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Wages, unemployment, and the underground economy

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While examining the macroeconomic effects of increased governmentcontrol of the informal sector, this paper develops a two-sectorgeneral equilibrium model featuring matching frictions and worker-firm wage bargaining. Workers search for jobs in both the formaland the informal sector. We analyse the impact of higher punishmentrates and a higher audit rate on labour market performance. We findthat a higher punishment rate reduces the size of the informal sectorand reduces unemployment. A higher audit rate has an ambiguousimpact on unemployment, and may actually increase the size of theunderground economy.JEL-codes: H26Keywords: Tax evasion, underground economy, matching, bargaining,unemployment.

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Ann-Sofie Kolm, Birthe Larsen

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