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TAX ENFORCEMENT POLICIES, TAX EVASION

AND TIME ALLOCATION


Several studies examine the eect of tax rates on households labor supply decisions in attempts
to account for observed dierences in work hours across countries. Interestingly, these studies fail
to consider a fundamental action associated with taxation: tax evasion. This paper introduces,
into a general equilibrium model of household labor supply, the possibility that households can
evade taxes by working in the underground economy. We nd that dierences in tax rates and tax
enforcement policies can potentially account for observed dierences in formal work hours in major
OECD countries. We also obtain estimates of hours worked in the informal sector for these countries.
Keywords: Labor Supply; Tax Enforcement; Informal Economy; Tax Evasion.
JEL Classication: E26; H26; J22; K42.
1
1 Introduction
A number of studies examine the eect of tax rates on households labor supply decisions in an
attempt to account for observed dierences in average work hours observed across countries. Inter-
estingly, these studies fail to consider a fundamental action associated with taxation - tax evasion. We
motivate our analysis in the context of Lemieux, Fortin and Frechette (1994) and Prescott (2004) by
introducing the possibility that households can evade taxes by working in the underground economy
into a general equilibrium model of household labor supply. The model is calibrated to Canadian
data, and the calibrated model is used to derive the eects of tax rates and tax evasion penalties on
formal work hours. We nd that dierences in tax rates and tax enforcement policy can potentially
account for observed dierences in formal work hours in the United States and European countries.
Large dierences in average market work hours are observed across OECD countries. Numerous
authors such as Prescott (2004), Rogerson (2007) and Olovsson (2009) have shown that dierences in
tax rates can account for a substantial portion of the observed dierences in hours worked. Alesina,
Glaeser and Sacerdote (2005) argue that Europeans work much less than Americans because of labor
market regulations. They note that particular unions restrict the number of hours per worker so as
to sustain higher employment levels. Ohanian, Rao and Rogerson (2008) extend Prescotts (2004)
analysis to study long-term changes in labor supply in OECD countries during the period 1956-2004
and nd that wedges are much smaller in a model with taxes than in a model without taxes. Dhont
and Heylen (2008) show that dierences in income taxes, productive government expenditures, and
nonemployment transfers are sucient to explain why Europeans work (much) less than Americans
and why some Europeans work less than others.
Within Europe, home production and government spending are potential explanations for such
dierences. For instance, tax distortions can be partially oset by subsidies on market goods, such
as day care, that are close substitutes for home goods. Burda et al. (2008) nd that Europeans
engage in 15 20 percent more time in home production than do Americans. Ragan (2005) presents
a home production model and analyzes the implications of two policies, a subsidy on market sector
home services and "workfare" transfers (publicly provided day care). Public expenditures on home
goods and home production, however, are insucient to explain the pattern of hours of market work
2
in Scandinavian countries.
Researchers fail to consider an important choice private agents face with taxes, namely, the choice
to avoid paying them by engaging in informal work. The presence of a substantial informal sector
in developed and developing countries has been well studied and documented and informal activities
is an important component of most OECD countries.
1
According to Schneider and Enste (2000),
among Eurozone countries the size of the informal sector (as a proportion of GDP) varies from a low
of 10 percent of GDP in Austria to a high of 29 percent in Greece. Figures for the Scandinavian
countries are around 18 percent of their GDP.
The informal sector is often dened as a sector that emphasizes small-scale, self-nanced and
unskilled labor intensive economic activities. Workers employed in this sector tend to be younger, have
less education, and earn less than their counterparts in the formal sector (Thomas, 1992; Maloney,
1999, Pratap and Quintin, 2006; Paula and Scheinkman, 2010; Caponi, 2010).
2
The representative
agent framework presented in this paper is a rst step to evaluate a households response to changes
in tax and enforcement legislation.
Among other factors, the decision to evade taxes and engage in informal activities is inuenced
by tax enforcement policy, namely evasion penalties and detection probabilities. Dierent countries
have dierent approaches regarding tax administration, enforcement and auditing procedures. OECD
(2010) provides comparative data on these measures for OECD countries. Alternative combinations
of tax evasion penalties and detection probabilities could be interpreted as an equilibrium outcome.
For instance, countries tough on the underground economy could use both policy instruments - high
penalties and more auditing. On the other hand, some countries could choose to punish harder
those informal workers that are eventually caught while others would approach this problem with
high inspection rates. Changes in evasion penalties relate to changes in the law at almost no cost.
Dierently, changes in the detection probability can be obtained only by investing more money in the
auditing activity. Increased enforcement through more auditing is costly and involves a portion of
tax revenues. Despite the availability of data on enforcement measures and penalties for tax evasion,
1
See Johnson et al. (1998), Friedman et al. (2000), Fugazza and Jacques (2003), Dessy and Pallage (2003),
Busato and Chiarini (2004), Choi and Thum (2005), Antunes and Cavalcanti (2007) and Dabla-Norris, Gradstein and
Inchauste (2008).
2
The International Labour Organization (ILO) denes the informal sector as enterprises with all or most charac-
teristics in a list that includes "family ownership, small scale of operations and labor-intensive methods".
3
obtaining a comparable measure of the probability of detection across countries is quite challenging,
and we approach this issue with caution.
We argue that taxes are relevant to explain labor supply, not only because people pay them
but also because people can evade them. The possibility of avoiding taxes introduces an additional
margin of substitution for the household. In addition to substituting leisure for market work, agents
can also substitute informal, non-taxed work for formal work. This paper explores the relevance of
informal activities and tax enforcement policies to explain dierences in observed hours worked in the
formal sector of Austria, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Norway, Spain,
Sweden, the United Kingdom and the United States. We consider the existence of an informal sector
where its total factor productivity (TFP) is dierent than the formal sector TFP. The elasticity of
substitution between consumption and leisure and the elasticity of substitution between formal and
informal labor play important roles in this analysis.
The introduction of this extra margin implies that tax rates will have a large eect on the labor
supply decision of households. How large of an eect depends on tax enforcement policies. In order
to determine the size of the eect it is necessary to calibrate a model using estimates of tax rates,
tax evasion penalties and probabilities of being caught. To proceed, we calibrate our model to the
Canadian economy, making dierent assumptions about the two key elasticities. We then examine
the implications of the model for formal and informal time allocation in Canada and other economies
that are the same in all aspects except for their tax and enforcement policies.
We nd that dierences in tax rates and tax enforcement policy can potentially account for
observed dierences in formal work hours in these countries. The elasticity of substitution between
formal and informal labor plays a critical quantitative role in how formal hours change in response
to changes in tax enforcement policies. As the income tax rate increases, labor supply decreases.
For formal labor provision, the eect is stronger the lower this elasticity. If agents are more willing
to substitute formal for informal work, an increase in taxes increases the expected penalty for tax
evasion, reducing informal hours. Formal (informal) labor increases (decreases) as either the detection
probability or the evasion penalty increases. The eect on formal labor provision of a change in the
penalty for tax evasion is stronger the higher the elasticity of substitution of labor between the formal
and informal sectors. When agents can engage in informal activities it represents an alternative way
4
to allocate their time associated with a reduction in formal work, and leisure time tends to respond
less to changes in enforcement policies. The eects of changes in the tax and enforcement policies
are stronger the lower the elasticity of substitution between leisure and consumption.
Once the model is calibrated to Canada we address the question of how much a model with
informal activities can account for the observed patterns in hours worked in major OECD countries.
Assuming a high elasticity of substitution between consumption and leisure, the model performs well
in explaining the magnitude of formal work hours in Austria, France, Greece, Spain, Sweden, the
United Kingdom and the United States. For a lower elasticity of substitution between leisure and
consumption, the model explains more than eighty percent of hours worked in Denmark, Germany
and Norway and almost seventy percent of market labor supply in Finland and Ireland. We conduct
several experiments to assess the quantitative signicance of particular parameters and nd that the
results are robust to these changes. We calculate the size of the informal sector as a percentage of the
formal sector and compare our results to the existing estimates provided by Schneider and Klinglmair
(2004). The model performs well in this respect for Scandinavian countries, but it underpredicts the
size of the informal sector in Greece, Italy and Spain.
Our results show that a model with informal activities does well in explaining the magnitudes of
observed formal work hours and provides estimates of informal worked hours for a broad range of
OECD countries. To the best of our knowledge, this information is not available in the literature
and, thus, is a major contribution of this paper. We conclude that the combination of three elements
is relevant to explain cross-country dierences in hours worked in the formal sector: tax and enforce-
ment policies, the utility curvature parameter, and the elasticity of substitution between formal and
informal labor.
The structure of the paper is as follows. Section 2 presents an informal sector model. In Section
3 the model is solved and calibrated to assess the quantitative eects of tax enforcement policies on
agents time allocation. In Section 4, we study the eects of enforcement policies on hours worked in
major OECD countries. A sensitivity analysis is also presented. Concluding comments are oered in
the last section.
5
2 An Informal Sector Model
We present a standard representative agent framework in order to analyze the implications of tax
enforcement policies on market work and informal activities. The benchmark model has a formal and
an informal sector. The production technology diers across sectors. Formal and informal production
requires labor and physical capital is an additional factor of production in the formal sector. The
TFP diers across sectors to capture the relative productivity of labor in the formal and informal
sectors.
The agent is endowed with one unit of time and allocates it between work in the formal sector
(/
n
), work in the informal sector (/
i
), and leisure (|). The households preferences are dened over
consumption (c) and leisure (1 /
n
/
i
). Following Prescott (2004), preferences are restricted to
be of the form:
n(c. 1 /
n
/
i
) = log(c) + clog(1 /
n
/
i
).
where 0 c 1 species the value of leisure for the household.
The nature of economic activities in the informal sector imposes a limit on the scope of these
activities. Informal workers tend to operate in small informal markets that government authorities
cannot monitor very easily. Moreover, as labor becomes more specialized in a larger market, it also
becomes more visible to the tax authorities. The model is based on a concave earnings function in
the informal sector,
i
=
i
/

i
, 0 1, to capture the increasing visibility to the tax authorities
of larger scale of production (Lemieux et al., 1994). The formal sector production function is dened
as
n
=
n
/
o
/
1o
n
and
n
and
i
represent the formal and informal sectors TFPs, respectively.
The government levies a proportional tax t
j
on formal labor income, a consumption tax t
c
and
a capital income tax t
I
. An agent can evade taxes by working in the informal sector, and informal
activities can be detected and taxed with a given positive probability. If the government can catch
and punish workers engaged in informal activities, tax enforcement policies will clearly aect the
agents labor supply decisions in both formal and informal sectors. Let o denote the probability of
being caught evading taxes and let ` 1 denote the penalty for tax evasion, which is proportional to
the amount of the tax (t
j
) evaded (Fugazza and Jacques, 2003). The proceeds of these taxes nance
a non-excludable lump sum transfer 1. When informal activities are not considered (/
i
= 0), the
6
model reduces to the one studied by Rogerson (2007).
The optimization problem of the household is
max
c

,c
1
,I
0

,I
0
1
,Im,I
i
1n(c. |) = o (log c
0
+ clog(1 /
n
/
i
)) + (1 o) (log c
10
+ clog(1 /
n
/
i
))
:n/,cct to
(1 + t
c
)c
0
+ /
0
0
= (1 t
j
)n
n
/
n
+ [1 + (1 t
I
)(: o)]/
0
+ (1 `t
j
)n
i
/
i
+ 1
(1 + t
c
)c
10
+ /
0
10
= (1 t
j
)n
n
/
n
+ [1 + (1 t
I
)(: o)]/
10
+ n
i
/
i
+ 1
where c
0
and /
0
represent consumption and capital stock of agents detected working in the informal
sector and c
10
and /
10
, otherwise, /
0
is the capital stock in the next period, n
n
and n
i
are the real
wage rates in the formal and informal sectors, respectively, : is the real price of capital and o is the
capital depreciation rate. The government budget constraint and the economys resource constraint
are, respectively
(1) 1 = t
c
(oc
0
+ (1 o)c
10
) + t
j
n
n
/
n
+ o`t
j
n
i
/
i
+ t
I
(: o)(o/
0
+ (1 o)/
10
)
(2) oc
0
+ (1 o)c
10
= n
n
/
n
+ n
i
/
i
o(o/
0
+ (1 o)/
10
)
The optimality conditions for an interior solution with respect to formal and informal work hours are

o
(1 + t
c
)c
0
+
1 o
(1 + t
c
)c
10

(1 t
j
)n
n
=
c
(1 /
n
/
i
)
(3)

o(1 `t
j
)
(1 + t
c
)c
0
+
1 o
(1 + t
c
)c
10

n
i
=
c
(1 /
n
/
i
)
(4)
Equations (3) and (4) equate the gain from formal and informal work income to the marginal utility
of leisure, respectively. These two conditions characterize the equilibrium value of time devoted to
market work and informal activities as a function of taxes (t
j
. t
c
. t
I
) and enforcement policies (o. `).
From equations (3) and (4), we have that at an optimum the individual wants to equate the expected
marginal product of formal and informal activities.
7
3 Quantitative Assessment
We calibrate the model to match features of the Canadian economy, and then we consider the
implications for changes in the tax enforcement policies while holding all of the preferences and
technology parameters xed. The choice of Canada is mainly due to data availability, in particular,
data on informal hours of work and the concavity parameter .
Market (formal) labor supply (/
n
) is computed based on the employment / population ratio (in
the 15 64 age group) ratio and the annual hours worked, using data from OECD Labor Database
(2005) for the period 2000 2004. Each individual has 14 hours per day available to allocate
among market labor, informal activities and leisure. The remaining hours are spent on sleep and
maintenance. That is, each person has 5100 hours per year of non-sleep and non-maintenance (14
hours times 365 days). Thus, market hours are expressed as:
(5) /
n
=

1:j|o:c:t
1ojn|ctio:

c:cqc ::nc| Hon:: \o:/cd


5100

Fortin et al. (2000) estimate that a representative worker spends 339 hours per year (or, equiv-
alently, 6.52 hours per week) in the underground sector in the Province of Quebec, Canada. The
marginal personal tax rate on labor income is 30.1 percent (t
j
= 0.301), which combines federal
(21.3%) and provincial (8.8%) tax rates. The consumption tax in Canada includes a general sales
tax (GST) and a provincial sales tax (PST). To make the consumption tax consistent with the ob-
served hours in the informal sector, we set t
c
= 0.135 which is the sum of a 5.0 percent GST and
a 8.5 percent PST. We assume that the capital income tax rate in Canada is 27.6 percent (OECD,
2011) and the capital depreciation rate is o = 0.1671 (Statistic Canada, 2007). In Canada, penalties
for tax evasion range from 50 percent to 200 percent according to the seriousness of the oence.
3
We
set ` = 1.5 (i.e., the amount of tax evaded plus a fty percent penalty), as the baseline.
The probability of detecting an agent working underground or evading taxes is related to auditing
procedures and monitoring technology. Detection probabilities based on the proportion of tax returns
3
In Canada, a judicial nding of tax evasion can be quite painful. Section 239(1) of the Income Tax Act sets out the
penalty: a ne of not less than 50%, and not more than 200% of the amount of the tax that was sought to be evaded.
In addition, the convicted taxpayer may be imprisoned for a period of up to ve years (See http://www.duhaime.org
for more details).
8
audited (frequency of audit) are reportedly very low. In the United States, according to Andreoni
et al. (1998), the audit rate for individual tax returns was 1.7 percent in 1995. Data from the
Internal Revenue Service indicate that this rate decreased to 0.93 percent in the period 1996-2002.
Similarly, Busato and Chiarini (2004) estimate a 3 percent probability of detection in Italy and Ratto,
Thomas and Ulph (2005) found a 0.7 percent probability of being caught evading taxes in the United
Kingdom. In Canada, according to Canada Revenue Agency, this audit rate fell from 1.01 percent
in 2002 to 0.75 percent in 2006. We set the detection probability in Canada equals to 1 percent
(o = 0.01).
Lemieux et al. (1994) estimate the elasticity of substitution between formal and informal labor
using a microlevel data set from a survey carried out in Quebec City, Canada. They report estimates
of ranging from 0.655 to 0.729, and their point estimate of the curvature parameter is 0.71, which
implies an elasticity of substitution of labor between the formal and informal sectors of 3.44. We
use their point estimate for this parameter.
The formal sector TFP,
n
, is calibrated to match the earnings gap between regular sector and
informal sector. Lemieux et al. (1994) estimate an earnings gap of 1.24, meaning that earnings are
about twenty four percent higher in the formal sector. The informal sector TFP (
i
) and the utility
parameter (c) are chosen to satisfy equations (3) and (4) and to match /
n
= 27.10 and /
i
= 6.52.
The calibrated parameters of the model are
i
= 0.3418 and c = 0.1031. Note that the informal
sector is less productive than the formal sector, a result consistent with compelling evidence about
the informal sector (see Maloney, 1999, 2004; Pratap and Quintin, 2006 and Amaral and Quintin,
2006). In this case, as suggested by Ihrig and Moe (2004), the trade-o for the agent is between
higher productivity per unit of labor input in the formal sector and lower productivity but possible
avoidance of taxes in the informal sector. Table 1 presents the baseline values for Canada.
9
Table 1 - Baseline Values: Canada
Value Source

n
formal sector TFP 1.24 Calibrated

i
informal sector TFP 0.3418 Calibrated
c leisure parameter 0.1031 Calibrated
t
j
tax rate on formal income 0.301 OECD (2004)
t
c
consumption tax 0.135 Canada Revenue Agency
t
I
capital income tax 0.276 Statistic Canada, 2007
o depreciation rate 0.1671 Statistic Canada, 2007
o detection probability 0.01 Canada Revenue Agency
` penalty for tax evasion 1.50 Income Tax Act - Canada
production concavity parameter 0.71 Lemieux et al. (1994)
Table 2 shows the relative time devoted to formal and informal work associated with dierent
values for income tax, probability of detection and evasion penalty and dierent values of . All
values in the table are relative to t
j
= 0.301. o = 0.01 and ` = 1.5 and other parameters are kept at
their baseline values. The parameters
i
and c are recalibrated for each value of . The lump-sum
transfer 1 is adjusted accordingly.
Notice that as the income tax rate increases, both formal and informal labor supply decrease. For
formal labor provision, the eect is stronger the lower the elasticity of substitution of labor between
formal and informal sectors (). The opposite eect is observed for hours worked in the informal
sector. Since the evasion penalty is proportional to the tax evaded, if the agent is more willing to
substitute formal for informal work, an increase in taxes also increases the expected penalty for tax
evasion, reducing informal hours. The relative time devoted to formal and informal work associated
with dierent probabilities of detection and evasion penalty values are also presented in Table 2.
As expected, formal (informal) labor increases (decreases) as either the detection probability or the
evasion penalty increases.
10
Table 2 - Taxes, Enforcement Policies and Formal and Informal work: = 1
= 0.40 = 0.50 = 0.60 = 0.71 = 0.80
/
n
/
i
/
n
/
i
/
n
/
i
/
n
/
i
/
n
/
i
t
j
= 0.40 0.776 0.902 0.752 0.893 0.737 0.892 0.760 0.913 0.799 0.953
t
j
= 0.50 0.628 0.844 0.631 0.821 0.636 0.792 0.646 0.751 0.663 0.708
o = 0.10 1.032 0.926 1.032 0.911 1.031 0.888 1.031 0.842 1.030 0.770
o = 0.20 1.065 0.847 1.063 0.818 1.061 0.774 1.056 0.695 1.049 0.577
` = 1.75 1.022 0.990 1.022 0.988 1.022 0.984 1.023 0.976 1.024 0.964
` = 2.00 1.045 0.979 1.045 0.975 1.046 0.968 1.047 0.954 1.050 0.928
Baseline values: t
j
= 0.301. o = 0.01. ` = 1.5
Rogerson (2007) assumes preferences of the form n(c. 1 /
n
/
i
) = log(c) + c
(1ImI
i
)
1
1
and
argues that = 3 should be an upper bound for the utility curvature parameter. This parameter
is central to the debate in the labor supply literature and it is signicant in terms of assessing the
quantitative signicance of tax and enforcement policies on labor supply. However, there is consid-
erable controversy over its appropriate value. As stated in Rogerson (2007), no reliable estimates
of exists. Table 3 presents the results for = 3 and, again, all values are relative to t
j
= 0.301.
o = 0.01 and ` = 1.5. The parameters
i
and c are recalibrated for each value of and . The
lump-sum transfer 1 is adjusted accordingly.
Table 3 - Taxes, Enforcement Policies and Formal and Informal work: = 3
= 0.40 = 0.50 = 0.60 = 0.71 = 0.80
/
n
/
i
/
n
/
i
/
n
/
i
/
n
/
i
/
n
/
i
t
j
= 0.40 0.669 0.992 0.641 0.671 0.631 0.607 0.625 0.518 0.649 0.449
t
j
= 0.50 0.435 0.585 0.401 0.530 0.344 0.465 0.344 0.277 0.450 0.174
o = 0.10 1.081 0.920 1.090 0.903 1.102 0.877 1.125 0.829 1.162 0.747
o = 0.20 1.148 0.839 1.161 0.808 1.179 0.764 1.211 0.680 1.258 0.559
` = 1.75 1.052 0.984 1.056 0.979 1.063 0.972 1.079 0.958 1.145 0.914
` = 2.00 1.165 0.959 1.223 0.946 1.225 0.936 1.213 0.926 1.184 0.919
Baseline values: t
j
= 0.301. o = 0.01. ` = 1.5
11
The eects of changes in the tax and enforcement policies are stronger for a lower elasticity of
substitution between leisure and consumption (higher ). For instance, for the same change in the
probability of detection (o) or the penalty for tax evasion (`), hours worked in the formal sector tend
to increase more when = 3. Hours worked in the informal sector are less sensitive (downward) to
changes in the enforcement policies when the elasticity of substitution is lower. This exercise shows
that the combination of tax and enforcement policies, the elasticity of substitution between formal
and informal labor and the utility curvature parameter can potentially explain changes in hours
worked in the formal and informal sectors. In the next section we conduct a cross-country analysis to
assess the quantitative signicance of these policies to explain market labor hours worked in major
OECD countries.
4 Tax Enforcement Policies and Time Allocation
4.1 Tax Enforcement Policies and Hours Worked
With the model calibrated to Canadas data, we can address the question of how much a model with
informal activities can account for the observed patterns in hours worked in major OECD countries.
To assess the quantitative eects of tax enforcement policies on an agents time allocation to formal
and informal work, the production concavity parameter (), the probability of detection (o) and the
formal and informal sector TFPs (
n
,
i
) are kept at the benchmark levels for all countries. Our
benchmark value for the utility curvature parameter is = 1. Tax and enforcement policies (t
j
,
t
c
, t
I
, `) are country-specic. This step amounts to asking what cross-country dierences one can
generate in the context of this model out of tax enforcement policy dierences alone. The results are
presented in Figure 1.
12
0.15 0.2 0.25 0.3 0.35 0.4 0.45
0.15
0.2
0.25
0.3
0.35
0.4
0.45
Formal Hours of Work - Actual
F
o
r
m
a
l
H
o
u
r
s

o
f

W
o
r
k

-

P
r
e
d
i c
t
e
d
AUS
CAN
DEN
FIN
FRA
GER
GRE
IRE
ITA
NOR
SPA
SWE
UK
USA
Figure 1 - Formal Hours Worked in the Informal Work Model ( = 1)
The model performs well in explaining the magnitude of formal work hours in Austria (98%),
France (81%), Greece (76%), Spain (93%), Sweden (78%), the United Kingdom (75%) and the United
States (72%). Values in parentheses represent the percentage of the formal hours worked explained by
the model. However, the model overpredicts hours worked in Denmark, Finland, Germany, Ireland,
Italy and Norway.
In order to verify how important informal activities and tax enforcement policies are in accounting
for labor supply, we conduct the following exercise. We eliminate the informal sector and keep the
leisure parameter c at the calibrated value of 0.1031. That is, we do not recalibrate this parameter
for an economy without the informal sector. Figure 2 shows that a model without informal activities
cannot reconcile the levels of formal work in OECD countries and, moreover, it would overestimate
hours worked in the formal sector. The bars represent the data on formal hours worked (scale on the
left) and the predictions of the model without informal activities are plotted with stars (scale on the
right).
13
AUS CAN DEN FIN FRA GER GRE IRE ITA NOR SPA SWE UK USA
0
0.1
0.2
0.3
0.4
D
a
t
a

-

F
o
r
m
a
l

H
o
u
r
s

W
o
r
k
e
d
0.74
0.76
0.78
0.8
0.82
M
o
d
e
l

w
i
t
h
o
u
t

I
n
f
o
r
m
a
l

A
c
t
i
v
i
t
i
e
s
Figure 2 - Formal Hours Worked in a Model without Informal Activities ( = 1)
4.2 Sensitivity Analysis
In this section, we conduct several experiments to assess the quantitative signicance of particular
parameters for the prediction of labor supply in OECD countries. In particular, we conduct sensitivity
analysis and check robustness when the elasticity of substitution between formal and informal labor
parameter , the evasion penalty `, the formal tax rate t
j
, the probability of detection o and utility
curvature parameter vary. The baseline values of these parameters are as described in Table 1.
In each experiment, only one variable is changed at a time, while others are kept at their baseline
values. The parameters
i
and c are recalibrated accordingly. Data and results are also presented
in the Appendix, Tables .1 and .2.
Experiment 1: Elasticity of substitution parameter
Figure 3 reports the cross-country estimates of formal worked hours for the values of reported by
Lemieux et al. (1994). The left panel presents estimates for = 0.655 and the results for = 0.729
are displayed on the right panel. The results are very robust to changes in the elasticity parameter
and the percentage explained of formal work hours is quite similar to the ones observed in our baseline
14
case (Figure 1).
0.15 0.2 0.25 0.3 0.35 0.4
0.15
0.2
0.25
0.3
0.35
0.4
0.45
=0.655
Formal Hours of Work - Actual
F
o
r
m
a
l

H
o
u
r
s

o
f

W
o
r
k

-

P
r
e
d
i c
t
e
d
AUS
CAN
DEN
FIN
FRA
GER
GRE
IRE
ITA
NOR
SPA
SWE
UK
USA
0.15 0.2 0.25 0.3 0.35 0.4
0.15
0.2
0.25
0.3
0.35
0.4
0.45
=0.729
Formal Hours of Work - Actual
F
o
r
m
a
l

H
o
u
r
s

o
f

W
o
r
k

-

P
r
e
d
i c
t
e
d
AUS
CAN
DEN
FIN
FRA
GER
GRE
IRE
ITA
NOR
SPA
SWE
UK
USA
Figure 3 - Formal Hours Worked: = 0.655; 0.729
Experiment 2: Evasion Penalty `
As noted above, evasion penalties are generally imposed as a percentage of the additional tax payable,
and most countries adopt a range for evasion penalties and the penalty imposed varies according to
the seriousness of the oence. For our benchmark case, we used the lower bound of these penalties
for Canada and other OECD countries. In this section, we evaluate how sensitive our results are to
dierent values of evasion penalties. The parameters
i
and c are recalibrated assuming the upper
bound penalty for Canada, i.e., ` = 3.0, and predictions of the model are found for each OECD
country in our sample using its highest level for evasion penalty. The model still overpredicts hours
worked in Denmark, Finland, Germany, Ireland, Italy and Norway, and the percentage explained
by the model is smaller, compared to the baseline, for Austria (95%), France (77%), Greece (76%),
Spain (89%), Sweden (73%), the United Kingdom (72%) and the United States (68%). Results are
reported in the left panel of Figure 4.
15
Experiment 3: Labor Income Tax Rate t
j
It is well known that marginal labor income taxes vary substantially across countries. In our bench-
mark case and experiments so far, we have used the combined marginal tax rate; i.e., the sum of
central and sub-central government income tax rates. However, the tax burden on formal workers
also includes employee social security contributions and these, as well, dier across countries. For
instance, the combined tax rate in Canada is 30.1 percent, while the all-in tax rate, calculated as the
combined tax rate plus employee social security contributions, is ve percent higher. In this section
we use this concept of marginal tax rate to assess the relevance of tax and enforcement policies to
explain formal labor supply in OECD countries. In general, the tness of the model to the data im-
proves for all countries except for Austria, Denmark, Finland, Germany, Ireland, Italy and Norway.
We illustrate the results of this experiment in Figure 4 (middle panel).
Experiment 4: Probability of Detection o
The probability of detecting an agent working in the informal sector or evading taxes is related to au-
diting procedures and monitoring technology. Dierent countries have dierent approaches regarding
tax administration, enforcement and verication procedures. OECD (2010) presents a comprehensive
survey of tax administration arrangements, practices and performance across 34 OECD countries.
Despite the availability of data on enforcement measures, obtaining a comparable measure of
the probability of detection across countries is quite challenging. OECD (2008) reports data on the
coverage of tax verication activities measured as a proportion of the estimated size of the taxpayer
population. Verication comprises activities undertaken by revenue bodies to check whether tax-
payers have properly reported their tax liabilities. The primary verication activity undertaken by
revenue bodies is usually described by the term tax audit or tax control. However, across rev-
enue bodies, audit activities vary in their scope, intensity and the precise nature of actions taken
by ocials that are deemed to constitute an audit. Revenue bodies also carry out various other
activities (e.g. investigations, income/document matching, computer-based checks, and inspections)
that result in changes to taxpayers reported liabilities.
We use this coverage concept (the ratio of number of completed actions to the taxpayer population)
as a proxy for the probability of being audited by the tax authority. The coverage of verication
16
activities varies considerably across countries. High coverage rates are observed in Norway (12%),
Ireland (8%) and Sweden (7%). On the other hand, these rates are less than one percent in Finland,
France, Greece and the United Kingdom. These data suggest a much higher probability of detection
for Canada (o = 0.148), our baseline economy. We recalibrate parameters
i
and c.
Figure 4, right panel, reports the results for all countries when tax and enforcement policies (t
j
,
t
c
, t
I
, ` and o) are country-specic. The performance of the model is better for France (82%), Greece
(78%), Spain (96%), Sweden (79%), the United Kingdom (76%) and the United States (73%).
0.2 0.3 0.4
0.15
0.2
0.25
0.3
0.35
0.4
0.45
Evasion Penalty
Formal Hours of Work - Actual
F
o
r
m
a
l

H
o
u
r
s

o
f

W
o
r
k

-

P
r
e
d
i c
t
e
d
AUS
CAN
DEN
FIN
FRA
GER
GRE
IRE
ITA
NOR
SPA
SWE UK
USA
0.2 0.3 0.4
0.15
0.2
0.25
0.3
0.35
0.4
0.45
Labor Income Tax Rate
y
Formal Hours of Work - Actual
AUS
CAN
DEN
FIN
FRA
GER
GRE
IRE
ITA
NOR
SPA
SWE
UK
USA
0.2 0.3 0.4
0.15
0.2
0.25
0.3
0.35
0.4
0.45
Probability of Detection
Formal Hours of Work - Actual
AUS
CAN
DEN
FIN
FRA
GER
GRE
IRE
ITA
NOR
SPA
SWE
UK
USA
Figure 4 - Formal Hours Worked - `. t
j
. and o
Before we present and discuss the next experiment, it is interesting to point out that the model
with informal activities performs quite well in explaining the market labor supply in seven OECD
countries, namely, Austria, France, Greece, Spain, Sweden, the United Kingdom and the United
States. However, the model also consistently overestimates hours worked in the formal sector in
Denmark, Finland, Germany, Ireland, Italy and Norway. The results presented so far are obtained
for an utility curvature parameter equals to one ( = 1), as in Prescott (2004).
17
Experiment 5: Utility curvature parameter
In this section we investigate the robustness of our results to a higher value of (lower elasticity
of substitution between leisure and consumption). We follow Rogerson (2007) to assume = 3 and
present cross-country estimates of formal work hours. As emphasized in the labor supply literature
and illustrated in Section 3, the value of the utility curvature parameter is quantitatively relevant
in analyses of this nature. Figure 5 presents the results and illustrates this point. Interestingly, a
lower elasticity of substitution not only has a signicant impact on the predictions of the model but
also inverts the results obtained for = 1. In other words, the model performs well for Denmark
(85%), Finland (66%), Germany (89%), Ireland (67%) and Norway (88%), while it overpredicts hours
worked in Austria, France, Greece, Italy, Spain, Sweden, the United Kingdom and the United States.
This result is robust for Experiments 1 4 for = 3. To conrm that this result is driven by both
the utility curvature parameter and the inclusion of informal activities, we conduct a similar exercise
as displayed in Figure 2, but now for = 3. Once again, a model without informal activities cannot
reconcile the levels of formal work in OECD countries.
0.15 0.2 0.25 0.3 0.35 0.4 0.45
0.15
0.2
0.25
0.3
0.35
0.4
0.45
Formal Hours of Work - Actual
F
o
r
m
a
l

H
o
u
r
s

o
f

W
o
r
k

-

P
r
e
d
i c
t
e
d
AUS
CAN
DEN
FIN
GER
GRE
IRE
ITA
NOR
SPA
SWE
UK
USA
Figure 5 - Formal Hours Worked in the Informal Work Model ( = 3)
18
4.3 Informal Hours and the Size of the Informal Sector
Ideally, one would also compare the models predictions for informal worked hours with data, in the
same fashion that we did for formal hours. However, no comparable data on informal hours worked
for the countries considered in this study are available. Even though there is a broad literature about
informal activities and the underground economy, only a few studies have estimated the incidence
of such activities and hours devoted to informal activities. Feld and Schneider (2010) argues that
although there are several survey studies
4
that are broadly comparable in design and recent attempts
by the EU to provide survey results for all EU member states (European Commission, 2007; Renooy
et al., 2004), the wording of the questionnaires becomes more and more cumbersome depending on
the culture of each country with respect to the underground economy.
Based on the models predictions, we obtain an estimate of informal hours for each country.
Hours worked in the informal sector ranges from 3.35 hours/week in France to 8.45 hours/week in
Norway (Figure 6, left panel). We argue that these are valid estimates to the extent that the model
can successfully replicate the data for formal labor supply, which is the case for a good number of
countries in our sample (Figures 1 and 5). Also, we calculate the size of the informal sector as a
percentage of the formal sector and compare our numbers to existing estimates reported by Schneider
and Klinglmair (2004). Figure 6 (right panel) shows that the model performs well in this regard for
Scandinavian countries, but it underpredicts the size of the informal sector in Greece, Italy and Spain.
The results presented in Figures 1 and 5 refer to variations in the policy instruments only. Vari-
ation in the TFP across countries could potentially account for dierent sizes of the informal sector
in these countries and potentially improve the results. Data from OECD Productivity database pro-
vides evidence that labor productivity, measured as the ratio of GDP to hours worked, is relatively
similar in these countries. Notable exceptions are Greece and Norway (Table .1, Appendix). As
most comparisons of labor productivity levels focus on GDP as the measure of output, the size of
the informal economy itself may inuence the comparability of GDP across countries.
5
4
Feld and Larsen (2005, 2008) and Merz and Wol (1993) for Germany and Isachsen and Strom (1985) and Pedersen
(2003) for Nordic countries and Great Britain.
5
See www.oecd.org/statistics/productivity for details.
19
AUSCANDENFIN FRAGERGRE IRE ITA NORSPASWEUK USA
0
1
2
3
4
5
6
7
8
9
I
n
f
o
r
m
a
l
H
o
u
r
s

o
f

W
o
r
k

-

P
r
e
d
i c
t
e
d
5 10 15 20 25 30
5
10
15
20
25
30
Size of Informal Sector - Schneider and Klinglmair (2004)
S
i
z
e
o
f I n
f o
r
m
a
l
S
e
c
t o
r

-
I n
f
o
r
m
a
l S
e
c
t o
r

M
o
d
e
l
AUS
CAN
DEN
FIN
FRA
GER
GRE
IRE
ITA
NOR
SPA
SWE
UK
USA
Figure 6 - Informal Hours Worked and Size of the Informal Sector
5 Conclusion
The inclusion of informal activities enhances the analysis of the impacts of government policies on
hours worked in the formal sector. We illustrate quantitatively how modeling informal activities and
tax enforcement policies can potentially generate labor supply patterns that are consistent with the
data and explain the levels of labor supply observed in major OECD countries. Using the calibrated
model, we estimate hours worked in the informal sector for these countries. We conclude that three
elements are relevant to explain cross-country dierences in hours worked in the formal sector: (i)
tax and enforcement policies, (ii) the utility curvature parameter and (iii) the elasticity of substitu-
tion between formal and informal labor. Further analysis of the relevance of government sponsored
benets, progressivity of the tax system and home production in the presence of informal activities
may provide additional insights into dierences in how time is allocated in dierent countries. We
leave this for future research.
20
Appendix
Table .1 - Constructed Formal Hours of Work/Week and Tax Enforcement Policies
Country /
n
t
C
j
t
||ia
j
t
c
`
1c&
`
1ijI
o t
I
G11
1c&vc WcvIco
Austria 24.8 0.301 0.482 0.200 1.00 2.00 0.012 0.250 48.7
Canada 27.0 0.301 0.351 0.135 1.50 3.00 0.148 0.276 43.8
Denmark 23.8 0.355 0.435 0.250 2.00 3.00 0.043 0.250 47.3
Finland 26.3 0.405 0.470 0.220 1.00 1.30 0.001 0.260 45.8
France 22.1 0.180 0.317 0.196 1.10 1.80 0.001 0.344 54.7
Germany 21.9 0.355 0.561 0.160 1.00 1.00 0.016 0.302 53.1
Greece 26.8 0.210 0.370 0.180 1.02 3.00 0.002 0.200 34.2
Ireland 24.4 0.427 0.500 0.210 1.03 2.00 0.086 0.125 57.9
Italy 21.6 0.292 0.387 0.200 2.00 3.00 0.035 0.275 44.3
Norway 21.8 0.370 0.448 0.240 1.01 1.60 0.123 0.280 73.6
Spain 24.6 0.262 0.326 0.160 1.50 2.50 0.032 0.300 46.7
Sweden 25.6 0.245 0.315 0.250 1.03 1.20 0.073 0.263 48.2
United Kingdom 26.1 0.200 0.310 0.175 1.00 2.00 0.005 0.260 45.8
United States 27.9 0.217 0.294 0.120 1.20 1.75 0.024 0.392 56.8
Notes:
1. /
n
: formal hours worked constructed according to equation (5);
2. t
C
j
: the combined central and sub-central government income tax;
3. t
||ia
j
: the all-in tax rate, calculated as the combined central and sub-central government
income tax plus employee social security contribution, as a percentage of gross wage earnings;
4. t
c
: consumption tax;
5. `
1c&
. `
1ijI
: lower and upper bound of penalty for tax evasion. Enforcement of taxpayers
liabilities - penalties for non-compliance (failure to correctly report tax liability).
Austria: Penalties of up to double the amount evaded; Denmark: For serious evasion, penalty
from 100-200 of the tax evaded; Finland: Penalty up to 30% of increased income for intentional
wrong information or gross negligence; France: Penalty ranging from 10%-80% of tax evaded;
Germany: Generally no penalty unless facts are reported incorrectly or incompletely with
intention or through gross negligence; Greece: Penalty of 2% per month on tax due (2.5%
per month for failure to le at all) up to 200% of tax payable; Ireland: Rates from 3% to
100% depending on culpability and co-operation of taxpayer; Italy: 100% to 200% of the
dierence between tax due and tax paid; Norway: 1%-60% additional tax calculated of the
dierence; Spain: 50% to 150% of the amount assessed by the tax administration; Sweden:
Additional tax 2.5% to 20%; United Kingdom: Penalty of up to 100% of additional tax
payable, according to the seriousness of the oence; United States: Penalties available range
from 20% to 75% of the understatement depending on the seriousness of the oence.
6. o: the ratio of number completed actions to the taxpayer population.
21
7. t
I
: . the combined central and sub-central (statutory) corporate income tax rate
For more details see OECD Tax Database, available at www.oecd.org/ctp/taxdatabase, and OECD
(2010).
Table .2 - Formal and Informal Hours of Work/Week
Formal Work Hours /
n
Informal Work Hours /
i
Actual Experiments Experiments
Country hours 0 1 2 3 4 5 0 1 2 3 4 5
Austria 24.8 24.4 24.4 23.6 39.8 25.3 30.9 6.1 6.2 5.8 9.2 7.8 6.1
Canada 27.1 27.1 27.1 27.1 27.1 27.1 27.1 6.5 6.5 6.5 6.5 6.5 6.5
Denmark 23.8 31.1 30.9 29.9 43.2 33.7 20.2 8.3 8.0 7.8 9.8 9.7 7.1
Finland 26.3 41.6 42.0 35.6 40.6 39.4 17.4 10.0 9.6 10.2 9.8 11.1 7.2
France 22.1 17.8 17.6 16.9 21.3 18.0 7.5 3.4 3.7 3.1 5.1 4.3 3.4
Germany 21.9 30.9 30.8 27.0 34.3 35.1 19.5 8.4 8.0 7.7 7.6 10.6 7.4
Greece 26.8 20.5 20.3 20.2 27.7 20.8 38.6 3.9 4.2 3.6 6.9 5.0 3.9
Ireland 24.4 40.0 40.5 41.5 38.4 38.9 16.0 8.5 8.3 8.6 8.1 8.9 6.0
Italy 21.6 24.9 24.9 24.0 30.5 25.9 30.9 6.0 6.1 5.6 8.0 7.3 5.9
Norway 21.8 29.9 29.7 27.8 42.0 30.7 19.1 8.9 8.4 8.3 10.5 9.6 7.9
Spain 24.6 22.9 22.9 22.0 23.7 23.5 34.5 5.2 5.4 4.9 5.5 6.4 5.1
Sweden 25.6 20.0 19.9 18.6 20.8 20.2 38.1 4.5 4.8 4.1 4.9 5.4 4.5
United Kingdom 26.1 19.5 19.4 18.7 22.1 19.8 39.8 3.7 4.1 3.4 4.9 4.8 3.7
United States 27.9 20.1 20.1 19.0 21.2 20.5 38.8 4.2 4.5 3.9 4.6 5.2 4.1
Notes: Experiment 0: Benchmark case; Experiment 1: Elasticity of substitution between formal
and informal labor parameter (Table shows the results for = 0.655); Experiment 2: Evasion
penalty `; Experiment 3: Formal tax rate t
j
; Experiment 4: Probability of detection o and Experi-
ment 5: Utility curvature parameter .
22
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