What causes black market?

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Journal of Public Economics 91 (2007) 1575 – 1590 www.elsevier.com/locate/econbase Efficient black markets?
Carl Davidson a,b , Lawrence Martin a , John Douglas Wilson a,⁎ a Department of Economics, Marshall-Adams Hall, Michigan State University, East Lansing, MI 48824, United States b GEP, University of Nottingham, United Kingdom
Received 17 May 2005; received in revised form 9 October 2006; accepted 23 October 2006
Available online 3 February 2007

This paper investigates analytically the welfare effects of black-market activities that firms undertake to evade taxes. The desirability of a black market is linked to the attributes of the goods supplied by blackmarket firms. The analysis identifies cases where a
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Low-asset activities (per unit of output) self-select into the black market because the potential fine from detection is relatively low. For simplicity, the model abstracts from the myriad other considerations behind the decision to enter the black market; in particular, all firms are randomly audited for tax purposes. Following Rosen, we next assume that the tax system distorts the decision of whether to devote resources to any taxed activity. In particular, activities are ranked by a continuous parameter called “quality,” interpreted here as the attribute of a good produced by firms. Each consumer purchases at most a unit of a variable-quality good, with choices based on a heterogeneous “taste” parameter. Recognizing the costs involved in administering a quality-differentiated tax system, we assume that the government 's expenditure needs are met by taxing all variable-quality goods at a uniform statutory rate. Such a tax system causes consumers with low tastes for quality to drop out of the market — that is, they devote no resources to purchasing variable-quality goods, whereas those who remain reduce the qualities of the goods that they purchase.
With such a setup, we provide conditions that determine whether the black market consists of low- or high-quality goods. In the latter case, neither the Slemrod–Bakija nor Rosen arguments are relevant: a small black market (maintained through an appropriately low expected fine) does not distort
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