Underground Activities and Labour Market Performance

Larsen, Birthe; Kolm, Ann-Sofie Working Paper Underground Activities and Labour Market Performance Working paper, No. 5-2010 Provided in Cooperation with: Department of Economics, Copenhagen Business School (CBS) Suggested Citation: Larsen, Birthe; Kolm, Ann-Sofie (2010) : Underground Activities and Labour Market Performance, Working paper, No. 5-2010, Copenhagen Business School (CBS), Department of Economics, Frederiksberg, https://hdl.handle.net/10398/8209 This Version is available at: https://hdl.handle.net/10419/208565 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/3.0/ Department of Economics Copenhagen Business School Working paper 5-2010 Title Author _________________________________________________________ Department of Economics -Porcelænshaven 16A, 1.fl. - DK-2000 Frederiksberg UNDERGROUND ACTIVITIES AND LABOUR MARKET PERFORMANCE Ann-Sofie Kolm Birthe Larsen Underground activities and labour market performance Ann-So…e Kolmand Birthe Larseny November 12, 2010 Abstract This paper develops a general equilibrium search and matching model where an underground economy co-exists along with the formal part of the economy. In analyzing how tax and punishment policies a¤ect labour market performance, we …nd that punishment of informal sector activities induce workers and …rms to reallocate towards the formal sector. However, more importantly, we …nd that this reallocation tends to improve e¢ ciency in search, reduce the overall wage pressure, and reduce actual unemployment. JEL-codes: H26, H24, J64 Keywords: Tax evasion, Underground economy, matching, unemployment. Department of Economics, Stockholm University, S-106 91 Stockholm, Ph. +46 8 163547, Fax +46 8 161425. E-mail address: ann-so…e.k[email protected] yCopenhagen Business School, CEBR and Insead, Boulevard de Constance, FR-77305 Fontainebleau, E-mail address: [email protected] 1 1 Introduction There is a large interest in combatting the underground economy across the industrialized world. Undeclared work will, among other things, deprive countries from revenues needed in order to …nance the provision of public services. Estimates of the amount of undeclared work in the European union amounts to between 7 and 16 percent of EU’s GDP, which translates into about 10 million to 28 million jobs.1However, it is unclear if, and if so how, undeclared work can be turned into declared work and thus into increased government revenues. Will policies reducing underground job opportunities really increase formal sector employment opportunities? However, if so is the case, to what extent will formal sector jobs replace jobs in the underground economy? Moreover, through what mechanisms will these policies a¤ect the creation of jobs in the formal and the informal sector? To analyze the full impact of combatting undeclared work requires a general equilibrium framework. In this paper we build an equilibrium search and matching model with an informal sector. Workers will allocate their search for formal and informal sector jobs optimally. Wages are set in wage negotiations between workers and …rms and unemployment features as an equilibrium outcome. To keep the model simple and transparent, the di¤erences between the formal and the informal sector are kept at a minimum. In fact, the only di¤erence between the formal and the informal sector is that taxes are paid in the former and a …ne is paid upon detection in the latter. We also allow the separation rate 1See European commission COM/98/0219. The commission has also conducted the …rst EU wide cross-nationally comparable questionnaire to increase the knowledge about tax evasion in Europe in order to combat it (see EC, 2007). Also the OECD stresses the importance of combating tax evasion as it threatens government revenues, and has initiated the "Global forum of transparency and exchange of information for tax purposes" (OECD, 2010). 2 to be higher for informal sector workers than for formal sector workers, as the former faces an additional probability of separation in case of detection. The assumption of separation upon detection is however not important for the results. The model is used to analyze the impact of tax and punishment policies on labour market performance. We …nd that increased punishment of the informal sector induces a reallocation of …rms and workers towards the formal sector. While this is somewhat expected, it is less clear from an a prior point of view, how wages and aggregate unemployment are a¤ected by such policy. We …nd that informal sector producer wages increase and formal sector producer wages fall, and that unemployment most likely falls with increased informal sector punishment. Thus, formal sector employment increases by more than informal sector employment falls. This follows as workers allocate too much time to search for informal sector jobs as these jobs are untaxed. Thus, as …rms and workers reallocate towards the formal sector, search becomes more e¢ cient, aggregate wage pressure falls, and aggregate job creation increases. Early theoretical analyses of tax evasion are provided by Allingham and Sandmo (1972) and Srinivasan (1973), where under-reporting of income is modelled as a decision made under uncertainty. Subsequent papers have enhanced the basic model of individual behavior by, for example, incorporating endogenous labour supply decisions.2Also equilibrium models with tax evasion have been developed (for examples see the early study by Cremer and Gahvari (1993) and the recent study by Tonin (2010)). These models of tax evasion, however, features perfectly competitive labour markets. The principal contribution of the analyses in this paper is that we consider tax evasion in a model featuring involuntary unemployment, which, in contrast to most 2See for example Sandmo (1981) for an early contribution of endogenous labour supply and underreporting of income. 3 previous work on tax evasion, enables us to study the impact of tax evasion on wage formation and unemployment. During the last decade, however, there have been some studies of underground activity in models of involuntary unemployment; see Kolm and Larsen (2005, 2006), Boeri and Garibaldi (2002), Fugazza and Jacques (2004) and Albrecht et al (2009). The focus and modelling strategies are, however, di¤erent in these papers. The recent paper by Albrecht et al (2009) considers the impact of payroll taxes and severance pay on unemployment in the presence of an informal sector. Their informal sector is modelled from a Latin American perspective where the informal sector is large and can be seen as an unregulated sector which is not a¤ected by these policies. As their focus is not on the illegality of this sector, punishment policies of informality are not modelled. Previous studies investigating the impact of punishment policies of the informal sector in models featuring equilibrium unemployment, assumes an asymmetry across the informal and the formal sector in order to generate coexistence of both sectors. The study by Kolm and Larsen (2006), for example, explores the consequences of punishment policies on labour market performance in an economy where the underground economy produces di¤erent goods as compared to the formal part of the economy. The coexistence of both a formal and an informal sector is generated only because workers like to consume both types of goods. The studies by Kolm and Larsen (2005) and Fugazza and Jacques (2004), on the other hand, explore the consequences for unemployment when workers have moral considerations when deciding on informal sector work. With workers being heterogenous with respect to moral, only workers with low moral are willing to work in the informal sector. The paper by Boeri and Garibaldi (2002), also considers punishment policies in a model of informal employment and involuntary unemployment. However, in order to generate coexistence of both formal and informal jobs in their 4 model, all jobs are started as legal jobs. Informal jobs come about as legal …rms are hit by a bad productivity shock and face the option of becoming illegal. The current paper, on the other hand, investigates the impact of tax and punishment policies on labour market performance in an equilibrium search and matching model where coexistence of both sectors is not based on an exogenously imposed asymmetry across the two sectors. 2 The model3 This section considers a two sector general equilibrium model featuring matching frictions and worker-…rm wage bargaining. Workers search for jobs both in a formal sector and in an informal sector. The only di¤erence between the two sectors are that the formal sector can be taxed whereas the informal sector can not. Rather than taxing the informal sector, the government audits the economy. With probability pa worker-…rm pair in the underground economy is detected and then has to pay a punishment fee.4 2.1 Matching The matching function for the formal (F) and the informal (I) sector respectively are given by Xj= (vj)1(j)u; j =F; I; where Xjis the number of matches, vjis the number of sectorial vacancies, and uis the number of unemployed workers. The unemployed workers allocate their search e¤ort optimally between 3The model is along the lines of Pissarides (2000). 4For realism one may also assume that the match is dissolved as a consequence of detection. We introduce this feature in the model although no results depend on this. It will, however, reinforce the impact of tax and punishment policies on unemployment. This is discussed in the last section. 5 the formal and the informal sector. On the job search is disregarded for simplicity. Each worker’s total search intensity is exogenously given and normalized to unity, where I=denotes search e¤ort directed towards the informal sector, and F= 1 denotes search e¤ort directed towards the formal sector. The parameter  < 1captures that the e¤ectiveness of search falls with search e¤ort, i.e., the …rst unit of search in one sector is more e¤ective than the subsequent units of search. This could capture that di¤erent search methods are used when searching for a job in a market. The more time that is used in order to search in a market, the less e¢ cient search methods have to be used. This particular modelling strategy of search e¤ort has a close resemblance to how search is modelled in van den Berg and van der Klaauw (2006), where search for a job can be conducted using di¤erent search channels. The transition rates into formal and informal sector employment for a particular worker i, are F i= (1 i)F1and I i= iI1; where F=vF (1)uand I=vI uare labour market tightness measured in e¤ective search units. The rates at which vacant jobs become …lled are qj=j; j =F; I. 2.2 Value functions Let U; EF, and EIdenote the expected present values of unemployment, and employment in the two sectors. The value functions for worker ithen reads: rUi=R+F i(EFUi) + I i(EIUi);(1) rEF i=R+wF i(1 t) + s(UEF i);(2) rEI i=R+wI i(1 p)+(s+p) (UEI i);(3) where ris the exogenous discount rate, wjis the sector wage, and sis the exogenous separation rate. Ris a lump sum transfer that all individuals 6 receive from the government which re‡ects that the government has some positive revenue requirements.5The parameter tis the proportional income tax rate, pcaptures the probability of being detected working in the informal sector, and is the proportion of the evaded income the worker has to pay as a punishment fee if detected. For realism we here introduce the assumption that the match is dissolved when detected. However, no results will depend on this assumption. In fact, the only real implication of this assumption is that the e¤ect of tax and punishment policies on unemployment is reinforced. A separate proposition is included to discuss the implications of this assumption. For simplicity, we disregard from unemployment bene…ts. Let JFand VFrepresent the expected present values of an occupied job and a vacant job in the formal sector, respectively. The arbitrage equations for a job paying the wage wF iand a vacant job in the formal sector are then rJF i=ywF i(1 + z) + s(VFJF i);(4) rV F=qF(JFVF)k; (5) where zis the payroll tax rate and yis productivity. Vacancy costs are denoted k. Analogous notation for the informal sector yields: rJI i=ywI i(1 + p)+(s+p) (VIJI i);(6) rV I=qI(JIVI)k; (7) where is the proportion of the evaded wage the …rm has to pay as a punishment fee if detected. The unemployed worker iallocates search, i, between the formal and the informal sector in order to maximize the value of unemployment, rUi. 5Everyone receives this transfer. The government cannot exclude the informal sector workers as the government does not know who the informal sector workers are (if it did, it could just punish all of them). 7 3.2 Unemployment We summarize the results of how the tax and punishment rates a¤ect unemployment in the following proposition: Proposition 3 A fully …nanced increase in the punishment rate (or ) will always reduce o¢ cial unemployment (uo). Actual unemployment (u) falls with a fully …nanced increase in the punishment rate (or ) if < 1. It is a prior not clear what would happen to aggregate unemployment. It turns out that the increase in formal sector employment more than outweighs the fall in informal sector employment as long as formal sector taxation exceeds informal sector punishment, i.e., if < 1. Thus unemployment falls with increased punishment of the informal sector in this case. The reason why unemployment falls with increased punishment is that search becomes more e¢ ciently allocated when redirected towards the formal sector in the case when < 1. With < 1, attractive untaxed job opportunities in the informal sector induce workers to search too much for informal jobs. With decreasing returns to search in a sector, total search e¢ ciency then improves when search is reallocated towards the formal sector in this case. The fact that search becomes more e¢ cient when reallocated towards the formal sector also has an impact on unemployment working through wage formation and tightness. As search is reallocated towards the formal sector, the wage demand is moderated in the formal sector and exaggerated in the informal sector. As search e¢ ciency in the formal sector increases more than search e¢ ciency in the informal sector is reduced, the formal sector wage moderation will dominate the informal sector wage push. Thus, the incentives to open up a vacancy in the formal sector exceeds the disincentives to open up a vacancy in the informal sector; formal sector tightness will increase by more than informal sector tightness falls when < 1. 14 To sum up, an increased punishment of the informal sector tends to increase total search e¢ ciency, moderate overall wages and increase total tightness if < 1. This implies that the increase in formal sector employment exceeds the reduction in informal sector employment; unemployment falls. None of the results derived in this paper hinges on the assumption that the match is dissolved upon detection. However, by assuming that matches dissolve upon detection, the negative impact of higher informal punishment on unemployment is further reinforced. This follows as workers are reallocated towards the formal sector where jobs on average last a longer time. This also implies that unemployment is reduced as a consequence of increased punishment of the informal sector even if exceeds unity. However, if > 1, that is the informal sector punishment exceeds the formal sector taxation, further punishment of the informal sector has an ambiguous e¤ect on unemployment. Unemployment tends to increase as total search e¢ ciency then falls although unemployment tends to fall as formal sector jobs on average have a longer duration. The results following the assumption of dissolvement of the match upon detection is summarized in the following proposition. Proposition 4 Given a match is dissolved upon detection, a su¢ cient condition for actual unemployment (u) to fall with a fully …nanced increase in the punishment rate (or ) is 1. 4 Conclusion This paper investigated if, and to what extent, undeclared work could be turned into declared work and higher government revenues by a more sever punishment of the underground economy. Moreover, we analyzed through which channels these policies a¤ected the creation of jobs in the formal and the informal sector. 15 To o¤er a proper investigation we built a general equilibrium search and matching model with an informal sector, where the coexistence of both sectors were not based on an exogenously imposed asymmetry across the two sectors. Workers allocated their search for formal and informal sector jobs optimally and wages were set through wage negotiations between workers and …rms. In order to focus on the mere impact of tax evasion, the only di¤erence between the formal and the informal sector was that taxes were paid in the former and a …ne was paid upon detection in the latter. We did allow for an additional probability of separation in case of detection in the informal sector but this assumption was of no importance for the results. We showed that increased punishment of the informal sector induced a reallocation of …rms and workers towards the formal sector. Informal sector producer wages increased whereas formal sector producer wages fell. Unemployment was reduced if the government was unable to audit and punish the informal sector to the same extent as it could tax the formal sector. Thus, formal sector employment increased by more than informal sector employment fell. This was a consequence of that workers allocated too much time to search for informal sector jobs as these jobs were untaxed. Thus, the reallocation towards the formal sector improved search e¢ ciency, reduced aggregate wage pressure, and increased total job creation. References [1] Albrecht J, L Navarro & S Vroman (2009) "The e¤ects of labour market policies in an economy with an informal sector" Economic Journal 119, p 1105-1129. 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