Income Tax Flattening:Does It Help to Reduce the Shadow Economy?

This paper examines the effect of global transition to simpler, flatter income tax systems onthe size of the shadow economy. By offering a new estimation framework, the paper revivesthe traditional electricity consumption approach to measuring the shadow economy. Itovercomes the limitations of previous literature by using a new functional form, better qualitydata, a larger sample of 170 countries, a longer time span of 25 years, a panel framework,and instrumental variables. Our analysis provides strong evidence of a positive relationshipbetween income tax rates and the size of the shadow economy. The effects of structuralprogressivity and complexity of national tax schedules are also found to be positive andstatistically significant. These positive effects are reinforced when tax changes areaccompanied by improving government services and strengthening the legal system. The flattax is estimated to reduce the shadow economy in the short run, but this effect diminishesand disappears in the long run....