We propose a theory of firm that is consistent with empirically observed phenomenon of firms simultaneously engaging in both formal and informal activities. Firms face endogenous probability of auditing that depends on the scale of underreporting of both sales and wages. We characterize the conditions for a firm facing corporate, value added and payroll taxes to hide a part of its activities. Underreporting gives rise to employment levels above those expected for firms that report truthfully. We also show that an underreporting firm is less affected by the introduction of the minimum wage. It further decreases the level of reported sales to mitigate the adverse effect that the minimum wage causes and decreases optimal employment by relatively less than an honest firm. The latter hypotheses is tested empirically using a matched employer-employee data set for Slovenia during the period of several minimum wage hikes (2007-2010).
