Modelling the Effects of Corporate Taxation in the Underground Economy

This paper develops a two-sector search model of the labour market in which firms in one sector (the informal sector) evade profit taxes (underground economy). A comparative static analysis is employed to analyze the impact of corporate taxation on unemployment, occupational choice of individuals, mix of jobs, welfare of agents and the size of informal sector. The findings suggest that profit, firing and payroll taxation have the same effects on the above economic variables. However, if a certain condition does not hold, then the number of individuals searching for jobs only in the informal sector decreases with profit taxes. The above result implies that the adoption of active labour market policies, which accelerate the matching process between employers and employees, will mitigate the positive (negative) impact of taxation on the size of underground economy (wages).