The effect of the underground economy on aggregate economic activity

Abstract

This paper aims to quantify the underground economy for Malta and express it as a percentage of the Gross National Income (GNI). The approach used in this paper is based on the currency demand method proposed by Tanzi (1983), which calculates the underground economy indirectly. The period under investigation is that between 1995 and 2005, which coincided with certain tax reforms adopted in Malta. Various variables that are believed to affect currency demand are used in the model, including tax and interest rate variables, and a variable to capture the improvements in the banking facilities. The relationship between currency demanded and income tax is used to predict the amount of currency needed for formal economic activity and that for tax evasion purposes. The results give an indication as to the extent of the underground economy in Malta expressed as a percentage of GNI. However, these results should be interpreted with great caution due to the various assumptions on which they are based.