Tax evasion, fiscal policy and public debt: Evidence from Spain

We reconsider the macroeconomic effects of fiscal policy in an estimated dynamic stochastic general equilibrium model with limited tax enforcement. The results of the Bayesian estimation provide evidence in favor of a sizeable underground sector in Spain, with the associated tax evasion having contributed, on average, to 23% of public debt accumulation over the period 1985-2015. From the standpoint of fiscal policy, the estimated results show that the presence of tax evasion triggers a resource-reallocation mechanism that dampens the effects on economic activity caused by an increase in government spending, while it amplifies those due to changes in tax rates. Because of this mechanism, we show that tax-based consolidation plans may become completely ineffective in reducing the debt-to-GDP ratio if tax enforcement is imperfect. Moreover, by characterizing the long-run Laffer curve, we show that the actual taxation in Spain is inefficiently too high, in the sense that the government might increase tax revenues by cutting the actual tax rates on both corporate and personal income.