Globalizing Tax Evasion: How Competition Affects the Size of theUnderground Economy

The underground economy expanded substantially during the late 1990s, both in the industrialized and the developing world. I argue that this development is a response to the sharp increase in market competition worldwide. I develop a parsimonious oligopoly model of free entry and free sector choice, where the intensity of competition is captured by the degree of (exogenous) product differentiation. Operating in the underground economy reduces variable costs, but comes at the risk of being detected and fined. The keener is competition, the higher is the pressure to reduce costs, and the more pervasive is the underground economy.