model implies that the incentive of firms to produce underground and evade taxation depends on statutory tax rates relative to firmspecific thresholds of tax toleration. The concept of firm-specific tax toleration helps explain why tax evasion and underground production varies so greatly across enterprises operating in the same national institutional environment and facing the same regulations and tax rates. Some key predictions of the model concerning the determinants of firms’ tax toleration and the relative scale of their unofficial production receive broad support from empirical analyses of enterprise-level data from the World Bank’s World Business Environment Surveys.