Equilibrium Implications of Fiscal Policy with Tax Evasion

This paper studies equilibrium effects of fiscal policy within a dynamic general equilibrium model where tax evasion and underground activities are explicitly incorporated. There are three main results. (i) The underground sector mitigates the distortionary impact of fiscal policies, while lessening the drop (rise) of aggregate production after restrictive (expansionary) tax shifts. In this respect, tax evasion and the informal economy offer a channel for insuring income and consumption from distortions generated by fiscal policy. (ii) Tax evasion and underground economy can completely reverse the theoretical predictions of the standard neoclassical growth model and rationalize expansionary responses to contractionary fiscal policies. (iii) A dynamic general equilibrium with tax evasion gives a rational justification for a variant of the Laffer curve.