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This study develops a dynamic general equilibrium model, applied to Pakistani data, in which optimizing agents evade taxes by operating in the underground economy. The cost to firms of evading taxes is that they find themselves subject to credit rationing from banks. Our model simulations show that in the absence of budgetary flexibility to adjust expenditures, raising tax rates too high drives firms into the underground economy, thereby reducing the tax base. Aggregate investment in the economy is lowered because of credit rationing. Taxes that are too low eliminate the underground economy, but result in unsustainable budget and trade deficits. Thus, the optimal rate of taxation, from a macroeconomic point of view, may lead to some underground activity. We note, in particular, that incorporating a VAT without any other tax reductions greatly reduces the tax compliance of the service sector. We have applied our model to Pakistan, and have calibrated our model to an 8 year period from 2004-2011. We note that it gives a reasonable approximation of Pakistani macro data. We then use a sectoral breakdown of tax data generated by the model to estimate tax gaps on a sector by sector basis. We note that certain sectors are currently paying taxes below their potential, while others may be above their tax potential. These sectoral gap estimates may be used as indicators of where greater tax enforcement efforts should be directed.

A Computational General Equilibrium Approach to Sectoral Analysis for Tax Potential: An Application to Pakistan