Measuring the Underground Economy with the Currency Demand Approach : A Reinterpretation of the Methodology, with an Application to Italy

We contribute to the debate on how to assess the size of the underground or shadow economy with a reinterpretation of the traditional Currency Demand Approach (CDA) à la Tanzi. We introduce three main innovations. First, we take as dependent variable in the money demand equation a direct measure of the value of cash transactions: the flow of cash withdrawn from current accounts relative to total non-cash payments. This avoids use of the Fisher equation and so overcomes two severe criticisms of the traditional CDA. Second, instead of the tax burden, usually taken as the main motive for non-compliance, we include among the covariates two direct indicators of detected tax evasion. Finally, we also control for the role of illegal economic activity, such as drug dealing and prostitution, which – jointly with the shadow economy – contributes to the larger aggregate of the unobserved economy and represents a significant component of total cash payments. We then propose an application of this “modified CDA” to a panel of 91 Italian provinces for the years 2005-2008