Fiscal Consolidation in the Presence of Tax Evasion and Corruption

The path of economic recovery from the recent global recession has been rather slow and fragile. Growth in advanced economies has been throttled by mounting government debt and the financial crisis has turned into a fiscal one. In the aftermath of this crisis, policymaking has mainly focused on the implementation of sizeable and long-lived fiscal consolidation plans, including cuts in various components of government spending and increases in taxation, so as to decrease government deficit and debt levels. 

These developments in the economy have recently excited renewed interest in the strand of research examining the macroeconomic impacts of fiscal consolidations, tending to suggest in general that expenditure cuts rather than tax hikes should be used to generate government savings. However, two crucial aspects of political economy related to the presence of rent seeking activities and tax evasion in many countries undertaking such policies have been left unnoticed, despite the obvious implications for the government budget. Rent seeking, which is viewed as a form of bureaucratic corruption, is defined as “the socially costly pursuit of winning a contestable prize” (Drazen (2000, p.335)) and occurs mainly through the public sector. In other words, the monopoly rent that the government creates, e.g. via coercive taxation, generates a prize worth pursuing. Tax evasion refers to failure to report or to reporting inaccurately taxable income to the tax authorities. The two of them often coexist, in various forms, and possibly interact. 

My  current  research  with  Professor  Evi  Pappa  and  Rana  Sajedi  from  the  Department  of Economics aims at developing a theoretical model that allows assessing both the output and unemployment effects of alternative fiscal consolidation policies in an economic environment characterized by the presence of tax evasion and rent seeking. We calibrate the model to the Italian economy, which seems particularly suitable for such an exercise as there is a lot of evidence for the presence of both corruption and tax evasion. Italy scores poorly in international rankings of institutional quality: for instance, it currently ranks 72 among 176 countries in the Corruption Perception Index. There are also available estimates for a sizeable and steadily growing  underground  economy,  which  appears  positively  correlated  with  unemployment (Boeri and Garibaldi (2007)). Using measures of detected tax evasion from the Italian finance police, Ardizzi et al. (2012) find for a panel of Italian provinces that the average size of the unobserved economy amounted to 16.5% of GDP over the period 2005-2008, which is very close to the figures by Istat (2010). Orsi et al. (2012) estimate a higher size (23% of GDP over 1982-2006) and argue that the size of the underground economy has steadily increased in the last two decades, owing primarily to the persistent increase in taxation since the eighties. 

Rent seeking and tax evasion are two existing phenomena with important implications for fiscal consolidation policies, the simultaneous presence of which has not been accounted for by existing macroeconomic models with involuntary unemployment. This research is therefore expected to shed some new light on these topics by offering timely policy lessons.