Modelling the Hidden Economy and the Tax-gap in New Zealand

and Ken White for their many comments, suggestions, and assistance with data. The insightful comments of two referees led to a significant improvement of this paper, including the addition of Appendix II. The content this paper is the responsibility of the author, and should not be attributed to Inland Revenue New Zealand, which financed this study. The author's related papers on the hidden economy and tax evasion are available in Adobe pdf format on the internet at Abstract This paper develops and estimates a structural, latent variable, model for the hidden economy in New Zealand, and a separate currency-demand model. The estimated latent variable model is used to generate an historical time-series index of hidden economic activity, which is calibrated via the information from the currency-demand model. Special attention is paid to data non-stationarity, and to diagnostic testing. Over the period 1968 to 1994, the size of the hidden economy is found to vary between 6.8% and 11.3% of measured GDP. This, in turn, implies that the total tax-gap is of the order of 6.4% to 10.2% of total tax liability in that country. Of course, not all of this foregone revenue would be recoverable, as not all of the activity in the underground economy is responsive to changes in taxation or other policies.