The non-linear effect of income on the shadow economy

Abstract

This paper aims to explore the correlation between individual income and tax evasion. We develop a novel theoretical model based on the argument that the level of public goods provision and the perceived fairness of public services significantly influence an individual's attitude towards taxation. The model reveals a concave pattern, indicating the presence of an income threshold. Initially, as an individual's income increases, tax evasion decreases due to the perceived fairness of their contributions relative to the benefits received from public services. However, beyond this threshold, the tax burden is perceived as unfair, leading to an increase in tax evasion as income levels rise. We also proof that this income threshold is influenced by the tax rate and enforcement system. We also conduct a panel data analysis on a sample of 35 OECD countries from 2007 to 2020 to support the theoretical findings. The empirical investigation confirms a U-shaped relationship between income and the underground economy. Our findings suggest that policymakers should introduce measures to improve the quality of public goods provision, considering the potential adverse effect of higher income on economic growth. This study is the first to theoretically investigate the non-linear relationship between income and tax evasion while also providing empirical evidence.