Taxes,Risk Aversion,and the Size of the Underground Economy

Non‐parametric regression analysis was used to investigate the relationship between the effective tax rate and the relative size of the underground economy, using New Zealand data. The underlying theoretical framework is established, and it suggests an ambiguous prediction regarding the sign of the relationship we are studying. However, our non‐parametric empirical analysis, which also allows for the non‐stationarity of the time‐series data, produces a positive and ‘S‐shaped’ relationship, and this supports earlier empirical studies that imposed such functional forms. The estimated model is used to simulate the effects of hypothetical tax changes on the size of the New Zealand underground economy, and to draw policy conclusions.