Tax Reform, the Informal Economy, and Bank Financing of Capital Formation

41 Pages Posted: 26 Mar 2011 Last revised: 26 Jun 2012

See all articles by Andrew Feltenstein

Andrew Feltenstein

Georgia State University - Department of Economics

Maral Shamloo

London School of Economics & Political Science (LSE) - Department of Economics

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Date Written: March 1, 2011

Abstract

This paper develops a model that relates entry into the underground economy to tax rates and the need to access the banking system. The model uses a dynamic approach in which both firms and banks optimize and in which the benefits to a firm of accessing the banking system are endogenous. A firm compares the return to capital with the marginal tax rate on capital income and uses the difference to determine how much of the tax to pay. At the same time, banks use a firm’s capital tax payments, combined with the capital tax rate to obtain an estimate of the firm’s minimum capital value. If the firm pays at least some taxes then it will have access to the banking system, which will allow it to finance investment. If the firm pays no taxes, then it cannot access the banks and cannot invest. We compare the equilibria resulting from tax compliance and tax evasion.

We calibrate the model to the macro aggregates of the Russian economy, and analyze the effect of potential tax changes on the underground economy. We compute a dynamic equilibrium for our model, and note that it tracks the path of the Russian economy with some accuracy for the years 2001-2008. We then carry out a series of counterfactual simulations, first asking if noncapital intensive firms have an incentive to evade taxes under existing value added tax rates. We find that they do, and that the incentive would have been greatly reduced if the value added tax rate had been selectively reduced for the non-capital intensive sectors. We then ask what the effect would be if the corporate tax rate were raised on capital intensive sectors. The simulations indicate that the capital intensive sectors would not increase their entry into the underground economy.

Suggested Citation

Feltenstein, Andrew and Shamloo, Maral, Tax Reform, the Informal Economy, and Bank Financing of Capital Formation (March 1, 2011). Andrew Young School of Policy Studies Research Paper Series No. 11-25, Available at SSRN: https://ssrn.com/abstract=1791883 or http://dx.doi.org/10.2139/ssrn.1791883

Andrew Feltenstein (Contact Author)

Georgia State University - Department of Economics ( email )

P.O. Box 3992
Atlanta, GA 30302-3992
United States
404-4130093 (Phone)

Maral Shamloo

London School of Economics & Political Science (LSE) - Department of Economics ( email )

Houghton Street
London WC2A 2AE
United Kingdom

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