Might Fundamental Tax Reform Increase Criminal Activity?

There is a widely held perception that fundamental tax reform would reduce the level of criminal and other “underground” economic activity. The popular argument relies on the idea that replacing the income tax with a sales tax would implicitly tax the return to criminal activity, whereas the return to crime is effectively untaxed by an income tax. This paper finds instead that the impact of tax reform on the underground sector of the economy depends on the relative labor intensity of production in the legitimate and illegitimate sectors of the economy. In the likely event that illegal output is produced using more labor-intensive techniques than is legitimate output, then replacing an income tax with a sales tax reduces the cost of criminal and other underground activity, thereby increasing such activity. JEL Classification: K42, H26, H25. James R. Hines Jr. Office of Tax Policy Research University of Michigan Business School 701 Tappan Street Ann Arbor, MI 48109-1234 United States of America