Taxes Do Make a Difference (I)

Despite drugs and human organs, however, the most important stimulus for the underground economy likely comes from taxes. Let’s face it, if your marginal tax rate were only, say, 15 percent, how much effort would you spend to avoid reporting income?
Probably not very much, given that each dollar of unreported income would only save you 15 cents in taxes. In contrast, at a marginal income tax rate of, say, 40 percent, you might be tempted to seek plenty of ways to earn unreported income. In other words, you might wish to become part of the underground economy, at least for some portion of your annual income.
We thus infer that in every country in the world, the greater the marginal income tax rate, the larger will be the share of total annual economic activity that will be unreported and therefore untaxed. This conclusion merely reflects the fact that everyone responds to incentives on the margin.
Now, this does not mean that high marginal tax rates cause the entire workforce to seek off-the-books income. Rather, the higher the marginal income tax rates are, the greater will be the proportion of individuals who will seek to earn unreported income.

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