Estimating the Size of the Underground Economy and Tax Evasion: An Empirical Analysis in Iran

The Iranian economy is facing with tax evasion like most other economies, and in recent years due to the economic sanctions imposed on Iran, oil price falls and budget deficits, Iran’s government seeks to substitute oil revenues with tax revenues. By taking into consideration this necessity, the present study has been carried out with the aim of estimating the size of the underground economy and the level of tax evasion in the Iranian economy using the Currency Demand Function and Vector Error Correction Model (VECM) for 1973-2013 time series data. In this model, “the ratio of currency holdings”(C) to “money” (denoted as M2) is assumed as the dependent variable and “the ratio of wages and salaries to national income” (WSNI), “real per capita National income” (YNR), “the real rate of interest paid on time deposits” (RL) and “effective tax rate” (Tax Burden) are taken as independent variables. Based on the research results, two variables of Tax Burden and WSNI have positive effects on the ratio of C to M2 and the variables of RL and YNR have negative effects on this ratio in the long-run. Moreover, the research results show that the estimated size of the underground economy and tax evasion levels indicate an ascending trend during the period under study.