On tax evasion and optimal taxation composition

The Laffer project again had an opportunity to present our work at the recently concluded “Corruption, Tax Evasion and Institutions” conference in Riga, Latvia. The conference was organized by the Baltic International Centre for Economic Policy Studies (BICEPS), the Stockholm School of Economics in Riga (SSE Riga), the Stockholm Institute of Transition Economics (SITE) and Centre for Media Studies at SSE Riga. Our paper received a positive response from conference attendees, though our audience thought we should be more ‘realistic’ in one of our assumptions (more on that in a moment).

The idea of our paper is that one can obtain plausible estimates of the level of labor market duality – the so called underground economy or informal work, by looking at firms’ tax burden of employing a worker. This burden in our paper is in the form of ‘firms social security’ contributions. This variable varies substantially across countries. While we do not provide any explanation for this variation, we however use the country specific value of this variable to calibrate a macroeconomic model where firms can hire workers for whom they make full social security contributions (primary – P) and those for whom they don’t (Secondary – S). Hiring S workers is a form of tax evasion which exposes the firm to the risk of audit and a penalty. The challenge for a model such as ours is in calibrating the value of the audit probability and accompanying penalty. These numbers vary substantially across multiple legal jurisdictions. To overcome this challenge, we exploit the equilibrium conditions implied by our model and aggregate data; specifically tax revenues from employer contributions to social security. From this, we are able to back out the implied expected evasion penalty (a combination of the audit probability and penalty if caught) and, by our model design, the implied level of labor market duality or underground work. Our estimates of secondary work show a significant positive correlation (64%) with estimates of the size of the underground economy found in the literature.

We then ask what would be the optimal share of firms contributions to social security tax in an environment characterized by labor market duality as ours. Our findings are that from a welfare and tax revenue perspective, it would be better to increase this share in most countries of the EU. While the increase means there are modest gains in the share of S workers in the economy, the gains in hours worked and output over-compensates for the loss in tax revenue due to higher evasion. In our last presentation, the main complaint was that our model assumes that the government makes lump sum transfers to all workers regardless of their social security contributions status. While this may be a legitimate concern, we assume that workers declare all their income and thus this issue does not really arise.