This paper focuses on the nexus among selected firm-oriented fiscal policies (tax relief and capital subsidies), physical capital accumulation and underground activities. In particular, we examine the implications of fiscal policies aimed to support firms, such as capital subsidies and tax allowances, in the presence of an underground economy. In addition, we investigate whether the technology structure of “hidden” production may facilitate or counteract the effects (the effectiveness) of the fiscal policies on firm behavior. Subsidies programmes and tax advantages for “infant” industries or depressed areas are often justified because the industry is not competitive enough and prices do not show full flexibility. However, granting capital subsidies and tax allowances to firms has also important implications for underground activities and tax evasion. Underground activities occur in many countries, and there are significant indications that this phenomenon is large and increasing. The estimated average size of the underground sector, as a percentage of total ɢdp, in the late 1990s was about 17 percent in oecd countries (Schneider and Enste, 2002).
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