Tax Toleration and Tax Compliance: How Government Affects the Propensity of Firms to Enter the Unofficial Economy

How do government‐supplied institutional benefits and the taxation and regulation of producers affect the propensity of private firms to enter the unofficial economy and evade taxation? We propose a model in which the incentive of firms to operate underground depends on tax rates relative to firm‐specific thresholds of tax toleration that are decisively affected by quality of governance—in particular by the presence of high‐grade institutions delivering services enhancing official production that anchor profit‐maximizing firms to the official economy. Some key predictions of the model concerning the determinants of firms' tax toleration and tax compliance receive broad support from empirical analyses of enterprise‐level data from the World Bank's World Business Environment Surveys.