Modelling the Hidden Economy and the Tax-Gap in New Zealand

This paper develops and estimates a structural, latent variable, model for the hidden economy in New Zealand, and a separate currency-demand model. The estimated latent variable model is used to generate an historical time-series index of hidden economic activity, which is calibrated via the information from the currency-demand model. Special attention is paid to data non-stationarity, and diagnostic testing. The size of the hidden economy is found to vary between 6.8% and 11.3% of measured GDP. This, in turn, implies that the total tax-gap is of the order of 6.4% to 10.2% of total tax liability in that country, though of course not all of this foregone revenue would be recoverable.