Working Papers in Economics,
University of Gothenburg, Department of Economics

Abstract: How do government-supplied institutional benefits and the taxation and regulation of produc- ers affect the propensity of private firms to enter the unofficial economy and evade taxation? We propose a model in which the incentive of firms to operate underground depends on tax rates relative to firm-specific thresholds of tax toleration that are decisively affected by quality of governance - in particular by the presence of high-grade institutions delivering services enhancing official production that anchor profit-maximizing firms to the official economy. Some key predictions of the model concerning the determinants of firms' tax toleration and tax compliance receive broad support from empirical analyses of enterprise-level data from the World Bank's World Business Environment Surveys.

Keywords: tax toleration; tax compliance; tax evasion; corruption; quality of government; institutions; unofficial production; black economy; shadow economy; underground economy; micro political economy of firm behavior

JEL-codes: D21; H26; K42; O17

32 pages, First version: August 23, 2005. Revised: June 18, 2009. Earlier revisions: June 12, 2006.

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Douglas A. Hibbs Jr. and Violeta Piculescu, (2010), 'Tax Toleration and Tax Compliance: How Government Affects the Propensity of Firms to Enter the Unofficial Economy', American Journal of Political Science, vol 54, no 1, pages 18-33

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