Taxation and evasion in the presence of extortion by organized crime

We model the taxation behavior of a revenue-maximizing government in the presence of a competing tax collector, i.e., the mafia, and tax evasion. Firms choosing to evade taxes must shift some of their sales underground, possibly incurring costs. In the mafia's presence, the government's optimal tax rate and payoff depend on the importance to firms of the public goods provided by the government and those provided by the mafia. When public goods are important, both the state's tax rate and revenues are lower in the presence of the mafia than without it. However, when public goods are unimportant, the government benefits from the mafia's taxation of the firms' underground activities. (C) 2004 Association for Comparative Economic Studies. Published by Elsevier Inc. All rights reserved.