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The shadow economy as an equilibrium outcome

We construct a dynamic, general equilibrium model of tax evasion where agents choose to report some of their income. Unreported income requires using a payment method that avoids recordkeeping – cash. Trade using cash to avoid taxes is the theoretical measure of the shadow economy from our model. We then calibrate our model using money, interest rate and GDP data to back out the size of the shadow economy for a sample of 30 countries and compare our estimates to traditional ad hoc estimates. Our results generate reasonably larger estimates for the size of the shadow economy than exist in previous literature.

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