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.