Scandinavian Working Papers in Economics

Working Papers,
Copenhagen Business School, Department of Economics

No 11-2003: Wages, unemployment, and the underground economy

Anne-Sofie Kolm and Birthe Larsen
Additional contact information
Anne-Sofie Kolm: Department of Economics, Copenhagen Business School, Postal: Department of Economics, Copenhagen Business School, Solbjerg Plads 3 C, 5. sal, DK-2000 Frederiksberg, Denmark
Birthe Larsen: Department of Economics, Copenhagen Business School, Postal: Department of Economics, Copenhagen Business School, Solbjerg Plads 3 C, 5. sal, DK-2000 Frederiksberg, Denmark

Abstract: While examining the macroeconomic effects of increased government control of the informal sector, this paper develops a two-sector general equilibrium model featuring matching frictions and worker-firm wage bargaining. Workers search for jobs in both the formal and the informal sector. We analyse the impact of higher punishment rates and a higher audit rate on labour market performance. We find that a higher punishment rate reduces the size of the informal sector and reduces unemployment. A higher audit rate has an ambiguous impact on unemployment, and may actually increase the size of the underground economy.

Keywords: Tax evasion; underground economy; matching; bargaining; unemployment

JEL-codes: H26

32 pages, October 20, 2003

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