Taxes and Unmarried Fathers’ Participation in the Underground Economy

In this paper we employ data from the Fragile Families and Child Well-Being Study in order to estimate a model of underground labor supply developed by Lemieux et al. (1994). We focus specifically on the underground labor supply of unmarried fathers, a group that is likely to have significant involvement in the underground economy. We also extend the empirical analysis of Lemieux et al. by taking into account exogenous state and local variation in marginal tax rates, as well as sociodemographic variables related to the likelihood of participation in the underground. In accordance with expectations, we find that a significant proportion of unmarried fathers report participation in the underground. However, although the theoretical model predicts a positive relationship between the tax rate and underground hours of work (under certain conditions), we find that the effect of the tax rate on hours is statistically indistinguishable from zero, even after including exogenous variation in tax rates. We also fail to find a positive and statistically significant effect of the tax rate on participation in the underground. Within the context of the model, these results have specific implications for the magnitudes of the probability of detection and the penalty on evaded tax. Therefore, we conclude that additional empirical information is needed regarding these parameters. Future research might also employ other datasets in the estimation of the theoretical model outlined by Lemieux et al., as well as investigate the applicability of other models of underground labor supply.