Currency Demand, the Subterranean Economy and Tax Evasion: The Case of Tanzania

Abstract. This paper estimates the magnitude of, and changes to the subterranean economy in Tanzania, as well as its adverse effect on tax revenue during the 1966-2015 period. To achieve this objective, the paper applies currency -ratio due to Gutmann and the traditional currency-demand approach à la Tanzi. Despite their differences, both approaches suggest the existence of a substantial size of the subterranean economy in Tanzania. This persistent large size of the subterranean economy is an important consequence of economic and social policies over the period of study. Using the currency-demand approach, the paper finds that tax evasion is positively correlated with the size and growth of the subterranean economy. Indeed, results show that the size of the subterranean economy and the magnitude of tax evasion over the 1966-2015 period, are on average, 32.7 percent and 6.6 percent of official GDP respectively. The implication of the results is that minimization of the size of the subterranean economy is necessary for effective addressing the problem of tax evasion and subsequent fiscal deficit in the long run.Keywords: Subterranean economy, Currency demand deposits, Currency demand approach, Tax evasion.JEL. E26, E41, H26, K42, O17