Fiscal multipliers and unreported production: evidence for Italy

This paper analyzes the effects of fiscal policy in Italy by defining a regular GDP measure constructed as GDP net of government expenditure and evaded VAT base.Within aVECframework, two alternative approaches are used in order to identify fiscal policy shocks: on the one hand, the standard Cholesky identification, and on the other hand, the “agnostic sign restriction” approach. The results reveal that we cannot rely upon the estimates of fiscal policy multipliers in countries with a sizeable unreported production, unless the dynamics of the hidden and regular components of the GDP are disentangled. Changes in public spending and the tax rate generate a reallocation from underground to the regular economy which contributes to obscure the spending and tax effect on totalGDP. In addition, the restrictive policy harms economic growth for the perverse effects that impinge on the regular–irregular dynamics of the GDP, highlighted by our model. Finally, the interaction between regular and unreported production demonstrates that the link between the two sectors is very harmful in the long term, since there is strong evidence that shocks to the unreported production have long-lasting negative effects for the regular economy.