1 University of Victoria Econometrics Working Paper EWP 9911 (ISSN 1485-6441) Asymmetric Responses of the Underground Economy to Tax Changes: Evidence From New Zealand Data David E. A. Giles, Gugsa T. Werkneh & Betty J. Johnson Department of Economics, University of Victoria Victoria, B. C., V8W 2Y2, Canada August, 1999 Abstract: We consider the relationship between taxes and the size of the underground economy in New Zealand. Previous studies indicate that a positive relationship exists in this and certain other countries. We address the following question: “Is the response of the underground economy to an increase in taxes the same as its response to a decrease in taxes?” To answer this question we modify an existing methodology for testing for both “timing symmetry” and “pattern symmetry”. Paying careful attention to the non-stationarity and cointegration of our annual data, we test for the presence of such symmetry in the tax-evasion relationship for New Zealand. We find that although the effect on the underground economy of an upward movement in the effective tax rate is numerically greater than that of a downward tax movement, this difference is not statistically significant in either the short-run or the long-run. Elasticity and multiplier calculations allow us to quantify some of the effects of changes in taxation policy on hidden output. Keywords: Tax evasion, underground economy, tax rates, asymmetry JEL Classification: C22; H26 Contact Author: Professor David Giles, Department of Economics, University of Victoria, PO Box 1700, STN CSC, Victoria, BC, Canada, V8W 2Y2 FAX (250) 721-6214; Voice (250) 721-8540; e-mail dgiles@uvic.ca