Effect of Tax Reform on the Size of the Hidden Economy: Evidence from the Post-Communist Natural Experiment

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Project Title: Effect of Tax Reform on the Size of the Hidden Economy: Evidence from the Post-Communist Natural ExperimentAdvocates of the adoption of flat taxes to replace progressive taxes claim that one of the benefits of such a reform will be a substantial reduction in the incentive of economic agents to hide income by participating in the hidden or underground economy. To date there is little evidence evaluating the validity of this claim. This project investigates whether this claim is supported by taking advantage of the natural experiment provided by the experience of tax reformers in the post-communist countries of Central and Eastern Europe. The research utilizes the fact that every federated state in the post-communist world split into one or more successor states in recent years and that in each of these groups of successor states at least one country implemented a flat tax reform while one or more of the other countries retained their complex, progressive tax system. The evolution of the size of the hidden economy in the flat tax adopters (Slovakia, Russia, Serbia and Georgia) is compared with that in the non-adopters (the Czech Republic, Ukraine (until recently), Croatia and Armenia). This research design provides a simple, easily understood, difference-in-difference estimate of the impact of major simplification of tax systems and lower tax rates on the decision to hide income from authorities. The existence of the comparison counties enables the elimination of the impact of many other factors that make results from any particular reform hard to isolate. Our estimates of the size of the hidden economy are based on multiple widely-used techniques including the relationship of physical inputs (especially electricity) to national output, the ratio of currency in circulation to the money supply, direct surveys of workers, and the estimation of the relationship between households' reported income and expenditure on various items including food and other commodities. The intuition is that households with unreported income will appear to spend more on purchases then they should based on their reported income. We use recently developed estimation techniques that enable us to relax the assumptions in previous work that only households with self-employed heads can hide income, and that all such households hide the same fraction of their income. This results in more believable estimates of the amount of unreported income in the economy. The provision of multiple, independent estimates also lends credibility to our estimate of the effect of the tax reform on the propensity to hide income from authorities. The effect of a flat-tax reform is an important public policy question. Many countries, including the United States, are studying the possibility of adopting such a reform. The results of this project will inform the debate in these countries, enabling the discussion of a significant proposed policy change to be based on much more solid empirical evidence than has previously been available.