Do Increased Tax Base and Reductions in the Underground Economy Compensate for Lost Tax Revenue Following a Tax Reduction Policy? Evidence from Italy 1982 to 2006

We here examine the frequent claim that an increase in the tax base and a decrease in tax evasion will compensate for a loss in tax revenues caused by a lower tax level. Using a unique data set for the estimated underground economy in Italy from 1982 to 2006, we found that a loss in tax revenues equivalent to 1% of the GDP would be partly compensated by an increase in GDP of 0.55%. The compensation would come from 0.31% of the GDP increase and from 0.24% of the reductions in the underground economy. These results apply to an economy with a high tax level (>32%) and a high underground economy (& GE;25%). Applying a high-resolution lead-lag method to the data, we ensured that tax changes were leading the GDP and, thus, a potential cause for changes in the GDP.