Fiscal consolidation with tax evasion and corruption

Using cross country data we show that tax evasion and corruption are highly important for determining the size of the .scal multiplier. We introduce these two features in a New Keynesian model with search and matching frictions, in order to revisit the e¤ects of tax and expenditure based consolidations. VAR evidence for Italy suggests that expenditure based consolidations reduce tax evasion signi.cantly, while tax based ones increase it. In the model, expenditure cuts reduce demand for both formal and informal goods, and, thus, tax evasion. Tax hikes induce agents to work and produce more in the informal sector, which is less productive, and so imply higher output and welfare losses. We use the model to assess the losses from the recent .scal consolidation plans in Italy, Spain, Portugal and Greece. Policy conclusions are sensitive to the model.s assumptions. Counterfactual exercises highlight the benefit of .ghting tax evasion and corruption in economies undertaking .scal consolidation.