Tax Evasion and Financial Repression: A Reconsideration Using Endogenous Growth Models 

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Chapter 2 Tax Evasion and Financial Repression: A Reconsideration Using Endogenous Growth Models

Introduction

Using two dynamic monetary general equilibrium models characterized by endoge-nous growth, flnancial repression and endogenously determined tax evasion, we analyze whether flnancial repression can be explained by tax evasion, based on an overlapping generations framework. We follow Drazen (1989), Espinosa and Yip (1996), Haslag (1998), Gupta (2008a), and Gupta (2008b) among others, in deflning flnancial repres-sion through an obligatory \high » reserve deposit ratio requirement, that banks in the economy need to maintain. The study attempts to assess whether there exists a plausi-ble explanation as to why the reserve requirements in some economies are higher than others. Speciflcally, we investigate whether flnancial repression is an optimal policy outcome in the presence of tax evasion.
Financial repression was originally coined by economists interested in less devel-oped countries. McKinnon (1973) and Shaw (1973), in their seminal, but independent, contributions were the flrst to spell out the notion of flnancial repression, deflning it as a set of government legal restrictions preventing the flnancial intermediaries in the economy from functioning at full capacity. Generally, flnancial repression consists of three elements. First, the banking sector is forced to hold government bonds and money through the imposition of high reserve and liquidity ratio requirements. This allows the government to flnance budget deflcits at a low cost. Second, given that the government revenue cannot be extracted easily from private securities, the development of private bond and equity markets is discouraged. Finally, the banking system is characterized by interest rate ceilings to prevent competition with public sector fund raising from the private sector and to encourage low-cost investment. Thus, the regulations generally include interest rate ceilings, compulsory credit allocation, and high reserve require-ments. However, given the wave of interest rate deregulation in the 1980s, and removal of credit ceiling some years earlier, the major form of flnancial repression is currently via obligatory reserve requirements.¹ There is still widespread evidence of flnancial repression, as pointed out by Espinosa and Yip (1996). The authors indicate that the concern is not whether flnancial repression is prevalent, but the associated degree to which an economy is repressed, since both developed and developing countries resort to such restrictive practices.
The motivation for our analysis emanates from a recent paper by Gupta (2008b). In this paper, using a Solow-type overlapping generations framework, calibrated to four southern European countries, the author analyzed the relationship between tax evasion, determined endogenously, and flnancial repression. Gupta (2008b) showed that a higher degree of tax evasion within a country, resulting from a higher level of corruption and a lower penalty rate, yields a higher degree of flnancial repression as a social optimum. However, a higher degree of tax evasion, due to a lower tax rate, reduces the severity of the flnancial restriction. In addition, a higher fraction of reported income, resulting from lower level of corruption or higher penalty rates, causes the government to in°ate the economy at a higher rate. Money growth rate though, tends to fall, when an increase in the fraction of reported income originates from a fall in the tax rate.
At this juncture, it is important to put into perspective the study by Gupta (2008b) to better understand our motivation to extend the analysis. Besides, a whole host of other factors² , studies like Roubini and Sala-i-Martin (1995), Gupta (2005 and 2006) and Holman and Neanidis (2006), by building on the empirical works of Cukierman et al. (1992) and Giovannini and De Melo (1993), have outlined tax evasion as a possible rationale for flnancial repression. However, Gupta (2008b) points out that all the above mentioned theoretical analyses dealing with tax evasion and flnancial repression sufier from a serious problem, in the sense that they treat tax evasion as exogenous. The author stresses that the optimal degree of tax evasion is a behavioral decision made by the agents of the economy, and is likely to be afiected not only by the structural parameters of the economy, but also the policy decisions of the government. Thus, all these models essentially sufier from the \Lucas Critique » as they treat tax evasion to be exogenous when ideally the same should have been determined endogenously in the model. It must be pointed out that all the above studies, looked at the optimal policy decisions of the government emanating from its welfare-maximizing objective following an increase in the exogenous rate of tax evasion without specifying what is causing the change in the degree of evasion in the flrst place. Under such circumstances, the optimal choices made by the government are likely to be non-optimal, since the actual level of tax evasion changes as policy choices change once we realize that tax evasion is endogenous. Hence, once one determines which policy variables, besides the structural parameters, are afiecting the degree of tax evasion, they cannot be available to the government for use to respond optimally to a change in the degree of tax evasion.
Our objectives in this paper are two-fold: First, given that tax evasion is endoge-nously determined, we want to see if the results of Gupta (2008b) continue to hold under the assumption of endogenous growth, with the endogeneity in the growth process ob-tained either via production externalities as in Romer (1986), or through productive public expenditures, as outlined in Barro (1990); The second of our objectives essen-tially follows from the fact that by incorporating a Barro-type model into our analysis, we are allowing for productive government expenditures , which in turn, when com-pared to the Romer-type model, would allow us to assess the difierences between the two alternative scenarios regarding the productivity capabilities of public expenditures.
This paper thus, extends the work of Gupta (2008b), besides, Roubini and Sala-i-Martin (1995), Gupta (2005, 2006) and Holman and Neanidis (2006), by re-evaluating the results in the presence of endogenous tax evasion, as in Atolia (2003), Chen (2003) and Arana (2004), and endogenous growth. To the best of our knowledge, such an at-tempt to rationalize flnancial repression based on endogenously determined tax evasion with the economy growing endogenously in steady-state, is the flrst of its kind.
To validate our analysis, as in Gupta (2008b), the theoretical model is numerically analyzed by calibrating it to four southern European economies, namely, Greece, Italy, Portugal and Spain. It must, however, be noted that our model is a general one and can be applied to any economy subjected to tax evasion. Our choice of countries has been mainly due data availability. Moreover, it has been argued that the chosen countries have experience of underground economies and hence, tax evasion and high reliance on seigniorage through high in°ation rates and reserve requirements (Schneider and Klinglmair (2004), Gupta, (2008b)).
This paper incorporates endogenous tax evasion in standard general equilibrium models of endogenous growth with overlapping generations. There are two primary assets in the model, namely, bank deposits and flat money. Deposits dominate money in rate of return. An intermediary exists to provide a rudimentary pooling function, accepting deposits to flnance the investment needs of the flrms, but are subjected to mandatory cash-reserve requirements. There is also an inflnitely-lived government with two wings: a Treasury which flnances expenditure by taxing income and setting penalty for tax evasion when caught; and the central bank, which controls the growth rate of the nominal stock of money and the reserve requirements. In such an environment, we deduce the optimal degree of tax evasion, derived from the consumer optimization problem as a function of the parameters and policy variables of the model. The paper is organized as follows: Section 2 lays out the economic environment; Section 3, 4 and 5 respectively, are devoted to deflning the monetary competitive equilibrium, discussing the process of calibration, and analyzing the welfare-maximizing choices of policy fol-lowing an increase in tax evasion, resulting from either policy changes or alteration to a speciflc structural parameter of the model. Finally, Section 6 concludes.

Economic Environment

Time is divided into discrete segments, and is indexed by t = 1, 2, . There are four types of economic activities: (i) each two-period lived overlapping generations household (consumer/worker) is endowed with one unit of labor when young, but the agent retires when old. Thus, at time t, there are two coexisting generations of young and old. N people are born at each time point t = 1. At t =1, there exist N people in the economy, called the initial old, who live for only one period. The population, N, is normalized to 1. The young inelastically supplies one unit of the labor endowment to earn wage income, part of the tax-liability is evaded, with evasion being determined endogenously to maximize utility, and the rest of the income is deposited into banks for future consumption; (ii) each producer is inflnitely lived and is endowed with a production technology to manufacture a single flnal good using the inelastically supplied labor, physical capital and credit facilitated by the flnancial intermediaries; (iii) the banks simply convert one period deposit contracts into loans after meeting the cash reserve requirements. No resources are assumed to be spent in running the banks, and (iv) there is an inflnitely lived government which meets its expenditure by taxing income, setting penalties for tax evasion and controlling the in°ation tax instruments -the money growth rate and the reserve requirements. There is a continuum of each type of economic agent with unit mass.
The sequence of events can be outlined as follows: When young a household works and receives pre-paid wages, evades a part of the tax burden and deposits the rest into banks. A bank, after meeting the reserve requirement, provides a loan to a goods producer, which subsequently manufactures the flnal good and returns the loan with interest. Finally, the banks pay back the deposits with interest to households at the end of the flrst period and the latter consumes in the second period.

Consumers

Each consumer possesses a unit of time endowment which is supplied inelastically, and consumes only when old. Formally, the problem of the consumer can be described as follows: The utility of a consumer born at t depends on real consumption, c_t+1, which implies that the consumer consumes only when old. This assumption makes compu-tation tractable and is not a bad approximation of the real world (see Hall (1988)). Consumers have the same preferences, so there exists a representative consumer in each generation. The consumer is assumed to be risk averse.

Financial Intermediaries

Financial intermediaries provide a simple pooling function by accepting deposits at the beginning of each period. They then make their portfolio decision (that is, loans and cash reserve choices) with a goal of maximizing proflts. At the end of the period they receive their interest income from the loans made and meet the interest obligations on deposits received. For simplicity bank deposits are assumed to be one period contracts. The intermediaries are constrained by legal reserve requirements on the choice of their portfolio (that is, reserve requirements), as well as by feasibility. Given such a structure, where ƒ_b is the proflt function for the flnancial intermediary, and M_t > °_tD_t deflnes the legal reserve requirement. M_t is the cash reserves held by the bank; L_t is the loans; i_Lt is the interest rate on loans, and; °_t is the reserve requirement ratio. The reserve requirement ratio is the ratio of required reserves (which must be kept in the form of currency) to deposits received. To gain some economic intuition of the efiect of reserve requirements on the banking sector, let us consider the solution of the problem for a typical intermediary. It is assumed that flnancial intermediaries behave competitively and free entry drives proflts to zero,

Firms

All flrms are identical and produce a single flnal good using the following production and aggregate per capita capital stock inputs at time t. At time t the flnal good can either be consumed or stored. We assume that producers are able to convert bank loans L_t into flxed capital formation such that p_ti_kt = L_t, where i_t denotes the investment in physical capital. In each of the respective technologies the production transformation schedule is linear so that the same technology applies to both capital formation and the production of the consumption good and hence both investment and consumption good sell for the same price p_t. We follow Diamond and Yellin (1990) and Chen, Chiang and Wang (2000) in assuming that the goods producer is a residual claimer, that is, the producer uses up the unsold consumption good in a way which is consistent with lifetime value maximization of the flrms. This assumption regarding ownership avoids the \unnecessary » Arrow-Debreu redistribution from flrms to consumers and simultaneously retains the general equilibrium structure of the models.

Chapter 1: Introduction 2
1.1 Introduction
Chapter 2: Tax Evasion and Financial Repression: A Reconsideration Using Endogenous Growth Models 
2.1 Introduction
2.2 Economic Environment
2.2.1 Consumers
2.2.2 Financial Intermediaries
2.2.3 Firms
2.2.4 Government
2.3 Equilibrium
2.4 Calibration
2.5 Welfare-Maximizing Monetary Policy in the Presence of endogenous Tax
Evasion
2.6 Conclusions
Chapter 3: Misalignment in the Growth-Maximizing Policies under Alternative Assumptions of Tax Evasion 
3.1 Introduction
3.2 Economic Environment
3.2.1 Consumers
3.2.2 Financial Intermediaries
3.2.3 Firms
3.2.4 Government
3.3 Equilibrium
3.4 Misalignment in the Growth-Maximizing Policies in the Presence of Tax Evasion
3.5 Conclusions
Chapter 4: Openness, Bureaucratic Corruption and Public Policy in an Endogenous Growth Model 
4.1 Introduction
4.2 Economic Environment
4.3 Equilibrium
4.4 Calibration
4.5 Optimal Policy Decisions
4.6 Conclusion
Chapter 5: Costly Tax Enforcement and Financial Repression 
5.1 Introduction
5.2 Economic Environment
5.3 Optimal Policy Decisions
5.4 Conclusion
Chapter 6: Costly Tax Enforcement and Financial Repression: A Re-consideration Using an Endogenous Growth Model 
6.1 Introduction
6.2 Economic Environment
6.3 Equilibrium
6.4 Calibration
6.5 Optimal Policy Decisions
6.6 Conclusion
Chapter 7: Optimal Public Policy with Endogenous Mortality 
7.1 Introduction
7.2 Economic Environment
7.3 Equilibrium
7.4 Optimal Public Policy
7.5 Conclusion
Chapter 8: Conclusion 
Bibliography
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