A MIMIC approach to modeling the underground economy in Taiwan

The size of underground economy (UE) expansion usually increases the tax gap, impose a burden on the economy, and results in tax distortions. This study uses the MIMIC approach to model the causal variables and indicating variables to estimate the UE in Taiwan. We also focus on testing the data for non-stationarity and perform diagnostic tests. By using annual time-series data for Taiwan from 1961 to 2003, it is found that the estimated size of the UE varies from 11.0% to 13.1% before 1988, and from 10.6% to 11.8% from 1989 onwards. That the size of the UE experienced a substantial downward shift in 1989 indicates that there was a structural break. The UE is significantly and positively affected by such casual variables as the logarithm of real government consumption and currency inflation, but is negatively affected by the tax burden at 5% significant level. Unemployment rate and crime rate are not significantly correlated with the UE in this study.