Salvatore Capasso on Tax Evasion, the Underground Economy and Financial Development

We study the relationship between the underground economy and
…nancial development in a model of tax evasion and bank interme-
diation. Agents with heterogenous skills seek loans in order to un-
dertake risky investment projects. Asymmetric information between
borrowers and lenders implies a menu of loan contracts that induce
self-selection in a separating equilibrium. Faced with these contracts,
agents choose how much of their income to declare by trading o¤ their
incentives to o¤er collateral against their disincentives to comply with
tax obligations. The key implication of the analysis is that the mar-
ginal net bene…t of income disclosure increases with the level of …nan-
cial development. Thus, in accordance with empirical observation, we
establish the result that the lower is the stage of such development,
the higher is the incidence of tax evasion and the greater is the size of
the underground economy.