Measuring the underground economy with the currency demand approach: A reinterpretation of the methodology, with an application to Italy

We contribute to the debate on how to assess the size of the underground (or shadow) economy by proposing a reinterpretation of the traditional Currency Demand Approach (CDA) à la Tanzi. In particular, we introduce three main innovations. First, we take a direct measure of the value of cash transactions-the flow of cash withdrawn from bank accounts relative to total non-cash payments-as the dependent variable in the money demand equation. This allows us to avoid unrealistic assumptions on the velocity of money and the absence of any irregular transaction in a given year, overcoming two severe critiques to the traditional CDA. Second, in place of the tax burden level, usually intended as the main motivation for non-compliance, we include among the covariates two direct indicators of detected tax evasion. Finally, we control also for the role of illegal production considering crimes like drug dealing and prostitution, which-jointly with the shadow economy-contributes to the larger aggregate of the non-observed economy and represents a significant component of total cash payments. We propose then an application of this "modified CDA" to a panel of 91 Italian provinces for the years 2005-08.