Shadow economy, “mixed” firms, and labour market outcomes

To shed light on the complex and ambiguous relation between shadow economy and labour market outcomes, this theoretical paper introduces tax evasion and undeclared work into the benchmark macroeconomic model of the labour market (the search and matching model). Unlike the related literature, this work assumes that registered firms manage job vacancies in both the formal and the shadow sector (named as “mixed firms”), to exploit the gains in both sectors. The unemployed search for a job simultaneously in both sectors and accept the first job offer they receive, while tax audits allow to punish firms that evade taxes and use undeclared work. In this framework, tax audit emerges as the key tool for reducing shadow economy without harming labour market outcomes too much. Tax audit, indeed, has little impact on unemployment and increases the wage (cost) of undeclared work.