Fiscal consolidation with tax evasion and corruption

Cross-country evidence highlights the importance of tax evasion and corruption in determining the size of fiscal multipliers. We introduce these two features in a New Keynesian model and revisit the effects of fiscal consolidations. VAR evidence for Italy suggests that spending cuts reduce tax evasi...

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Bibliographic Details
Published in:Journal of international economics 2015-07, Vol.96 (Supp.1), p.56-75
Main Authors: Pappa, Evi, Sajedi, Rana, Vella, Eugenia
Format: Article
Language:English
Subjects:
Corruption
Eastern Europe
Economic theory
Keynesianism
Public debt
Tax evasion
Vector-autoregressive models
Western Europe
Online Access:Get full text
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Summary:Cross-country evidence highlights the importance of tax evasion and corruption in determining the size of fiscal multipliers. We introduce these two features in a New Keynesian model and revisit the effects of fiscal consolidations. VAR evidence for Italy suggests that spending cuts reduce tax evasion, while tax hikes increase it. In the model, spending cuts induce a reallocation of production towards the formal sector, thus reducing tax evasion. Tax hikes increase the incentives to produce in the less productive shadow sector, implying higher output and unemployment losses. Corruption further amplifies these losses by requiring larger hikes in taxes to reduce debt. We use the model to assess the recent fiscal consolidation plans in Greece, Italy, Portugal and Spain. Our results corroborate the evidence of increasing levels of tax evasion during these consolidations and point to significant output and welfare losses, which could be reduced substantially by combating tax evasion and corruption. All rights reserved, Elsevier
ISSN:0022-1996