What causes black market?

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

Abstract
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 black market reduces (increases) the distortionary impact of taxation on the allocation of resources across the goods that the government is attempting to tax, leading to a welfare gain (loss).
© 2007 Published by Elsevier B.V.
JEL classification: H21; H26
Keywords: Black market; Underground economy; Shadow economy; Tax evasion; Optimal taxation

1. Introduction
By their nature, black-market activities are difficult to measure. Nevertheless, there is widespread agreement that black-market activities account for a significant portion of GDP in many countries.1
Less clear, however, are the welfare effects of such activities, particularly those motivated by tax evasion. In his leading undergraduate text on public finance, Rosen (2005, p. 353) states a second-

⁎ Corresponding author. Department of Economics, Marshall-Adams Hall, Michigan State University, East Lansing, MI
48824, United States. Tel.: [phone]; fax: [phone].
E-mail address: [e-mail] (J.D. Wilson).
1
Other terms for the “black market” are the “underground economy” and “shadow economy.” As reported by Schneider and Enste (2000), estimates of the size of the shadow economy as a percentage of GDP in the 1990–93 period ranged from

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