Austerity plans and tax evasion : theory and evidence from Greece

The austerity plans implemented in Greece in 2010 have yielded lower than expected increases in tax receipts. We argue that this has been the result of the arbitrage that firms face when choosing to declare their activity. A tax hike has a direct effect on the degree of tax evasion, and an indirect one through credit markets. A tax increase tightens the credit constraints of firms and depresses even further their incentives to be transparent. Using a dataset of about 30'000 Greek firms per year over the period 2002-2011, we provide evidence that firms adjust their declared profitability, and this adjustment depends on the tax burden and their need for credit. We then calibrate our model and show that leakages due to tax evasion are quite high : a 21% increase in tax rates only delivers a 7% increase in tax receipts. The response of transparency generates an additional investment slack which is the result of a contracting demand for credit by small and medium size firms induced by tax evasion.