Impact of Fiscal Shocks on the Iranian Official and Underground Economy in the Framework of Dynamic Stochastic General Equilibrium Models (DSGE)

Limitation of Iran''s oil revenues has increased the need to finance the public sector more ýthrough taxationþ.þý So¡ in such circumstances¡ a study of underground economy and tax ýevasion may help policymakers and economic advisers. Underground economies have a large impact on public finances and distorting effects on production¡ as they create unfair competition among firms. Furthermore¡ it may create additional social costs because the overall tax burden is shared among a smaller number of citizens¡ thus increasing economic inequality¡ and because of the lack of labor protection for the individuals who are working in the underground market. Tax rates and social security ýcontributions are the two main variables affecting the size of an underground economy ýand tax evasion issues.
Many previous studies estimated and examined underground economy of Iran by using different methods such as: monetary¡ fuzzy logic and MIMIC methods. But¡ none of these studies examined the fiscal shocks and its effect on underground production and other macroeconomic variables in dynamic stochastic general equilibrium models framework. This study attempts to do this. Recently¡ with the expansion of DSGE models¡ this approach has been used to study the underground economy in the world.
This study used a DSGE model framework for modelling the Iranian underground economy and impacts of oil revenues shocks¡ fiscal shocks (such as changing tax rates¡ social security contributions)¡ on the official economy¡ tax evasion ýand on the underground economy of Iran.
Model: The main framework is derived from Busato and Chiarini (2004)¡ and Orsi¡ Raggi and Turino (2012) articles. We consider an economy which consists of a continuum of homogeneous goods that are indexed by i ∈ [0¡ 1]¡ each produced by a perfectly competitive producer. Goods are sold by firms to a continuum of measure 1 of identical households for consumption and investment purposes and to the government¡ which collects taxes from households and firms in order to finance public spending. The economy is divided into two sectors¡ the official and the underground sector¡ and none of the transactions occurring in the latter are recorded by the government authorities. Firms¡ therefore¡ provide most of their factors of production from underground markets in order to cash parts of their production for tax evasion purposes. In each period of time¡ however¡ firms face a non-negligible probability of being inspected by the fiscal authorities¡ convicted of tax evasion and forced to pay taxes augmented by a penalty surcharge. Households might also avoid personal income tax by reallocating their labor services from the regular to the underground sector¡ and by supplying capital in the underground market. All of the interactions among firms¡ households and the government occur in a stochastic environment in which the short-run dynamics of the economy are driven by social security contributions¡ oil revenues and fiscal shocks.
One of the purposes of the study is investigating the responses of variables to various fiscal and oil shocks. The impulse response function shows the dynamic reaction of variables after receiving a shock. Shock effect of income tax rates and corporate tax rates¡ social security contributions and oil revenues on the official production¡ underground production and tax evasion are investigated.
Results indicate that the present model is suitable to simulate cyclical behavior and volatility of the variables. According the results¡ a positive shock of the corporate tax rate and of income tax rate reduced the official production¡ increased underground production and tax evasion¡ and decreased the government revenues.
Also¡ a positive shock of social security contributions reduced the official production¡ increased underground production and tax evasion. A positive shock of oil revenues increased official production and reduced underground economy¡ and consequently reduced tax evasion and increased government ýrevenue.ý
Planning for the economic development and making a decision for the implementation of economic policies¡ one needs to understand the performance of the whole economy¡ including the official and the underground sectors. Understanding the performance of the whole economy requires gaining information on economic system situation and its efficiency. This study used a DSGE model framework for modelling the underground economy and the effect of oil shock and fiscal shocks on the official economy and underground economy. According to the results¡ a ýpositive fiscal shock reduced the official ýproduction¡ increased underground production and tax evasion¡ and decreased government ýrevenues. A positive shock of oil revenues increased official production¡ reduced ýunderground economy¡ consequently reduced tax evasion¡ and increased government ýrevenue.ý
Finally¡ the findings suggest that by reducing bureaucracy and trying to improve the business environment and reducing the rate of corporation tax¡ income tax and social security contributions - in line with the implementation of VAT in the tax system that annually increases at the rate of one per cent - appropriate policies should be implemented to guide the underground to the official production.