Underground Activities and Labour Market Performance

This paper develops a general equilibrium search and matching model where an underground economy co-exists along with the formal part of the economy. In analyzing how tax and punishment policies affect labour market performance, we find that punishment of informal sector activities induce workers and firms to reallocate towards the formal sector. However, more importantly, we find that this reallocation tends to improve effciency in search, reduce the overall wage
pressure, and reduce actual unemployment.