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abstract

This paper investigates analytically the welfare effects of black-market activities that firms undertake to evade taxes. The desirability of a black market is linked to the attributes of the goods supplied by blackmarket firms. The analysis identifies cases where a black market reduces (increases) the distortionary impact of taxation on the allocation of resources across the goods that the government is attempting to tax, leading to a welfare gain (loss).

6. Concluding remarks

Proponents of a Haig–Simons income tax argue on both equity and efficiency grounds that all sources of income should be treated equally for tax purposes. Under this view, black-market activities are clearly inefficient, because they destroy this “neutrality.” Modern public finance has taught us, however, that optimal tax systems are usually characterized by unequal treatment of income. But unequal treatment involves higher administrative and collection costs, arising in part from informational asymmetries that limit the government's power to tax. To the extent that a black market can be used to circumvent such informational problems, it can bring the tax system closer to the one that would be optimal if the government could optimally discriminate among different income-generating activities. The current paper has shown that a black market may or may not serve this role, depending on the attributes of the goods supplied there. In our model, goods are distinguished by their “quality,” and it is always the case that a small black market containing high-quality goods raises welfare, whereas a black market with low-quality goods worsens welfare. In both cases, however, it is the relatively labor-intensive firms that choose to occupy the black market, given our initial assumption that the fine imposed on tax evaders depends on their total assets at the time they are caught, not on the mix of different assets. But by using a fine that depends on this mix, the government is able to locate the black market at high-quality goods, even if they are capital-intensive, thereby ensuring a welfare improvement.