Currency demand and the growth of the underground economy in Canada, 1991-1995

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Abstract
The extent to which the recent introduction of a value-added tax in Canada contributed to the growth of the underground economy remains controversial. If underground economy growth led to increased currency holdings and shifted the currency demand function, forecasts for the period after the introduction of the tax should tend to underestimate currency holdings. Using a cointegration-based error correction mechanism in vector autoregression models, currency demand is estimated using quarterly data for 1968–1990 and dynamic forecasts are made for 1991–1995. On average, currency demand is underpredicted, but by a small amount. The results are consistent with an increase in the underground economy of between 0.01 and 0.3% of GDP as a result of the new tax. If changes in marginal direct tax rates are considered, the underground economy may have grown between 0.1 and 0.7% of GDP in 1991–1995.