Sovereign Default, Taxation, and the Underground Economy

Abstract

This paper studies the dynamic interaction between sovereign default risk, taxation, and the underground economy. For a large sample of countries, we find that the size of the underground economy is positively correlated with sovereign debt and interest spreads. We rationalize these empirical regularities within a quantitative model of sovereign default that explicitly accounts for underground activities. We highlight a vicious circle: Higher sovereign risk premia tighten the endogenous borrowing constraint and force the government to raise taxes. Tax hikes, however, induce the private sector to invest less and to evade taxes by producing in the underground sector. Eventually, falling tax revenues force the government to either implement further tax hikes or to default. Our quantitative findings suggest that the underground economy fosters sovereign default risk and deepens debt crises.