A Fuzzy Logic Approach to Modelling the Underground Economy

The availability of data for the size of the “Underground Economy” is important for macroeconomic policy. We use fuzzy set theory and fuzzy logic to construct an annual time-series for the (unobservable) New Zealand underground economy over the period 1968 to 1994. Two input variables are used – the effective tax rate and an index of the degree of regulation. The resulting underground economy time-series is compared with one previously constructed by the second author using a structural “Multiple Indicators, Multiple Causes” (MIMIC) model. The two approaches each yield sensible, but somewhat different, pictures of the New Zealand underground economy over this period. The fuzzy logic approach to this measurement problem involves several subjective judgements, but our results are quite robust to these choices.