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Estimating the Underground Economy and Tax Evasion: Cointegration and Causality Evidence in the Case of Cyprus, 1960-2003

Author: MERYEM DUYGUN FETHI, SAMI FETHI, and SALIH TURAN KATIRCIOGLU
Published in IJED, Vol. 6 No. 3

We empirically investigate the size of the underground economy and the amount of tax evasion in the light of Tanzi’s currency demand framework for the Cyprus economy. The study covers the period 1960–2003. The paper has two purposes: (1) to find out whether any long run relationship exists for the pairs of measured GDPunderground economy, tax rates, tax evasion and underground economy-tax rates, and (2) to investigate the direction of causality between the pairs. Our findings suggest that (i) one co-integrating vector exists between the variables by using the Johansen cointegration approach; (ii) the measured GDP and tax rates are the causes of underground economy and tax evasion respectively whereas bidirectional causality is found between tax rates and underground economy when the FPE, Wald, Sim’s LR and Holmes-Hutton causality techniques are applied; (iii) significant underground economic activity and changes in tax rates might stimulate greater loss of tax revenue or more tax evasion with a larger budget deficit and slower economic
growth.

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