The underground economy in the Czech Republic: dynamic general equilibrium modeling and policy analysis

This paper studies the issue of tax evasion in the context of the underground economy. A dynamic general equilibrium model is built where individual households and entrepreneurs decide rationally whether to go underground and under-report their earnings. These behaviors affect tax revenues, which are used to finance productive public services. This model is applied to the Czech Republic, because transition economies face admittedly high public investment needs but also large problems in the tax collection process. When deep parameters are calibrated on this economy, the predicted relative size of the underground economy lies around 15% of measured GDP in the long-run, which is in the upper band of current estimates for this country. In this framework, we first evaluate how the design of the tax system – as described by tax rates, tax mix between direct and indirect taxes and the efficiency of fraud detection – affects the relative size of the underground economy, measured and total output and aggregate welfare in the long-run. Our second experiment is to identify the effects of an underground economy on the transition process, by comparing our model economy to a benchmark where agents have no access to an underground technology. We find that the underground economy significantly decreases the speed of adjustment. The model also predicts that the relative size of the underground economy should rise in the beginning of the transition process, and then eventually return to its long-run level.