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Does tax evasion affect unemployment and educational choice?

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Does tax evasion affect uneployent and educational choice? Ann-Sofie Kol Birthe Larsen WORKING PAPER 2004:4 The Institute for Labour Market Policy Evaluation (IFAU) is a research institute under the Swedish
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Does tax evasion affect uneployent and educational choice? Ann-Sofie Kol Birthe Larsen WORKING PAPER 2004:4 The Institute for Labour Market Policy Evaluation (IFAU) is a research institute under the Swedish Ministry of Industry, Eployent and Counications, situated in Uppsala. IFAU s objective is to proote, support and carry out: evaluations of the effects of labour arket policies, studies of the functioning of the labour arket and evaluations of the labour arket effects of easures within the educational syste. Besides research, IFAU also works on: spreading knowledge about the activities of the institute through publications, seinars, courses, workshops and conferences; creating a library of Swedish evaluational studies; influencing the collection of data and aking data easily available to researchers all over the country. IFAU also provides funding for research projects within its areas of interest. There are two fixed dates for applications every year: April 1 and Noveber 1. Since the researchers at IFAU are ainly econoists, researchers fro other disciplines are encouraged to apply for funding. IFAU is run by a Director-General. The authority has a traditional board, consisting of a chairan, the Director-General and eight other ebers. The tasks of the board are, aong other things, to ake decisions about external grants and give its views on the activities at IFAU. A reference group including representatives for eployers and eployees as well as the inistries and authorities concerned is also connected to the institute. Postal address: P.O. Box 513, Uppsala Visiting address: Kyrkogårdsgatan 6, Uppsala Phone: Fax: Papers published in the Working Paper Series should, according to the IFAU policy, have been discussed at seinars held at IFAU and at least one other acadeic foru, and have been read by one external and one internal referee. They need not, however, have undergone the standard scrutiny for publication in a scientific journal. The purpose of the Working Paper Series is to provide a factual basis for public policy and the public policy discussion. ISSN Does tax evasion affect uneployent and educational choice? Ann-Sofie Kol and Birthe Larsen April 15, 2004 Abstract To exaine the acro econoic effects of governent tax and punishent policies, this paper develops a three-sector general equilibriu odel featuring atching frictions, heterogenous abilities and an inforal sector with tax evasion. The choice of education is deterined endogenously. Job opportunities in an inforal sector are available only to workers who choose not to acquire higher education. We find that increased punishent of inforal activities increases the nuber of educated workers and reduces the nuber of uneployed workers. Characterizing the optial tax and punishent syste, we show that it is optial to ore than fully counteract the distortion created by the governent s inability to tax the inforal sector. The optial choice of tax and punishent syste, however, iplies an inefficiently low stock of educated workers. JEL-codes: H26, I21, J64 Keywords: Tax evasion, underground econoy, education, atching, uneployent. Especially we want to thank Per Engströ and Gerard van den Berg for valuable coents and discussions. We also want to thank Bertil Hollund, Toas Lindströ, Oskar Nordströ Skans, Rick van der Ploeg, Åsa Rosén, participants at a CESifo workshop, a CIM workshop and seinars at Uppsala University, Copenhagen Business School, Aarhus School of Business, and CEBR. The first version of the paper was written while the first author was visiting the University of Michigan Institute for Labour Market Policy Evaluation (IFAU), and Departent of Econoics, Uppsala University, Box 513, S Uppsala, Box 513, S Uppsala. Ph , Fax E-ail address: Centre for Research in Social Integration and Marginalization (CIM) and Copenhagen Business School, Departent of Econoics, Solbjerg Plads 3, DK-2000 IFAU Does tax evasion affect uneployent and educational choice? 1 Contents 1 Intro duct i on 3 2 The odel Manual workers Matching Valuefunctions Wage deterination Labourarkettightness Highly educated workers Education Uneployent Equilibriu Coparative statics Tightness, search i nt ensity, and pro ducer wages Eployent and uneployent rates Wage dispersion Education Uneployent Welfare 21 5 Conclusion 26 6 App endix Equilibriu The ipact of an increase in the wedge Proofs of propositions and leas The ipact on governent revenue IFAU Does tax evasion affect uneployent and educational choice? 1 Introduction The last couple of years have witnessed a surge of acadeic as well as journalistic writings on tax evading activities. 1 One reason for this interest is that tax evasion opportunities ay create various distortions in the behaviour of econoic agents. For exaple, too uch work ay be carried out in the inforal sector if consuer wages are relatively higher in this sector. 2 In this paper we argue that the choice to acquire higher education ay also be distorted by tax evasion opportunities. If workers with a lower level of education to a larger extent face job opportunities in an inforal sector, there are less incentives to acquire higher education. More inforal job opportunities, higher taxes and lower punishent fees reduce the relative pay-off fro education which, in turn, induce less workers to educate theselves. This hypotheses is consistent with data. For exaple, using survey data of the shadow sector in Sicily, Boeri and Garibaldi (2002) show that ainly workers at the lower end of the skill distribution engage in inforal activities. Pedersen and Sith (1998), using coprehensive survey data, show that alost half of the inforal sector activities in Denark are carried out within the construction sector. They also find that around 70 percent of the total hours perfored in the inforal sector is carried out within the service sector or construction sector. Furtherore, Pedersen (2003), using the sae questionnaire design for five countries, concludes that ost inforal activity in Great Britain, Denark, Norway, and Sweden is carried out within the construction sector. In Gerany ost inforal activity takes place within a group of sectors denoted: Fishing, Agriculture (including tree-felling and gardening) and Mining. Finally, perforing logistic regressions for the five countries, Pedersen (2003) confirs that skilled blue color workers carry out ore black arket activities than others, and that the likelihood of black arket activities falls with the length of education. 3 1 See Slerod and Yitzhaki (2002) and Schneider and Eneste (2000) for two surveys of tax avoidance and tax evasion. 2 See Pedersen and Sith (1998) for evidence for Denark. One can note that tax evasion opportunities ay, in fact, also reduce distortions. Tax evasion ay, for exaple, reduce the distortion caused by too high consuption of untaxed leisure. 3 Note also that in the literature on crie, it is often stressed that workers with low arket wages have ore incentives to coit cries. Most epirical studies of criinal incoes find that criinal activities offers low skill en higher hourly wages IFAU Does tax evasion affect uneployent and educational choice? 3 With this evidence in ind, the ai of the paper is threefold. First, we want to exaine how the governent tax and punishent policies affect the incentives to acquire higher education. Second, wewanttoexaine how labour arket perforance, including wage foration, uneployent, wage dispersion, and the size of the inforal sector is affected by tax and punishent policies. Third, we ai at characterizing the optial tax and punishent syste. To that end, we develop a three-sector general equilibriu odel featuring atching frictions and worker-fir wage bargains. Workers differ in ability and decide whether or not to acquire higher education. We assue that it is costly in ters of effort to acquire higher education, iplying that only high ability workers find this worthwhile. Only workers who choose not to acquire higher education, who we refer to as anual workers, face job opportunities in both the foral and the inforal sector. This assuption approxiates that eployent opportunities in an inforal sector to a larger extent face workers with a lower level of education. Uneployed anual workers search for jobs in both sectors by allocating their search effort optially between the. We find that increased governent punishent of the inforal sector reduces the size of this sector. Moreover, the nuber of uneployed workers is likely to fall, foral wage dispersion increases, and the nuber of highly educated workers increases. While considering welfare, we find that it is optial to choose the punishent rates so to ore than fully counteract the distortion created by the governent s inability to tax the inforal sector. The optial choice of tax and punishent syste, however, iplies an inefficiently low stock of educated workers. Early theoretical analyses of tax evasion are provided by Allingha and Sando (1972) and Srinivasan (1973), where underreporting of incoe is odeled as a decision ade under uncertainty. Subsequent papers have enhanced the basic odel of individual behaviour by, for exaple, incorporating endogenous labour supply decisions. 4 Also general than legitiate activities. See Freean (1999) for a survey of the econoics of crie. Also, the theoretical study by Burdett, Lagos and Wright (2003) develops a odel where workers are less likely to coit cries when their wages are higher. This has a parallel to inforal sector work where high skill workers ay not to the sae extent get full pay-off for their higher productivity, which akes inforal activities less attractive for highly educated workers. 4 See for exaple Andersen (1977) and Sando (1981) for early contributions of endogenous labour supply and underreporting of incoe. 4 IFAU Does tax evasion affect uneployent and educational choice? equilibriu odels with tax evasion have been developed (for an excellent exaple see Creer and Gahvari (1993)). Several theoretical papers have also recognized that the opportunities for tax evasion differ across occupations. See for exaple Watson (1985), and Pestieau and Possen (1991). Occupational choice in this literature is usually thought of as a choice between self-eployent, where under-reporting is possible, and regular eployent, where under-reporting is not an option. Pestieau and Possen (1991) assue that workers choose either to be entrepreneurs or regular eployees. Workers differ in risk aversion and under-reporting is only available for entrepreneurs. They argue that tax evasion should be allowed to soe degree in order to aintain a large stock of productive entrepreneurs. The principal contribution of the analyses in this paper is that we shed light on how the presence of work opportunities in an inforal sector can affect the educational attainent in an econoy. This has, to our knowledge, not been explored in the previous literature. Another iportant contribution is that we incorporate an iperfectly copetitive labour arket, which facilitates an analysis of how tax and punishent policies affect wage setting and uneployent. Previous research is ainly conducted within the public finance tradition, where wages are either assued to be fixed or deterined by arket clearing. By definition, such fraework is unable to exaine how involuntary uneployent is affected by tax and punishent policies. There have, however, been soe recent studies of how tax and punishent policies affect involuntary uneployent; see Kol and Larsen (2001,2002), Cavalcanti (2002), Boeri and Garibaldi (2002) and Fugazza and Jacques (2003). This paper differs fro these previous studies in that it does not rely on relative price adjustents (as Kol and Larsen, 2001, 2002, and Cavalcanti, 2002) or heterogeneity in oral attitudes and a fixed nuber of vacancies (as Fugazzi and Jacques, 2003), to generate a stable equilibriu where both foral and inforal jobs coexist. Neither does it rely on the assuption that inforal jobs only coe about as atched foral jobs are hit by a bad productivity shock (as Boeri and Garibaldi, 2002) in order to generate coexistence of foral and inforal jobs. Rather this paper assues directed search where the uneployed workers are optially allocating search effort into both the foral and the inforal sector. We assue that the effectiveness of search falls with search tie into a sector. This could capture that different search eth- IFAU Does tax evasion affect uneployent and educational choice? 5 ods are used when searching for a job in a arket. The ore tie that is used in order to search in a arket, the less efficient search ethods have to be used. This particular odeling strategy of search effort has a close reseblance to how search is odelled in van den Berg and van der Klaauw (2001). They extend the Mortensen (1986) odel to account for that workers can use ore than one search channel when seeking for a job, and generate an optial split of search tie between different channels by assuing increasing and convex search costs. This paper is organized as follows. Section 2 describes the odel. Section 3, exaines how the equilibriu variables (e.g. tightness, wages, wage dispersion, eployent and uneployent rates, uneployent stock, and the stock of educated workers) are affected by a fully financed change in the punishent syste. Section 4 concerns the optial design of tax and punishent policies. Section 5 concludes. 2 The odel 5 The econoy consists of a labour force which differs in ability to acquire education. Abilities, e, are uniforly distributed between 0 and 1,e [0, 1]. Based on ability, workers decide whether or not to educate theselves. We assue that it is costless to becoe a anual worker, but that workers who educate theselves find it costly to do so. 6 The cost of education, c(e) is decreasing in ability, c 0 (e) 0. Manual workers face job opportunities in both a foral and an inforal sector, whereas highly educated workers only face eployent opportunities in a foral sector. This is a siplifying assuption approxiating the fact that anual workers perfor inforal sector work to a uch higher extent than highly educated workers. The econoy thus consists of three sectors; the foral anual sector (denoted the foral sector F ), the inforal anual sector (denoted the inforal sector I), and the highly educated sector (denoted h). Manual workers have productivity y and highly educated workers have productivity y h y. 5 The odel is along the line of Pissarides (2000). 6 This is a siplifying assuption, allowing us to focus on the choice between two skill levels. 6 IFAU Does tax evasion affect uneployent and educational choice? 2.1 Manual workers Matching The anual workers search for jobs in the foral and the inforal sector. For siplicity, we assue that only uneployed workers search for jobs. This is a siplification, i.e. we do not acknowledge that the connection to the labour arket given by working in the foral sector ay bring about job opportunities not available while uneployed. Workers accept job offers as long as the expected payoff exceeds their reservation wage. The atching functions for the anual sectors are given by ³ σ X j = v 1 η j j γ η u,j = F, I, where X j is the sectorial atching rate, v, j is the sectorial vacancy rate, and u is the uneployent rate facing anual workers. The rates are defined as the nubers relatively to the anual labour force. Manual workers allocate search effort optially between the foral and the inforal sector. Each worker s total search intensity is exogenously given and noralised to unity, where σ I = σ denotes search effort directed towards the inforal sector, and σ F =1 σ denotes search effort directed towards the foral sector. The paraeter γ 1 captures that the effectiveness of search falls with search effort, i.e., the first unit of search in one sector is ore effective than the subsequent units of search. The transition rates into foral and inforal sector eployent for a particular anual worker i, areλ I i = σ γ i θ I 1 η and λ F i = (1 σ i ) γ θ F 1 η, where θ F v = F (1 σ) γ u and θ I = vi σ γ u are labour arket tightness. Labour arket tightness is easured in effective search units. 7 The rates at which vacant jobs becoe filled are q j = θ j η,j = F, I Value functions Let U,E F,andE I denote the expected present values of uneployent, and eployent in the two sectors. The value functions for worker i then 7 One could, of course, choose a different definition of tightness, for exaple θ F = v F /u and θ I = v I /u. This is, however, of no iportance for the results. IFAU Does tax evasion affect uneployent and educational choice? 7 reads: ru i = R + λ F i(e F U i )+λ I i(e I U i ), (1) rei F = R + wi F (1 t)+s(u Ei), F (2) rei I = R + wi I (1 pδ)+(s + p)(u Ei), I (3) where r is the exogenous discount rate, w j is the sector wage, and s is the exogenous separation rate. R is a lup su transfer that all individuals receive fro the governent which reflects that the governent has soe positive revenue requireents. The paraeter t is the proportional incoe tax rate, p is the probability of being detected working in the inforal sector, and δ is the proportion of the evaded incoe the worker has to pay as a punishent fee if detected. The atch is dissolved when detected which iplies that the separation rate in the inforal sector exceeds the foral sector separation rate. For siplicity, we disregard fro uneployent benefits. Let J F and V F represent the expected present values of an occupied job and a vacant job in the foral sector, respectively. The arbitrage equations for a job paying the wage wi F andavacantjobintheforal sector are then rji F = y wi F (1 + z)+s(v F Ji), F (4) rv F = q(j F F V F ) k, (5) where z is the payroll tax rate and y is productivity. Vacancy costs are denoted k. Analogous notation for the inforal sector yields: rji I = y wi I (1 + pα)+(s + p)(v I Ji), I (6) rv I = q(j I I V) I k, (7) where α is the proportion of the evaded wage the fir has to pay as a punishent fee if detected. The uneployed worker i allocates search between the two sectors, σ i, in order to axiize the value of uneployent, ru i. A necessary condition for an interior solution is that γ 1, which holds by assuption. The first order condition can be written as: (1 σ i ) 1 γ µ θ F 1 η (σ i ) 1 γ = E F U i θ I E I. (8) U i Workers allocate their search between sectors to equalize returns to search effort across the two sectors. 8 IFAU Does tax evasion affect uneployent and educational choice? 2.1.3 Wage deterination When a worker and fir eet they bargain over the wage, w j i,taking econoy wide variables as given. The first order conditions fro the Nash bargaining solutions, with the worker s bargaining power being equal to β, can be written as: where φ t = 1+z 1 t and φp = 1+pα 1 pδ β 1 1 β φ t JF = E F U, (9) β 1 1 β φ p JI = E I U, (10) are the tax and punishent wedges, and where we have iposed syetry and the free entry condition, V j =0, j = F, I. We can now derive an equation deterining how search is allocated between the two sectors in a syetric equilibriu by substituting (9) and (10) into (8) and using that J F = k together with free entry. This yields: q F and J I = k q I fro (5) and (7) (1 σ) 1 γ (σ) 1 γ = θf θ I ψ, (11) where ψ = φp φ t = 1+pα 1 pδ /1+z 1 t, (12) is the wedge between the inforal sector and the foral sector. We can interpret a ψ 1as if the inforal sector is punished to a lesser extent than the foral sector is taxed. 8 Equation (11) is the core equilibriu equation. Recall fro (8) that workers allocate their search between sectors so that the arginal returns to search effort in the two sectors are equal. With wages being endogenously deterined in equilibriu, this iplies to account for the wedge, ψ, and for differences in sectorial labour arket tightness, θf, when deciding θ I 8 In contrast, if ψ =1, the inforal sector is punished equally
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