The market externalities of tax evasion

This paper presents evidence of the market externalities of tax evasion: firms' tax non-compliance distorts the outcomes of their competitors. Using novel administrative data on the universe of Italian firms, we compute a tax evasion proxy as the fraction of individual firms who manipulate their revenue to meet eligibility criteria for preferential tax regimes. Our empirical approach uses policy-induced changes in tax notch sizes to predict the fraction of non-compliant firms in each market. We find that non-compliant firms generate significant revenue and productivity losses for their competitors, who then pass on some of this burden to their workers. This unfair competition harms aggregate productivity, partly due to a worsening of allocative efficiency. Our findings show that cracking down on tax evasion not only increases tax revenues and promotes tax fairness, but can also enhance market efficiency by levelling the playing field.